Buyout Funds Are Unlikely to Escape Inflation’s Pain

Dealmakers have slowly found themselves trapped in an environment in which rising prices pose real threats to the valuations of their target companies.

Illustration by II

Illustration by II

There’s no nice way to put it: Dealmakers have been besieged by inflation.

After a banner year for the mergers and acquisitions markets, dealmakers have slowly found themselves trapped in an environment in which rising prices pose real threats to the valuations of their target companies. And without valuation certainty, they’re in no rush to make deals happen.

[An] increased level of uncertainty slows the pace of deals,” said Sean McKee, who leads public investment management at KPMG. He added that inflation can have a negative impact on valuations by bringing down cash flow expectations, or by raising borrowing costs. For private equity firms specializing in leveraged buyouts, inflation means that they have to “get a better deal to cover rising required rates of return,” which could lengthen the deal searching process, according to McKee.

It’s almost impossible for buyout funds to escape the rising inflation unscathed. Theoretically, funds that have secured low borrowing rates should be in a good position in an inflationary environment, but it’s unlikely that the low rates would carry them through consecutive rate hikes this year. “[Funds] are borrowing based on deals, and [they] don’t do all the deals all at once,” McKee told Institutional Investor. “Their financings tend to change over time.”

Investors can also expect more uncertainty in future cash flows amid the current inflationary environment. For one, companies facing rising prices in supply chains will see their profits shrink if they fail to pass the costs on to consumers. In the middle market, profitability has already taken a dive, with rising costs taking a bigger bite out of revenues in the first quarter. According to Craig Arends, managing principal of the private equity practice at the accounting and consulting firm CliftonLarsonAllen, the decreasing profitability means that M&A targets are not “being disciplined and [practicing] good business hygiene.” Arends added that globalization has helped keep costs and inflation down in recent decades, but business owners will need to reassess their cash flow prospects if they can’t keep sourcing raw materials from cheap importers.

Chris Legg, senior managing director at Progress Partners, a merchant bank based in Boston, expressed the frustration that many are feeling. “Just as we were working through Covid supply chain challenges, we now have a war in Ukraine and the knock-on effects of new supply chain challenges that are adjusting to a de-globalized future,” he said. The Russia-Ukraine conflict alone has disrupted the supply chain for chips and electric cars, he explained, as Russia was a top exporter of palladium and nickel. And he added that unlike the Covid disruption, which will end in the foreseeable future, the changes caused by geopolitical tensions are just beginning. “Some parts of the world will never be part of the global structure that they’ve been in for the last 30 years,” he said.

According to Legg, rate increases from the Federal Reserve are also a sign that inflation is a looming risk to the M&A market. “The Federal Reserve seems determined to use interest rate hikes to tame inflation by end of year,” he said. “But that in itself brings on additional risk, [because] most businesses have been operating for the last decade in a goldilocks environment of low interest rates and low inflation.”