As dealmakers debate whether the recent uptick in inflation will be transitory or sticky, the implications for private equity are coming into focus. Portfolio company operations will need to become streamlined, inflation-proof industries could see more interest, and a desire to reduce financing costs could dampen an already hot market.
“There’s no let down in activity in the near future,” says PwC U.S. private equity lead Manoj Mahenthiran. “The only thing that could put a damper on that is consistent inflation, if it were to creep up and interest rates edge upward, you’d see dealmaking slow down a little bit for returns and multiples paid.”
Private equity has historically responded to the rate hikes accompanying higher persistent inflation by pulling back on deal multiples. The impact could take time to manifest, though, given tailwinds that have created a sellers market at least two years in the making.
In the meantime, bridging the bid-ask gap in uncertain times could continue an ongoing trend: the rising use of earnouts shows the way. Nearly a fifth of mergers in SRS Acquiom’s 2021 M&A Deal Terms Study included an earnout mechanism compared to 15 percent in 2019. The study covers 1,400 deals with a private target the closed from 2016 to 2020.
The size of those contingent payments is equally significant. Last year, sellers could earn a median of 39 percent of deal value via earnout, up from 18 percent the previous year. That’s the highest figure since 2017’s 43 percent of deal value. For acquirers with a more constrained view on capital structure, the earnout could continue to prove the avenue of choice.
There’s some indication that operational improvements needed to maintain an edge in a persistently high inflation environment are already being implemented. When Mahenthiran told Mergers & Acquisitions about recent private equity trends earlier this week, he noted firms are already upskilling talent to handle robust deal flow. Could the same approach to data and tech filter down to portfolio company level’s emphasis on cash flow management?
Financials sponsors could also pivot to safe-haven plays in oil & gas and commodities to target inflation-resistant growth.
The impact of higher borrowing costs could take time to manifest, and be partially mitigated through earnouts that have already become more common. Watch deal flow in commodities and the frequency of contingent payouts for signs that private equity is betting on prices staying high for longer.