Rajeev Amara, who formed Arcline Investment Management, in 2018 after working for many years at Golden Gate Capital, sat down with PE Hub to talk about finding deals amid challenges with supply chain delays and looming inflation, as well as competing for deals in the high-priced markets.
Arcline closed its second fund on $2.75 billion earlier this year, after raising $1.5 billion for its debut fund in 2019.
How are you navigating persistent inflation?
Our strategy has been always to buy low volatility, recurring revenue industrial businesses in the middle of the value chain. We rarely invest in upstream or downstream oriented businesses. With upstream you may have uncontrollable supply and demand risk, and with downstream, you could have technology or customer adoption risk. Companies in the middle of the value chain, for the most part, are able to work through inflation and shortages with their suppliers and customers.
How are supply chain disruptions impacting your business?
We’re not immune to it. We saw a little bit of it in Q3 but a lot of it is happening in Q4. We are seeing raw material and labor shortages and increasing freight costs and labor costs. We believe it will take much longer to clear up, maybe years.
The popular example of raw material shortages is in semiconductors. The automotive sector, which temporarily shut down during the pandemic, took the brunt of the chip shortage. A lot of the chips got substituted into consumer electronics markets where demand spiked during the pandemic. Car production globally was pushing close to 100 million pre-covid and it is now pushing 80 million, largely due to supply constraints. Semiconductor supply is going to catch up at some point, but it may take 18 months to two years to build chip capacity to absorb all that. But this is a multi-trillion dollar global industry that is being impacted by double digits on a multi-year basis!
Freight costs are also an issue. There’s a lot of pressure on seaborn freight because of the lack of wide-body airline traffic, which was a big source of freight capacity. That’s going to unwind when the vaccination rates increase in the rest of the world. But that is going to take a lot of time, especially with net zero covid policies.
Labor may be the biggest issue companies are facing. There are 10 million job openings but only 8 million people looking for jobs. That’s unprecedented. Wages for the more portable categories of labor are going up materially, sometimes 20 to 30 percent. A lot of this could ripple through the economy next year as you will have an entire year of wage inflation. Government stimulus going through the economy is not helping the labor shortage.
All of this should correct over time, but it’s going to be difficult, at least for the next year to navigate through.
Where is your focus in this environment of inflation and supply chain disruptions?
Well, let’s talk about what we are not investing in. In this environment, we are staying away from several categories of businesses. Firstly, we are avoiding companies with price deflationary business models. For example, we are avoiding contract manufacturers as they are expected to pass on cost savings to their customers. Secondly, we are avoiding companies with concentrated customer bases, especially where the end customers are in commodity industries because undoubtedly you will get margin pressure down the road. Thirdly, we are avoiding people-intensive businesses where labor inflation and labor shortages are expected to continue through next year and beyond.
And finally, we are being mindful of investing in companies who want credit for a lot of pro forma earnings. A lot of companies are annualizing their recent price increases but they’re not annualizing their labor cost increases, labor shortages, raw materials cost inflation, so there’s a mismatch there and that could really manifest itself next year with lower margins, and you don’t see those in the quality of earnings, you just see the annualization of a price increase.
So even though we expect all of this to be transitory – 12 months or 18 months – you still have to think about it because you may have a year or two of flat Ebitda. Even though there’s healthy demand, your Ebitda may not grow as much over the next couple of years, so it is incorporated into our underwriting and valuation models.
How are you approaching sky-high prices in today’s market?
There are a lot of factors that have contributed to sky high valuations. They are too numerous to list here. As a generalization, the quality of the businesses that the majority of private equity firms have been buying are much higher than they were four to five years ago. Private equity firms are buying more growth-oriented businesses with higher margins in better-end markets with a lot of M&A potential. Four to five years ago, a forecast of 8 percent organic Ebitda growth may have been normal in industrials, now it is 10-12 percent and you are targeting 15 percent or a five-year doubling.
Also, rightly so, private equity firms have been forced to incorporate speculative, but “low hanging fruit” M&A into the upfront valuations. If you told your investment committee four or five years ago that you are forecasting multiple M&A deals over the next five years into your base underwriting case, you could have been fired on the spot. I’m joking. Well kind of. But now you are forced to pay up for that potential add-on M&A arbitrage, such as in fragmented services industries.
Another thing we’re seeing is that private equity valuations starting to be based a little bit more on VC narratives versus fundamentals. Stories have been part of the VCs’ paradigm for a while, but they are now infiltrating private equity and providing a lot more valuation support than pure fundamentals. For example, climate change is the big buzz word today. If we believed what every company for sale is telling us, climate change would be reversed some time in Q3 next year. We may even be approaching the next ice age in 2023. Finally, the seduction of buying and quickly flipping a mediocre business but a 10 percent concentration in a great end market like electric vehicles to a SPAC is also contributing to driving valuations up.
What is driving deal flow?
A lot of the deal flow over the past two years have been driven by uncertainty regarding tax policy. Founders rushed to exit over the last two years because of the potential of capital gains taxes going up. In addition, many PE firms sold their companies, sometimes prematurely, due to the potential of higher capital gains taxes as well as potential for higher carried interest taxes. We benefitted, and the whole industry benefited from this phenomenon.
Lightly edited for clarity.