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Winna Brown     

You’re listening to the EY NextWave Private Equity Podcast. I’m Winna Brown and I’m your host.

So, Greg, inflation is top of mind for everyone right now. In the US, it’s actually at a 40-year high. Can you maybe zoom out a little bit for us and speak to how inflation is playing out at a global scale?

Gregory Daco

Yeah. I think it’s important to understand the global backdrop when it comes to recent inflationary trends. The key underpinning of the record-high inflation figures that we’re seeing right now have really to do with a supply and demand imbalance, but the nature of inflation around the world is somewhat different. Overall, the background story is that we had very strong demand, a very rapid rebound from the COVID-19 crisis and supply has taken a bit more time to respond to that demand. That’s really the key US story, where there was a lot of fiscal stimulus to get us out of the COVID-19 crisis, and supply is taking a bit more time to respond. In Europe, there is a little bit more of an energy dynamic in terms of the inflationary trends, where higher energy prices are really pushing up inflation to record high levels. And then in Asia, it’s much more of a supply story, where supply chain constraints are affecting inflationary dynamics. Now in this global context, we also have global developments. The war in Ukraine is putting upward pressure on commodities prices against this inflationary backdrop. We have renewed lockdowns in mainland China, which are also leading to additional inflationary pressures. So, it’s a broad context with many different pressures leading to this multi-decade, high-inflation environment that we’re currently experiencing.

Brown  

So out of curiosity, I mean, you’ve obviously studied inflation, you know, for many years. Have you ever seen this kind of cross-section of factors play out this way before?

Daco     

I think we have to go back to the ‘70s to find something that was comparable, because we are in an environment where we’re seeing an odd combination of a global economy that is gradually cooling, so growth is slowing, and at the same time we have inflation that is firming, that is rising. So that unusual combination of faster inflation in an environment where economic activity is cooling is quite unusual. And that brings back the bad memories from the 1970s, where we had this so-called stagflationary shock, which was similar in nature, though not identical, where you saw essentially high inflation which was exacerbated by an energy price shock. And to some extent, that’s what we’re seeing today. We have an inflationary backdrop, and against this inflationary backdrop, we’ve seen a further rise in commodities prices. It’s not just energy. It’s not just oil and gas. It’s agricultural products. It’s fertilizers. It’s metal prices. All of these commodities are rising in terms of prices and they’re filtering through into the supply chain and leading to higher prices for final products, which ends up hurting US consumers and ends up hurting consumers throughout the world and creates a real dilemma for businesses in the sectors that are most affected, like the automotive sector, the advanced manufacturing sectors, where these price pressures are big because there is that question of pricing power. Do you pass on these higher input costs or do you take a hit in terms of your bottom line?

Brown  

Okay, and so, I understand the higher commodity prices, but we’re also hearing another area that’s being impacted and that’s around labor. I mean, you hear the headlines are the war for talent, the Great Resignation, and the real issues that are facing businesses. And in fact, what that’s doing is causing higher labor costs, which not dissimilar I guess to the commodities, you know, is due to high demand and low supply. So, can you help us understand what this fundamentally means for businesses given they’re facing high commodity prices and high labor prices? And how, more broadly, does it impact private equity investors who are looking to invest in businesses that are dealing with these two pressures?

Daco     

Yeah. I think it’s again important to come back to the origin of what we’re seeing in terms of labor costs. We, again, had a very sudden and massive sudden stop to economic activity because of the COVID-19 crisis, and that was also visible in labor markets throughout the world. In the US, we saw the loss of over 20 million jobs in March and April of 2020. Now, a lot of those jobs have come back. We’ve seen a comeback of about 95% of those jobs relative to pre-COVID-19 levels of employment, but they haven’t really come back in the same sectors as they were initially. So, there’s a bit of a mismatch again between that demand for labor and that supply of labor, which is still constrained by childcare issues, by early retirements, by the lack of immigration, by a number of factors that are essentially making today’s labor market and today’s labor supply very different from what it was before. That has led to rising wage pressures, because essentially potential employees have greater bargaining power. And initially, that wage pressure was seen at the lower end of the income spectrum, but we’ve seen it broaden out. So, we’ve seen a broadening out of wage pressures, wage increases across multiple sectors, and that creates a real dilemma again for businesses, because not only are they seeing a rise in input costs, but they’re also seeing a rise in labor costs. And usually, labor costs are a big part of business activity and business costs. So, then the question becomes, do you pass on these higher costs or do you find ways to offset these higher costs? And there are multiple alternatives. You can either reduce the amount of labor you’re hiring, or you can try to offset the cost of labor via greater productivity, via automation, digitization, different means to try to offset the rise in your unit labor cost. But that’s not that straightforward and that usually takes a bit of time. So really, we’re in this dilemma for businesses that are facing what I’ve called really the Great Renegotiation rather than the Great Resignation, because people are negotiating for better benefits, better terms, better salaries, more flexibility, and this war for talent, this environment where businesses are really looking to the next year, three years, five years down the road and they want to have the best talent to face the next few years. And so, from a private equity standpoint, there is also that question of how much are you willing to invest in a business that is really focusing on the medium term and on acquiring the right type of talent to grow its business and grow its profits over the next few years. So, there is that dilemma of cost versus long-term value which is visible in this paradox that we’re seeing right now with this labor market that’s extremely tight, historically tight and where wage pressures are on the rise.

Brown  

Yeah. That’s really interesting. And you know, in speaking to our clients and people who work within private equity, we always hear that the more successful or the most successful companies are those that have invested in the right management teams. And having the right teams on the ground makes a big difference between a successful exit at a high multiple or one that a business that stagnates and takes longer and you don’t create as much value. So, it’ll be interesting to see just how much they ultimately believe talent is worth in terms of creating value in these businesses.

Daco

Yeah, I think talent is really going to be worth a lot over the next few years because we’re going to be in for a fairly bumpy ride in the US and around the world in terms of this rebalancing of economic activity away from a COVID-19 economy towards a new normal, towards an economy that won’t be like the pre-COVID-19 economy. I don’t think we’re going back there. But I think we’re going to be in a new environment where there are new challenges to face. There is going to be this environment, as we’ve been discussing, of higher inflation, higher labor costs, questions around what the final demand and what the strength of the final demand is going to be, and questions around productivity development. So, all of these questions are going to necessitate a very strong labor pool, a very strong amount of talent for businesses, and that, for private equity investors, is going to be the key question. Do the companies they’re looking at have the right mix of talent to make face and be ready for this uncertain environment that we’re going to be facing over the coming years.

Brown

Yes, very interesting. Well, it’ll be interesting to see how that plays out over time. And so, then, shifting then maybe to the inflation itself, which is one of the factors, we’re starting to see that the Fed has started to act on inflation by raising interest rates and, you know, the signs are all pointing to the Fed continuing to pull this lever in the months to come. So, can you share with us maybe a little bit more of what they’re doing to combat inflation? And what the impact of higher rates for the cost of credit and investment valuations may be, looking into your crystal ball?

Daco

Yeah, I think, again, it’s important to take a step back and look at where we are in terms of monetary policy throughout the world versus the state of inflation. In the US, as an example, we have inflation that is at a 40-year high. As of March of this year, inflation was at 8.5%. Again, a rate we haven’t seen since the early 1980s, and the Fed feels that it’s really behind the curve in terms of normalizing monetary policy, in terms of raising interest rates, in terms of shrinking the size of its balance sheet. And it’s been caught a little bit off guard by the persistence of inflation. So, we’ve seen a very hawkish pivot by the Fed, unusually rapid pivot, in terms of monetary policy direction, and now the Fed has signaled a couple of things. First, the Fed has signaled via forward guidance that it intends to be much more deliberate in terms of regaining control over inflation. It used to say that inflation was transitory, that as demand would cool, as the spending mix would rotate away from goods and towards services, as supply would come on line, inflation would fade on its own and monetary policy was just an additional lever. Right now, that view has shifted completely, and now monetary policy is going to be the main leaver. The passive slowdown of inflation is still going to be in play, but that’s no longer going to be the key driver of monetary policy direction. The Fed wants to be much more deliberate in terms of tightening monetary policy and it’s going to do so via two mechanisms. First, raising interest rates, so raising the federal funds rate., And second, shrinking the size of its balance sheet. Now, the increases in the federal funds rate are likely to be fairly rapid. It may be that the Fed actually proceeds with the fastest tightening cycle since the early 1990s, since 1994 to be precise. There’s a very high likelihood that the Fed will proceed with 50-basis-point rate hikes at the next couple of FOMC meetings, and that thereafter, the Fed will continue with 25-basis-point increments at the next meetings until the end of the year. That would mean that the federal funds rate would go from 0 at the start of 2022 to above 2% by the end of 2022. That would be a massive tightening of monetary policy on its own and we’ve already started to see long-term rates reflect that expectation. Mortgage rates, the rate on the 10-year yield, have all risen very rapidly, and we’ve seen the cost of credit as a result rise quite significantly. The other mechanism via which the Fed is going to tighten monetary policy is via a reduction in the size of the balance sheet. The Fed proceeded with another round of QE, when COVID hit, and it’s looking now to shrink the size of its balance sheet, allowing maturing assets to roll off and reducing overall liquidity in the market. That, of course, is going to have direct implications in terms of the cost of capital and will have direct implications for the private equity sector. The initial perspective is that this will likely be a negative because it’s going to be more expensive to purchase companies because the cost of credit is going to be higher, but there can be actually some positive developments. You have to think that in an environment where there is perhaps less access to credit, there’s going to be less competition for certain targets and we may be in an environment where valuations, as a result, fall back. So there may be opportunities here in the private equity sector to purchase at a lower price. Because we know that that has really been a key issue with valuations rising very rapidly because of the easy access to credit and easy financing. There was a lot of competition and valuations were rising very strongly.

Brown

That’s really interesting. I hadn’t thought of it in that way. So, if I reflect on what you’ve just said, notwithstanding the interest rates going up, the cost of capital, the other lever being the cost of capital will potentially mean that it’ll be more expensive to do deals and, therefore, the competition for those targets will go down. So that’s kind of really interesting. Do you think that they will, the two levers will move at the same pace or do you think that one will go faster than the other so there will be a timing difference? So rates, perhaps interest rates, will go up, which will impact the appetite to do deals and then lagging behind maybe that cost of capital, so we’ll see something happen at the back end where we’ll see potentially deals or valuations going down. I’m just curious to see how you see this evolving.

Daco

Well, it may take a bit of time for the sequence that I described to take hold. Initially, the first impact will be a higher cost of credit. Because interest rates typically front-run even the Fed tightening interest rates, the long-term rates, the cost of borrowing, front-runs the Fed tightening interest rates. If you look at the situation today, the 10-year yield has risen well over 100 basis points since the start of the year and the fed funds rate has only gone up by 25 basis points. So, markets are anticipating what the Fed will do and that has led to a higher cost of credit. That has had an immediate negative effect actually on stock markets, where you’ve seen some depreciation of valuations across stock markets. But that will take a bit more time to filter through. As we see the Fed actually following through on its forward guidance and following through with tighter monetary policy, that will continue to put downward pressure on valuations. But I think it’s not going to be immediate. So, this idea of reduce competition, reduce valuations may take a bit of time to realize itself. I think what one of the things that’s telling in terms of the private equity sector is that if you look back at 2011, the average leveraged buyout was acquired at a multiple of 9 times EBITDA; in 2021, it was 11 times EBITDA; that’s an average. So there were acquisitions that were done at multiples of 20, for instance. If you look out the next year, the next three years, you’re going to be in an environment where those valuations are going to be put under some pressure and actually that may take some of the frothiness out of the market and put a better lens on the true value of certain targets. So that may again be an opportunity, maybe not in the very near term, but over the near to medium term, that may become more of an opportunity for the PE sector.

Brown

Okay, so the combination of potentially pressures on the cost of credit and the interest rates may decrease valuations, and at the same time, you know, we’ve got a PE sector that has, you know, over $1.4 trillion in dry powder. So we may actually find that there may be more deals happening down the track because of the combination of the two, but they’ll be at better multiples, which maybe may help on the value creation side because if your multiples are lower and you’re paying more for commodities and you’re paying more for labor, it’s easier for you to create value and get a multiple on exit if you haven’t paid top dollar for that target or that asset in the first place.

Daco

That’s exactly true. I mean, as you’ve said, there’s a lot of dry powder out there. So there is still that potential for acquisition. It’s just about acquiring at the right price and at the right time. The outlook over the next one to three years is going to be a very uncertain one. We’re going to be facing this economic rebalancing that will be really unique. There can be some parallels drawn to prior episodes, historical episodes, but we’re really going to be in a unique environment over the next year to three years. So it’s all going to be about discretion. Thinking about how much pricing power do companies have? Are they able to pass on the higher costs? And are they in sectors that are going to be more negatively impacted or positively impacted by the rise in inflation? Some sectors have favorable terms of trade, for instance in the energy sector, where they might have more pricing power in an environment where commodities prices are rising. So that may actually be a benefit to those types of companies. So it’s all about understanding what the position of a specific company is within its sector. How much pricing power does it have and ability to pass on some of the higher input costs, some of the higher labor costs. And then at what price are you acquiring a certain target considering the inflation backdrop and considering the rise in the cost of credit via higher interest rates. Those are really going to be the key gauges as to how much activity will take place over the coming year. And then I would add another layer of uncertainty, which is the dreaded R-word, which has come up again and again over the last few weeks, which is the risk of a recession. Because in this unique environment, we’ve never really seen the Fed tighten so aggressively without having a recession in economic activity. And that will bring its own challenges with the uncertainty as to how resilient the economy will be over the next 18 months. And that’s really going to be key in terms of thinking about the outlook and different targets to acquire, because you have to really look for resilience in this environment of high inflation and rising interest rates. And that’s going to be a key question going forward.

Brown

So a lot of different factors, and to your point, factors that we’ve, coming about in a way that we’ve historically not seen before that private equity investors need to track, assess and, in some ways, almost predict where they think these factors are going to land and how they’re going to evolve. Do you think there is certain trends that investors need to be really laser-focused on? And I’m also wondering, you mentioned, like, for example, the energy sector, which may perhaps have an opportunity to evolve, or, you know, may not be as impacted by some of these factors. I’m wondering whether there’s also an intersection with such a great focus on ESG right now, and if you think about, you know, some of the sentiment that’s happening in the market and you cross that with what’s happening economically, and you cross that with say a sector like the energy sector, do you think there’s an opportunity to create value and for opportunities to arise in areas that perhaps people hadn’t thought of before? And/or maybe just at the right moment that the world needs, thinking of the energy sector, this may be just an opportunity for us to kind of pivot and really double down on areas that may impact the world in an even more positive way.

Daco

Absolutely. I think every unique challenge, and especially this unique challenge, brings about new opportunities. And as you correctly pointed out, there is an increasing focus on ESG, including in the PE world. So we are going to see much more of a focus on this long-term value aspect of investments looking at the ESG dimension and ensuring that potential buyouts have this dynamic that is favorable for them. So whether it’s in the energy sector or in the tech sector or in the automotive sector, or even in health care, we’re going to see much more discrimination as to which targets are acquired and what type of value these targets can bring over the next few years, whether it’s from a talent perspective, whether it’s from an embedded technology or digitalization perspective, or whether it’s from a resilience perspective. How resilient are companies to an environment that’s going to be quite challenging? So, all those aspects are going to be key in determining the path forward for the private equity sector. As you mentioned, there’s a lot of dry powder but there are also a number of uncertainties and so there is going to be much more focus on that value from a labor perspective, from a tech perspective, from an ESG perspective, that will be key in determining the outlook for the PE sector.

Brown

Wow. Well, Greg, thank you so much for your time today. Clearly, there are a lot of interesting things going on in the world right now and no one knows where it’s going to land. But one thing for sure, it’s going to be very interesting and very exciting times and it’s going to take careful navigation. But those investors that do read the signs and really are thoughtful about their investments going forward in light of all that’s happening I think have a great opportunity to be very impactful and make great investments and create lots of value. So, exciting times ahead.

Daco

Certainly.

Thanks for tuning into the EY NextWave Private Equity podcast. For more thought-leading perspectives and to get in touch with Winna Brown, visit ey.com/privateequity. You can also follow us on Twitter @EYPrivateEquity. We’ll see you on the next episode. 

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