Rising oil prices have market commentators speculating that higher inflation could be here to stay. And it’s not just Russian bellicosity stoking the trend. Tight labor markets, supply chain stress, and threats to orderly price growth are all multiplying, and that could spell trouble for private equity.
An accompanying selloff in long-term bond yields could decrease investor commitments to private equity and increase finance costs, according to Preqin’s global private equity report. “Most critical of all, the market may assign lower multiples to deals as future earnings are discounted at a higher rate,” the note reads.
Credit fund sources have warned me of placing too much weight on inflation as an M&A risk, saying the real culprits for rising prices are supply chain bottlenecks. Let logistical mavens, technology, and a post-Covid shift in demand for goods ease congestion and inflation will last a year tops, they say. But rising oil prices adds a new element to the equation that could send sponsors girding for a longer-term inflationary environment.
What should the market expect if this materializes? The impact to private equity comes in different flavors. First, financing costs are expected to rise as the Fed adjusts rates to tame inflation. Next, as the market bakes in expectations of further rate increases, dealmakers could pump the brakes on deal valuations. Future earnings could get discounted at a higher rate, lowering the attractiveness of rich multiples.
Good news for dealmakers eager to ink transactions at reasonable multiples—at least those who have already raised funds, as increased pricing pressures are likely to weigh on returns, and eventually on fundraising efforts.