Private equity faced full effects of inflation in 2022: Story of the Year

Rising inflation has had significant ramifications for private equity in the past year. Even so, there are silver linings to be found.

Rising inflation has had significant ramifications for private equity in the past year following a decade of ideal dealmaking conditions.

A key implication has been the increase in interest rates across the board, which we will look at in more detail in an upcoming year-end story. Such hikes have increased borrowing costs while simultaneously causing a slowdown in dealmaking.

The volume of buyout-backed deals and exits dropped in the first half as inflationary pressures started to hit, Bain & Co noted in its Private Equity Report Midyear 2022 report. The deal market started the year off strongly, with $512 billion-worth of transactions taking place during the first half and an average deal size of close to $1 billion.

However, Bain & Co warned in its report that the outlook for the second half looked different. “Deal pipelines in many sectors are softening, in technology especially, and debt is becoming more expensive,” it noted. “Facing losses on loans committed before the slowdown, banks are asking a lot more questions about a company’s exposure to inflation and rising rates, making it harder to close transactions.”

Throughout the year, managers have been assessing the affects that rising inflation will have on portfolio companies.

“How you manage your cost base against the inflationary pressure your employees have – energy and food costs increasing, for example – and what that means for your ability to be able to put through price increases and how accepting your customers area is a key concern of ours,” one London-based GP told Private Equity International in July.

How private equity firms will invest in a high-inflation environment is a question that has also been on the minds of many senior executives this year. Many have voiced their concerns to PEI that a considerable number of private equity professionals – including some deal professionals in senior roles – have never had experience of investing in a downturn.

“I don’t know that the skills developed over the past 10 years will equip people well for the new environment if they’re not rigorous about redoing their models, re-examining their assumptions and setting up contingency plans,” said one veteran banker.

Joe Giannamore, who founded Europe-based financial services firm AnaCap Financial Partners, advised those who have not had the experience of investing in a downturn to “read your history, accept that debt levels will reduce, multiples will reduce, that there may be value at investing in this point in time, although your portfolio from the recent past may suffer because it just simply can’t hit the same heights”.

Hedge your bets

Although the negatives are obvious, there may be some positives to come out of today’s high-inflation environment.

Inflation and rising interest rates will mean new established pricing on entries – a good thing after years of high pricing, according to one consultant to institutional investors. The consultant added that this would create “sanity for investors” and better overall vintages.

While others may not have the same luck, infrastructure, credit and secondaries managers are expected to benefit as LPs look for pockets of private markets that are seen as hedges against inflation.

Beyond their defensive characteristics, one senior investment adviser told PEI there are “more flavours of ice cream” when it comes to opportunities to invest in infrastructure and credit.

“Twenty years ago… private credit wasn’t even a real thing – it was distressed or mezzanine, which is very different than the senior collateralised lending we’re talking about in private credit today,” the executive said. “You’re seeing that sort of confluence of things where, yes, it’s an interesting strategy in infra and credit because of the rate environment, but at the same time, the ecosystem of available funds, managers, financing capabilities and skill sets is just more developed and more accessible for more investors.”

As investors look for liquidity in this cash-strapped environment and buyers attempt to keep hold of their prized assets, the secondaries market is another area that is seen as an inflation hedge.

There’s no shortage of supply when it comes to secondaries opportunities, with a PJT Partners report finding there is over $150 billion of live transactions and deals forecast to be launched in the near term, affiliate title Secondaries Investor reported.

Indeed, LPs are warming to the idea of backing a market that could provide them with the liquidity they need: according to the results of PEI’s LP Perspectives 2023 Study, over half (56 percent) of LPs plan to find the cash to commit to private equity secondaries funds over the next 12 months – the highest proportion of respondents to express their interest in the market since 2019.