Home Private Equity Dark clouds of recession build for private equity-owned businesses

Dark clouds of recession build for private equity-owned businesses

27
0

Just as it seemed that global supply chain disruptions were easing, Russia’s invasion of Ukraine has now destabilised conditions for private equity-owned companies around the globe. I’m sorry to say this, but the environment is likely going to take a turn for the worse before it gets better.

In addition to squeezing oil supplies, the war is impacting shipments of grains and fertilizers, critical metals, chemicals and gases, adding pressure to rising global inflation.

The timing is unfortunate. Clouds that were gathering in 2021, even as global buyout deal value and exits soared to record highs, are getting darker.

Together, Russia and Ukraine account for about 30% of the world’s barley exports, 25% of wheat exports and 16% of corn exports, a major feedstock for beef production.

Ukraine is a major supplier of roughly half the world’s semiconductor-grade neon, critical for computer-chip production, and is home to some significant uranium mines. It’s hard to underestimate how important Ukraine is for certain sectors of the global economy.

And that’s just the war. Other storm clouds are gathering.

The pile-on effect
While we expected interest rates to rise gobally, we didn’t necessarily expect the US. Federal Reserve to project six additional rate hikes this year – including 50-basis-point increases. In the EU, European Central Bank governing council member Klaas Knot surprised markets when he said in May that possible worsening inflation could require a half-point interest rate hike. Also in May, the Bank of England boosted rates to a 13-year high. Another surprise was China’s January rate cut to offset its slowing growth rate.

These developments raise the possibility of an economic downturn, even a recession, this year or next.

Borrowing costs, which had been cheap for many years, are rising as interest rates increase. Lenders in the private equity market, now primarily hedge funds, will not let borrowers lock in current rates before they rise further. Borrowers will get adjustable rates no matter what, and private equity will have to adjust.

Until recently, companies have been able to pass on higher prices. But slowing economic growth could makes that more difficult. Additionally, it could cause a sudden decline in companies’ values.

I’m not convinced most PE firms have fully embraced or prepared for a likely slowdown. But I’m seeing some signs they’re starting to think about it. Deals have slowed. I suspect some dealmakers are starting to think twice about valuations as the prices of some transactions done over the past 12 months may start to look high.

Risks and opportunities
Manufacturers of capital goods and commodity producers, including oil and gas and chemical manufacturers, could be especially hard hit if a downturn in 2022 or 2023 causes investments in capital-intensive industries to decline. But there could be more interest among private equity dealmakers and operating partners in service-oriented businesses. During the 2008-2009 financial crisis, deals in service-oriented businesses did well even as capital intensive industry deals were hammered.

Are PE firms and their portfolio company management teams ready for the coming storm? Overall, I don’t think we’ll see a repeat of what happened during the Great Recession, but I do worry about the PE industry having enough capacity to deal with inflation or debt restructuring. A lot of PE deal teams have never experienced an entire business cycle with the volatility we are facing now. Running out of cash or breaking covenants (if they exist) is a hypothetical construct for a lot of deal teams. They’ve never managed through a period of rising inflation.

Adjustments to make now
No matter their level of experience, PE deal partners, operating partners and officers of portfolio companies should take a step back. They should scrutinise every item on their P&L and balance sheets statements, as well as their products, channels and customers and cost positions. No expense is too small to examine, whether it’s materials, labour, overhead, transportation, or back office.

In many cases, immediate actions may be appropriate to prepare for a likely downturn. Consider tactical margin or price improvements, short-term sourcing opportunities, general cost take-out in specific non-value add areas.

In general, stay away from growth initiatives now unless there is a clear short-term payback.

Balance sheets need to be shored up as quickly as possible, collect account receivables and dispose of excess inventory. Jettison anything that’s not profitable.

The most important topic is that PE and their portfolio companies need to understand the amount of cash/ liquidity they have on hand, and their cash flows going forward. Is the company able to cover leverage costs as rates rise? Is there a “war chest” that can sustain a prolonged downturn, or even be used to pick up market share when other companies fail.

We are, or will be, in a transition period shortly. The dealmaking environment is coming off an exuberant high; companies’ top-line and bottom-line growth is about to be sorely challenged.

The clouds are here, they’re getting darker, and are about to open.

Markus Lahrkamp is a managing director with the private equity performance improvement group of professional services firm Alvarez & Marsal in New York.

Source link

Previous articleJPMorgan’s Bitcoin price target is 28 percent above the current price
Next articleHSBC Names Global and APAC Head of Alternatives

LEAVE A REPLY

Please enter your comment!
Please enter your name here