The impact of inflation on private equity M&A
Michael West
by Michael West
Inflation is a sustained increase in the general price level of goods and services in an economy, which as a result can have a significant impact on the private equity M&A environment. After a period of a steady rise in inflation, businesses will be faced with higher supply chain costs and narrower profit margins, consequently impacting their bottom line.
The real impact on the private equity and M&A industries in the eyes of fund managers is higher borrowing costs for leveraged buyouts, and lower portfolio company valuations, which eventually impact investor returns (IRR). As the cost of debt rises, both fund managers and investors have to reposition their investment strategy to hold off on big ticket, leveraged buyouts, and refocus their growth strategy.
A common mechanism is to purchase smaller companies at lower valuations and fold them into a current portfolio of companies. An alternative and perhaps less common way to drive portfolio value is to explore ways of optimising margins and revenue returns.
In hindsight the pivot will be a combination of the two: refining operating leverage by generating organic growth to drive real improvements in EBITDA, as well as harnessing smaller and more lucrative opportunities to maintain company portfolio multiples during periods of slow growth.
In addition, the cost of borrowing has a real impact on company valuations. The increase in the cost of debt has negatively ramifications on the valuation of a portfolio company. The quantifiable impact to the valuation will depend solely on the portfolio companies’ gearing (the amount of debt – in proportion to equity capital – that a company uses to fund its operations). If all else remains the same, highly geared portfolio companies are likely to witness the greatest impact to their valuations.
Inflation can also have an impact on M&A deals through its effect on the financing of a transaction. When acquiring a company, the fund often needs to raise a mix of financing to cover the purchase price. Rising inflation and consequently interest rates can influence M&A and valuations in a variety of ways:
Structured-debt financed acquisitions are more costly;
Raising new equity takes extended periods of time at higher hurdle rates; and
Portfolio company divestment becomes more difficult and time consuming.
In conclusion, the anticipated impact of inflation on M&A deals is complex and can vary depending on the specific circumstances of a transaction or private equity fund. For many private equity firms this means a repositioning of investor mandate and a focus on improving EBITDA to drive and maintain investor returns. Likewise, key to deal success is the need for robust due diligence with an emphasis on valuation inflationary impacts.
Michael specialises in corporate finance with a focus on mergers & acquisitions and transactional services including due diligence, financial modelling, and valuations. He has over 3 years of combined experience in both the domain of private equity as well as advising SMEs and large publicly listed entities. Contact Michael.
GCG member firmNolands CapitalCape Town, Durban, Port Elizabeth, JohannesburgSouth AfricaT: +27 21 658 6600Advisory, Auditing & Accounting, Fiduciary & Estate Planning, Tax
Nolands Capital is an international auditing firm located in eleven offices in Africa. Nolands employs over 200 people and focuses on building relationships with its clients. The company prides itself on being “not ordinary” and on its ability to integrate services that provide the best possible solutions.
