GPs are reassessing strategies amid the threat of inflation

While inflation has caused GPs to look hard at portfolio companies' pricing power, it is not necessarily bad for private equity in the long run.

When the numbers came in, many – including the Federal Reserve – thought they were transitory. Now doubt is beginning to set in.

On 10 November, the US consumer inflation rate hit 6.2 percent, the highest level since 1990. Then, at the start of December, the Bank of England said it expected the UK’s inflation rate to rise to 5 percent in Q2 2022, also the highest level since the early 1990s. The situation is replicated in economies across the world.

Covid-impacted supply failing to keep up with demand and a personal savings glut brought about by government assistance are two commonly cited reasons for the spike.

In the private equity world, talk of inflation really picked up in early April when Blackstone‘s chief operating officer Jonathan Gray described it as the “major risk” in the market today. The asset manager is doubling down on high-growth sectors such as technology, life sciences and green electrification to try to outrun inflationary pressure.

“What we’re trying to do is position ourselves for things that look and feel as the least bond-like as possible,” Gray said.

The threat of prolonged inflation has caused GPs to think carefully about the pricing power of the businesses they buy. To what extent can a portfolio company pass on higher costs to others in the supply chain without driving their custom elsewhere?

According to John Stewart, founder and managing partner of MiddleGround Capital, in remarks reported by Private Equity International, B2C investors have to be most wary as B2B providers often have the contractual right to pass along costs.

Co-founder of Thoma Bravo Orlando Bravo, meanwhile, contended – somewhat self-interestedly – that enterprise software products are resilient, PEI reported in May. They are so much more valuable than their price in the market indicates that there is plenty of headroom for additional charges, he said.

A survey of GPs carried out by PEI in June indicated short-term concern but sustained optimism in the longer term. Most respondents believe the bout of inflation is transitory and that the long-term strategy of PE funds and their active ownership model should help portfolio companies thrive in the long run.

“There is always some sort of macroeconomic or geopolitical disruption to consider,” Adam Howarth, Partners Group’s head of portfolio management Americas, told PEI in the survey.

Even if inflation is not transitory, private equity is likely to benefit in some way. In October, no less a figure than BlackRock chief executive Larry Fink said that inflation was here to stay, driven by a structural economic change from consumerism to job creation, rising wages, and the transition to a zero-carbon economy. As inflation eats away at returns, he said in the interview with Reuters, the flow of capital to alternatives will only strengthen.

“We’ve built up alternatives platforms and raised another $100 billion of gross capital over the last five years,” said BlackRock president Robert Kapito, on the firm’s third-quarter earnings call. “And we expect to raise a $100 billion more in the next three years.”