Beware: cracks appearing on the deal front

By Markus Lahrkamp, Alvarez & Marsal

In a well-oiled private equity deal, things usually follow this proven pattern: acquire a company, put on debt leverage, work with management on a performance improvement plan, grow the top line, and sell the company for much more than the original acquisition price.

The formula works very well … until events significantly alter business conditions.

I believe we’re approaching such a turning point now. It’s one that’s likely to challenge the lofty expectations of PE owners and result in increasing stress – maybe even distress – within PE portfolios. Without some rapid course corrections, companies are destined to struggle in the months ahead.

Shocks of the post-pandemic economy

We’re emerging into a post-pandemic global economy that looks very different from the pre-covid version. Businesses are grappling with supply chain disruptions that have vastly inflated transportation costs. Labor costs have surged, without an accompanying increase in productivity. Raw material costs – everything from microchips to resins, metals and wood – have similarly rocketed. In addition, geopolitical events and the war in Europe are starting to create the next energy crisis.

Yet so far this year, we’re seeing PE deals priced higher than ever, reflecting the low-interest-rate environment and strong economic growth rates. That’s on the heels of last year, when PE-backed deals more than doubled to a record $818.4 billion in the first nine months of 2021 alone.

Yet those valuations and debt levels will look increasingly shaky as growth starts to slow and interest rates rise.

A loss of visibility into what consumers and customers want is compounding logistics problems. For example, demand for some work-at-home products (like exercise equipment) soared in 2020, then plummeted in 2021. This demand signal confusion has trickled down throughout the entire value chain, resulting in companies having too much of what their customers don’t want and unable to profit from what they do want.

Companies are also being saddled with often-dramatic rises in fixed costs. Add-on acquisitions have swelled expenses and complexity of their back-office operations in areas including HR, IT and finance.

A saving grace?

Amid this upheaval, there’s been one saving grace: The ability to pass on higher costs to customers in a fast-growing economy that’s been flush with cash. Hence the rise in inflation to 40-year highs. When the top line is rising and additional costs can be passed on, the increase in fixed and overhead costs appears marginal and rarely causes any concerns.

But that easy option is unlikely to be available much longer as growth rates fall back to earth and interest rates rise. As the tide goes out, many PE-owned companies will be left struggling with overly complex, costly operations that could lead them into performance and liquidity issues. Financial restructuring may be needed if the issues aren’t addressed.

Just to be clear, I expect supply chain problems and materials costs to ease later this year. However, wages are set to remain high and many businesses will still be burdened with unsustainably high overhead and mostly fixed cost structures.

Leading indicators for trouble ahead

This is a time when PE owners and their portfolio company management teams should be paying close attention to what may come next.

Together they should be closely examining their companies’ cash liquidity outlooks, and the impact of higher interest rates. Just a few basis points can add millions of dollars to debt payments, quickly leading to liquidity problems in a lower growth environment.

Management and PE should also be working in lockstep to reduce complexity and costs – even more than they usually do. Simplicity needs to be the guiding principle. Also, they should stay alert on variable costs to take advantage immediately when transport and material costs start to decline.

Different skills gain importance

An environment like this demands a change of direction and skill sets. Top-notch, operational-minded CFO’s, who understand the impact of higher costs and interest rates on their cash flow, will be in very high demand. It’s vital that PE, together with management, work on scenario planning and complexity reduction, to wring out costs when needed.

Some leadership skills that wouldn’t have been considered in recent years are taking on a new importance. An awareness of geo-political issues and planning for their potential impact on supply chains and demand is one of those, underlined by the current war in Ukraine and growing concern over China’s intentions toward Taiwan.

PE dealmakers will need to adapt to these new realities … or stay on course with optimistic predictions and risk having a very rude awaking in the not-so-distant future.

Markus Lahrkamp is Managing Director at Alvarez & Marsal, a global business consulting firm.