Inflation Roundup from the Ground Up – Part 2

“Inflation is taxation without legislation.” -Milton Friedman (economist)

If you’ve studied economics or followed David Bahnsen’s writings for any time, you’ve likely heard of Milton Friedman. Don’t hold it against me, but this may be the first time I’ve quoted an economist in Alt Blend (I’m also not checking to see if that statement is accurate, so the world will never know). Either way, the quote’s sentiment is undeniable, and consumers have been feeling the pinch of inflation lately. As we laid out in Part 1 of this topic, inflation and the higher interest-rate environment also affect many alternative investment strategies. Today we’ll continue the mission of examining the Alts landscape to learn more about what those effects are and what actions are being taken. Here we go!

Private Equity

We talked about real estate in Part 1, which is really a subset of private equity (it is, after all, equity ownership that is private), so we should notice some similarities with what we generally think of as “private equity” – which involves buying and operating private businesses, rather than buying and operating private real estate.

As we saw with real estate, higher interest rates increase borrowing costs and reduce the prices buyers are willing to pay for a given property. Since private equity is famous (or infamous) for the amount of leverage (debt) used in buying businesses – ignoring, for a moment, all other factors that go into a transaction – higher rates imply private equity managers (aka “PE sponsors”) reducing the prices they are willing to pay for acquisitions. Also, in addition to the higher financing costs, keep in mind that the target companies may be less profitable/valuable because of other inflated obligations, like labor and materials costs.

While that all sounds pretty dire on the surface, as we saw with real estate, there are measures managers can take to help mitigate risk and even benefit from these types of environments, such as:

  • Owning leading businesses: the best companies in a given niche generally have better pricing power than the competition. While it’s a balancing act – as prices cannot be raised to the point that demand is crushed – feedback from managers (thus far) is that they have generally been able to pass through higher costs to consumers without materially affecting demand.
  • Focusing on critical components: food supply is a matter of life and death for all humans, but we take it for granted in the developed world how many different ways we can source food. Humans can also eat thousands of unique foods, which is handy for survival. If one particular grocery store or one type of food ceased to exist, it would represent a minor inconvenience. Similarly, various inputs, like materials and labor, are “food” for many businesses. However, those needs may be VERY specific (in contrast to humans and our food options), and the inability to acquire those inputs at the right costs can mean life or death for a given company. Thus, proactive talent retention and supply-chain diversification strategies (including hedging freight and material costs) can help reduce risk. Research and development efforts can also uncover new ways of creating products and utilizing substitute materials for improved adaptation when needed.
  • Being responsible with debt: companies that were able to lock in long-term financing at the low rates of the recent past are now saving significantly on debt-service costs (just like people who should now feel very good about the 30-year mortgage @ 3% they obtained a couple of years ago). Most businesses have some exposure to currently higher rates, so keeping debt ratios at modest levels will help them to survive and thrive during these more challenging times. To those who took on too much floating-rate debt when rates were low (and whose interest payments are now subject to unaffordably higher rates): it was nice knowing you.
  • Value creation and evolving trends: Again, with real estate being a helpful analogy for most readers, imagine for a minute that we’re in a challenging housing environment (this doesn’t require a stretch of the imagination, as all you have to do is look around at the “affordability headwinds”). However, transactions will still occur in this more complex situation, as not all markets, property types, or specific opportunities are created equal. The same is true of businesses, and it’s important not to paint the “business environment” with a broad brush. Downturns can take an emotional toll on investors, but they are when better deals can be made. As this article points out, private equity investments made at times of lower valuations (i.e., better entry points) have historically resulted in better returns.
  • Focusing on resilient companies: some products and services are needed regardless of the environment. Others are “nice to haves.” One of those two tends to be more recession-resilient than the other, but I’ll leave you to guess which. A below-the-radar example I find interesting is that of a private school-bus service for special needs students in the Midwest – with government-funded long-term contracts. These types of businesses remain largely uninterrupted whether rain, shine, boom, or bust. The tradeoff of those lower-volatility characteristics? Less upside potential in recoveries. After all, There’s No Free Lunch, but many investors are happy to own such things.

It’s all about planning

Companies (and PE sponsors) are working to insulate margins and cash flow for continued growth and profitability by focusing on factors like the above. Similar to one’s personal financial situation, a lot of this comes down to planning for adversity in advance, as planning for only the best-case scenario is planning to fail. By expecting difficult future environments and underwriting acquisitions with downside scenarios in mind, the better PE sponsors can mitigate much of the current challenges, even if it worsens (e.g., assuming continued multiple contractions and declining valuations) and/or lasts for longer than anyone anticipates.

Next up: the credit side of the picture and maybe even some arbitrage. Stay tuned.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

 

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York.