Inflation Is Redefining Private Equity’s Perception of Value

Rising interest rates and persistent inflation have changed the way private equity investors gauge value in closely held businesses. Understanding what private equity firms look for in an inflationary environment can help business owners position their company as an attractive prospect for investors hoping to unlock additional value.

Shifting Perspectives and Lower Valuations

As interest rates rise, the increased cost of borrowing erodes potential returns on investments. Downward pressure on valuations is a predictable result, which is beginning to be seen across most sectors. Investors are understandably more cautious in this increasingly challenging environment.

And yet, there’s no lack of liquidity in private equity markets, which tend to perform well during recessionary periods. The strategy is simple: Buy when valuations are lower and let the inevitable economic recovery augment the value, which investors hope to make even better through strategic management.

The takeaway for small business owners is this: The money is out there, but investors are viewing closely held companies through inflation-tinted glasses. The obvious question, then, revolves around what private equity investors want in this environment.

Increased Focus on Essentials

Besides the perennial basics such as a well-run business with solid, accurate financial information, inflation shines a spotlight on companies that can withstand intervals of rising prices. Increases in costs for raw materials, energy, transportation, business services, and skilled labor often force companies to raise sales prices just to maintain current margins. That’s before considering pricing as a profit lever. Therefore, private equity investors want confidence that a target company has the pricing power to pass on rising costs without the risk of losing market share.

Essential products and services — things consumers will pay for even when prices rise — are a prime target for investors during inflationary times. Brand leaders, too, often hold a better position when prices are rising, since brand-loyal buyers are more likely to keep coming back despite rising prices.

These types of companies reduce the risk for investors if inflation sticks around for years. If inflation proves more transient, then so much the better; these businesses can deliver value for investors no matter how the Fed’s attempts to rein in inflation play out.

Who Benefits?

During periods of inflation, another prime consideration for private equity firms becomes: Who is benefiting, in broad terms, from the macro forces putting pressure on the economy?

Rather than zooming in on the challenges of a particular sector or moment, investors often prefer to think about the big picture. Viewing the scene from 30,000 feet lets them direct dollars to areas that stand to benefit from overall trends.

Businesses of every size and in almost all sectors are struggling to attract and retain the skilled labor they need. Remote work is not going away, and the impacts of fossil fuel use are becoming more visible with each passing season. These forces vary in their impact for individual businesses and sectors, but they’re global and omnipresent, with little chance that they’ll go away.

Given those facts, private equity investors might look with special interest at companies that can become more profitable through increased automation — and those that facilitate automation for other businesses. The latter category could include everyone from efficiency experts and production consultants to manufacturers of automated equipment and businesses that provide installation services.

Investors might likewise have a positive outlook on a similar range of businesses related to decarbonization, energy efficiency, workforce sourcing, secure digital access, remote work environments, and all the other needs that stem from today’s big-picture trends.

Disaster-proofing

Private equity investors also look for businesses that are less vulnerable to widespread challenges. For example, a company with minimal labor needs is insulated against rising labor costs and hiring headaches.

A supply and distribution network that resists fracturing under stress offers its own form of reassurance. If your company is vertically integrated and relies on local, geographically concentrated networks, it’s far less likely to suffer the negative consequences of protracted supply chain snarls. While that particular difficulty may be easing at long last, investors and business owners are now keenly aware of the disadvantages that accompany globalization. Organizations with built-in protection from future challenges of a similar nature look pretty appealing right now.

There’s one more key consideration at the top of investors’ wish lists these days: solid growth potential. Profitable businesses are attractive investments in any business climate, of course. Still, inflationary pressures highlight the need for a clear route to added efficiency and increased profitability.

With inflation still strong and interest rates not poised to drop soon, private equity firms may see your business as a shining star if it offers what investors are seeking: consistent cash flow, a business model that’s resistant to inflation pressures, and a long-term strategy to help the company thrive for years to come. Your CRI advisor can help you achieve all three of these critical elements.