How will inflation affect private equity in the caribbean?
Whether we want to admit it or not, inflation is going to be here for a while in the Caribbean. While clean, objective data is hard to find here – anecdotally food, energy and shipping costs have been steadily increasing month over month. I briefly want to explore the potential effects of inflation on an existing PE portfolio, and whether there are any measures that can be taken to offset those effects.
I put a picture of fruit and produce here, because the price of these things in Barbados is too damn high! - original photo from Pexels
Everything else remaining constant, as inflation increases, private market multiples tend to decrease. In the US, sometimes the informal “Rule of 12” is mentioned, where inflation + multiple = 12. For example, if we think that inflation is around 4% then we should see 8X multiples on average. Thus, if inflation were to rise to 6%, then we would expect to see multiples drop to 6X. That being said, multiples only really matter if you need a valuation (for a fund mark) or you plan (or need to) sell the position. If you only care about free cash flow being thrown off, then the valuation matters less. In fact, multiples going down could be a buying opportunity for a new fund or one with remaining dry powder. While outright valuation multiples are lower in the Caribbean, I broadly expect the phenomenon to hold directionally true.
If the above point holds true and inflation does lead to a contraction in multiples, then earnings growth potential becomes even more important when selecting among different opportunities. Some sectors and companies outperform others in an inflationary environment. Generalizing, we’re all looking for companies that have pricing power anyway, but I’ve seen the argument made that B2B companies are better positioned to pass on price increases vs B2C companies. Additionally labor costs will be a concern in a sustained inflationary environment, so businesses that can scale should outperform those that need to add staff linearly with revenue growth. Business models dependent on high long-term growth projections (i.e., are very capital intensive, typically young, unprofitable tech companies) should see valuations contract as the discounted value of long term profits is compressed. We’re beginning to observe this in public markets, as we’ve seen some of the more popular names start to retrace their COVID gains (Zoom, Peloton). Thoughtful asset selection will be key to generating alpha in this environment.
Zoom (blue, Docusign (orange) and Peloton (purple) relative performance from Feb 2020 to Feb 2022. Note the retrace almost back to pre-covid levels as inflation, and other factors, began to kick in - Graph from Koyfin
For existing portfolio companies, having effective working capital management in place, efficiently managing inventory, A/P, A/R and Cash positions will determine the difference between survival and failure. For PE sponsors, you need to make sure that the respective management teams are incentivized and aligned to optimizing the above. Notably, if your portfolio was already conservatively constructed and focused on the above, then you should do relatively well. Brent Beshore and his team at Permanent Equity come to mind here – a USD $300M+ capital base in a 27-year structure reduces the need to sell assets into a depressed market, low/zero leverage means that there isn’t a huge draw on FCF and interests are better aligned. Per Brent “It’s functionally permanent and it gives us the ability to do things differently”.
I would be remiss if I didn’t mention hurdle rates in this discussion. In PE, we have seen GPs lowering hurdle rates from 8% on average in the 1980s to closer to 6% today, and in some cases, eliminating it altogether. This trend hasn’t been popular among LPs. The Institutional Limited Partners Association actually recommends to its members (see page 10 of this document) that a “standard all-contributions plus preferred return back first i.e. whole of fund model” is best practice, or in other words, that a return of capital plus a preferred return or hurdle should be the standard. Thus, in this inflationary environment, it wouldn’t be surprising to see the trend of lower hurdle rates begin to reverse going forward.
So, in my view, in the Caribbean we will see continued focus from PE on businesses that are in non-cyclical industries that have strong growth trends. I expect that as valuations decrease, we will see more acquisitions from strategics (i.e. regional conglomerates). Businesses with a strong product portfolio, and pricing power should continue to be in high demand, while those with long, locked-in revenue streams (e.g. long term lease revenue) may suffer. Real estate funds will have to revise their strategies accordingly. The cost of debt financing will increase, which will limit PE funds ability to employ financial engineering (leverage) and should drive them toward growth via true value creation (increasing margins, topline growth, scale etc.). Given the already nascent stage of tech investing in the region, I’m concerned that in a sustained inflationary environment, tech entrepreneurs will find it difficult to raise capital.
