Inflation has re-emerged as a central theme in global markets, reshaping the investment landscape and challenging long-held assumptions in private equity (PE). For an asset class that has thrived in a low-rate, low-inflation environment, the shift to persistent inflation and higher interest rates demands a strategic rethink.
1. The End of the Easy Money Era
For the past two decades, PE returns were buoyed by falling interest rates and multiple expansion. As discount rates declined, asset prices rose, enabling GPs to generate outsized returns through financial engineering and leverage. However, the reversal of this trend—driven by central banks combating inflation—has created a new reality. With rates rising, asset prices have come under pressure, and the cost of debt has surged.
2. Key Risks to PE Returns in an Inflationary Environment
Inflation impacts PE returns through several channels:
- Higher Financing Costs: Rising interest rates increase the cost of leverage, which has historically been a key driver of PE deal economics.
- Lower Valuations: Elevated discount rates compress valuation multiples, making exits less lucrative.
- Margin Pressure: Input costs, wages, and energy prices are rising, squeezing EBITDA margins unless companies can pass costs to customers.
3. Operational Value Creation Takes Center Stage
With multiple arbitrage less reliable, PE firms must pivot toward operational improvements. Future returns will rely more heavily on organic growth, margin expansion, and market share gains. This shift requires deeper engagement with portfolio companies, including:
- Investing in automation to offset labor cost inflation.
- Enhancing pricing strategies to preserve margins.
- Building resilient supply chains to mitigate shocks.
4. Inflation-Resistant Strategies in PE
Leading fund managers are adapting by targeting businesses with pricing power and essential services. Sectors like healthcare, infrastructure, and software-as-a-service (SaaS) offer better inflation resilience due to their ability to pass on costs.
Moreover, “buy-and-build” strategies are gaining traction. By acquiring smaller companies at lower valuations and integrating them into platform businesses, GPs can average down entry multiples and create scale economies.
5. Private Equity as an Inflation Hedge
While PE is not immune to inflation, its active ownership model offers tools to mitigate its impact. Unlike passive public market investments, PE managers can restructure, reposition, and refinance portfolio companies to build resilience. Thematic investing—focusing on long-term trends like digitization, automation, and decarbonization—also provides a hedge against cyclical inflationary pressures.
6. Implications for Fund Finance
From a fund finance perspective, inflation introduces new considerations:
- Debt Structuring: Lenders must reassess covenant packages and interest coverage ratios in light of higher rates.
- Valuation Sensitivity: NAV-based lending may require more frequent re-marking and stress testing.
- GP Liquidity Needs: As exit timelines extend and distributions slow, GPs may seek NAV facilities or preferred equity solutions to manage liquidity.
Final Thoughts
Inflation is not just a macroeconomic headwind—it’s a structural shift that demands a recalibration of private equity strategies. For fund finance professionals, understanding how inflation affects PE returns is critical to underwriting risk, structuring deals, and supporting clients through a more volatile cycle.
