How should PE navigate high inflation?25th October 2022
This is the first time that many of today’s investors will be operating in a period of high inflation. But with the IMF expecting inflation in the OECD to exceed 9% in 2022, private equity must get to grips with navigating the inflationary threat both from an investment and portfolio management perspective.
COVID lockdowns effectively put the global economy on ‘pause’, disrupting supply chains across most sectors. Imbalances in supply/demand have been compounded by uncoordinated easing of restrictions. China’s zero-COVID policy, for instance, continues to create bottlenecks and shortages, which have then been amplified by its stimulus plans. The Russian invasion of Ukraine has triggered energy prices to rise to unprecedented levels contributing to even higher levels of inflation. To address this, Central Banks have increased interest rates sharply, negatively affecting investment and slowing the global economy, with some countries on the edge of and even in technical recession. Yet, even if inflation rates decrease and situation improves, this does not mean deflation, and prices are expected to remain high.
High inflation can have important consequences for PE returns, destroying value rapidly by affecting revenue and EBITDA growth. Continued uncertainty means PE funds considering an investment should assess as a priority whether a business is well-placed to operate in a high-inflation environment. Ultimately, businesses with significant pricing power that can protect themselves from inflation can create a competitive advantage
Key questions that should be considered include:
How important is the business to its suppliers?
The balance of power between stakeholders in the value chain will determine whether a business must absorb the impact of rising costs. Supplier concentration should be considered alongside share of suppliers’ revenues. Businesses that are key customers for their suppliers will be better placed to negotiate and recover increased input costs.
How critical is the product/service to customers? How much value-add does it deliver?
Similarly, spend on products and services that are critical to operations is typically non-discretionary. Ability to pass on costs while maintaining volume is greater as a result. This is even more true for products and services that account for a relatively low proportion of spend in comparison to the total cost base.
How does it contract with customers?
While under ‘normal’ circumstances, long-term contracts are attractive and provide revenue visibility, in a high inflation environment, businesses can be stuck in less profitable contracts if there are no provisions for significant price increases (and/or fixed vs variable contracts). On the flip side, short/no contracts coupled with high/rising prices can lead to customers switching more frequently. Assessing right-to-win in this context is important to understand whether the business will experience higher customer churn or benefit and gain market share.
Is it sophisticated in its approach to procurement?
In a high inflation environment, businesses can differentiate operationally based on how sophisticated and agile its procurement function is. Among other factors, the ability to identify alternative suppliers, use of brokers, ability to run competitive tender processes, or hedging capabilities can point to businesses that will better deal with high input prices.
Is the business at risk or could it benefit from any regulatory intervention?
High inflation may lead to regulatory intervention which could affect the business model of a target. It is important to assess the likelihood and risks/benefits of government support plans, regulatory-driven wage increases and price caps.
Strategy and value creation for portfolio companies
Understandably, these considerations may not have been front of mind for previous portfolio investments. High inflation means businesses are operating in a reduced visibility environment for which they may not be well prepared for. Market conditions are rapidly evolving with uncertainty regarding input costs, competitive pricing and ongoing share gain/loss. Uncertainty often leads to slower decision-making around investments and/or competitive response. This can negatively impact EBITDA and growth for the business as well as returns for the fund.
There are several strategic considerations that funds and management teams should think about to better navigate the current high inflation environment and create value for the business.
Is there an opportunity to substitute some inputs for slightly more affordable, lower quality alternatives?
Businesses are typically used to opting for cheaper inputs where it does not impact product/service performance. However, repositioning a product or service towards a more value for money price point can enable share gain in an increasingly price-conscious environment, while maintaining or increasing margins. This is worth considering even at the expense of slightly lower product/service performance.
Can the range of product/service be rationalised to drive cost-savings?
There is a cost to the complexity of maintaining a long tail of low volume products. Assessing the product portfolio to identify retirement opportunities can help reduce the cost base, improve the throughput of production facilities, and focus sales on growth/margin leaders. This also applies to low volume but high cost to deliver for service businesses.
Is there an opportunity to take advantage of the market price movement to raise prices?
Raising prices in an uncertain environment is highly challenging. The lack of visibility on what the competition is doing can lead to higher customer churn and market share loss if a blanket price increase is implemented. The approach often needs to be nuanced. It is key to first understand clearly what value is delivered to customers in order to assess the price elasticity across the customer base and product portfolio. The company’s pricing power can then be identified, allowing either to increase prices above market average or to gain share through not prices as much as competitors.
Can product positioning be adapted to support risk averse decision makers and gain market share?
In an inflationary environment, customers tend to be more risk-adverse which can make value for money offerings more attractive than premium offerings. This is particularly true for high value products/services where the customer is taking risk when selecting a new supplier. Adapting the revenue model to reduce the risk of adoption and the switching costs can help gain share.
Although a highly inflationary environment may be daunting for many, having a clear view of the key investment considerations and opportunities available can help business leaders and investors navigate through it successfully.
If you would like to discuss any of the points raised in this article, please get in touch.