There’s one word defining investor sentiment in 2021: inflation. Stock and bond markets have been tying themselves in knots trying to predict the state of play. Tech shares in particular have taken a knock of late. This is because these speculative assets are valued today on tomorrow’s expected earnings, making them especially sensitive to the eroding purchasing power of currencies.

But inflation generally acts like gravity across most sectors. Rising input costs and labour expenses can depress profitability, and with consumers feeling the pinch they tend to spend less, weighing on earnings growth. 

One of the main questions being asked today is if recent price movements are transitory, caused by supply shortages as the economy kicks back into gear, or whether they are here to stay. Central banks believe it’s the former but are nonetheless adopting a more hawkish stance. Last week, the Federal Reserve upped its inflation forecast for 2021 to 3.6%, from 2.4% just three months earlier. It also expects two possible rate hikes to follow in 2023, when previously it was anticipating taking action in 2024. Things are certainly heating up.

A private equity view

Regardless of whether this is a temporary phenomenon or spells something longer lasting, spurred by the unprecedented monetary expansion and fiscal response to the pandemic, private assets will be affected just like their publicly traded cousins. If earnings margins come under significant long-term pressure, this could eat into returns.

This is where GPs’ deal selection will become even more critical. Inflation is less of a concern for businesses with strong products and intellectual property. This is because they can pass costs along to customers without denting their revenues. On the flip side, companies with undifferentiated, me-too products and services will struggle as they have to compete on price.

It’s this pricing flexibility that will pay off. Any assets with fixed income streams, like long-term leaseholds, are going to suffer through any period of sustained inflation. Real estate funds will have to revise their strategies accordingly.

For buyout managers, there is more incentive than ever to back companies benefiting from strong secular tailwinds that are likely to see compounding growth over the coming decade. Big, definitive themes like renewables, electric mobility and emerging tech are likely to pay off handsomely in the long term, even if they face shorter term macroeconomic pressures. Growth is what will ultimately count.

Paying one’s debt

Other points to consider for the PE industry are financing and fundraising. A period of inflation can be a boon for private equity’s leveraged model, by making existing debts gradually less expensive as the value of a dollar or euro gradually erodes in real terms.

However, if inflation runs away then interest rates will have to rise to keep prices in check and to prevent the economy from overheating. The cost of leverage will inevitably rise as rates are increased, meaning portfolio companies will have to take on less debt to be able to service their liabilities and maintain an appropriate level of default risk. This has the potential to dampen returns for GPs that rely heavily on debt.

From a fundraising perspective, higher rates should cool PE fundraising as investors seek the improved returns available from lower-risk yielding assets, such as investment grade bonds. Weaker-performing GPs will be the most sensitive to this effect since they have a poorer value proposition. Managers that consistently deliver outsized returns are likely to continue to see their funds fully subscribed.

Burden of proof

The effects of inflation and subsequent rate rises are complicated and multivariate, impacting different sectors of the economy in various ways and to varying degrees. The same is true for private equity, not least because PE funds are simultaneously buying and selling. What inflation gives with one hand, it can take with the other.

For example, in the event of rate increases the value of risk-on assets tends to be negatively affected. Any fall in multiples will make exit gains less impressive. The other side of this coin is that GPs could see more buying opportunities.

Higher rates could prove to be a positive in other ways. If the amplifying effects of leverage are diminished due to the higher cost of capital, GPs will have to rely less on financial engineering and more on “true” value creation, something LPs want to see in any case. This could separate the wheat from the chaff.

Over the past decade prices rose at their lowest rate since the Great Depression. It is possible that we are facing a fundamental departure from this low inflation, low-rate period. But really PE’s challenge is the same as it has ever been: pick great companies and help them to grow. If anything, a period of inflation will be a true test of private equity’s abilities—and of investors’ sense of judgement in their fund manager selection.

Do you have any views on what inflation means for PE? Think we’ve missed anything or misjudged the potential implications? We’d love to hear your thoughts.