Figura 2: Developments in the ECB’s benchmark interest rate. Source: Banco de España.
With 10,0% inflation in the Eurozone in September, the spectre is more real than ever and consumers already feel its impact in the supermarket, on the electric bill and at the petrol station. private equity, like any other area of the economy, is no stranger to this phenomenon. private equity (or private capital), like any other area of the economy, is no stranger to this phenomenon.
To understand what inflation means for private equity, it is worth taking a step back and considering its causes. The global market of interest rates, hovering close to 0%, implied practically free access to financing and allowed for a flood of capital to be allocated to different financial products.
Among the different asset classes, investors have progressively increased their exposure to private equity due to the multiple advantages it offers compared to other alternatives, such as higher returns, lower volatility and greater resilience at troughs in the economic cycle.
Figure 2: Global evolution of capital raised by buyout funds. Source: Bain Global Private Equity Report 2022.
This increased demand for private equity has encouraged managers in the space to raise larger and more frequent funds. The result of increased capital raising by private equity funds has led to the accumulation of available capital (dry powder) and therefore greater pressure to put that money to work, seeking investment opportunities.
Figure 3: Global capital available (dry powder) from buyout funds ($ BN). Source: Preqin, as reported in Bain Global Private Equity Report 2022.
One way to alleviate the pressure to allocate available cash is to invest in the higher end of the market with higher value transactions. In higher market segments, managers can put money to work more efficiently by increasing the value of the transaction, thereby reducing the number of transactions needed to invest available capital and generating economies of scale by reducing the costs associated with each opportunity.
Figure 4: Evolution of the number of private transactions by size. Source: Dealogic, as reported in Bain Global Private Equity Report 2022.
The direct consequence of the rise of private equity fundraising is a mismatch between the demand for attractive private companies and their supply- a supply which has grown in line with the evolution of the economy. As in any other market, this mismatch leads to price appreciation. Although this effect has been most pronounced in the United States (where prices have also been historically higher), the inevitable increase in private company prices has also impacted European markets.
Figure 5: Evolution of the acquisition multiple (EV/EBITDA) in private transactions in the US and Europe. Source: S&P LDC as reported in Bain Global Private Equity Report 2022.
Qualitas Funds pursues a strategy focused on Lower-Mid Market managers that presents a number of advantages to protect against inflationary pressure. While fundraising has also increased among managers focused on small and mid-sized companies, this increase has been considerably less than that experienced by large private equity managers. As a result, the competitive edge for companies in this segment has not been impacted.
For reasons to be explained in future publications, access to funds in this market space is more difficult and, consequently, most of the capital allocated to private equity assets has been concentrated in the Large Buyout space.
Figure 6: Cumulative 3-year growth fundraising of Buyout funds by size. Source: Preqin, as reported in McKinsey Global Private Markets Review 2022.
Although counter-intuitive at first glance, managers in the Lower-Mid Market not only avoid inflationary pressures, but they are poised to benefit from current market conditions. As previously demonstrated, the rise of entry valuations in the Lower-Mid Market has been less drastic than that seen in the higher market space. This implies that Lower-Mid Market funds will benefit from this impact on exit valuations, which will be dragged by the price inflation experienced by larger buyout managers at entry
Figure 7: Evolution of EV/EBITDA acquisition multiple in EV< €100MM and EV>€100MM transactions.< > Source: Qualitas Insight, Qualitas Funds proprietary database.
This effect, known as multiple arbitrage, is an advantage afforded by investing in the Lower-Mid Market. Though not an objective that Qualitas Funds seeks per se, multiple arbitrage can have a powerful effect in driving returns. The managers in which Qualitas Funds invests are typically characterised by returns driven with operational improvements and growth of portfolio companies. Nevertheless, the discipline of buying at modest acquisition multiples can position funds to benefit from the arbitrage effect and offers an additional margin of security for preserving portfolio value.
