Economic uncertainty in 2023 doesn't mean portfolio activity has to stop. But it will mean extra due diligence in these three areas.
As we shared during Crowe Expertise Week for private equity, the economic picture for 2023 is looking increasingly recessionary. And while a downturn could be short and mild, the uncertainty has negatively affected deal markets.
Among the more concerning trends:
- Inflation rising to 40-year highs, which has increased buyer risk associated with underwriting normalized earnings
- Rising interest rates putting downward pressure on company valuations and causing bond markets to plummet
- M&A transaction volumes declining in 2022 for the first time in several years (other than the special case of 2020)
- Most worldwide stock market indexes and geographies suffering double-digit percentage declines in 2022
There are reasons for optimism despite these developments. First, the number of private equity transactions decreased from the previous year in only four years since 2008. And except for 2010, private equity transaction activity reached previous high levels the very next year. Also, the private equity sector consistently has outperformed public stock market indexes in nearly all markets, up or down.
The private equity space currently still has a lot of capital available, and companies should explore ways to put that to work in 2023. In particular, we’ve seen a significant amount of activity around add-ons to current portfolio companies because that’s an easier sell to investors and lenders.
Whatever moves you end up making with your portfolio companies, it’s important to keep these three private equity deal considerations in mind:
- Effects of inflation
- Inventory challenges
- Freight costs: Price increases in shipping container and trailer transport
- Labor: Wage growth
- Raw materials: Price increases, along with declines in volume discounts
- Distressed deal opportunities
Inflation is expected to cause headaches throughout 2023 and very likely into next year because of price instability. Although supply chain indexes have begun to stabilize, the demand for labor still is exceptionally high in relation to supply, particularly for skilled hourly workers. The upward pressure on wages is sustaining a rise in inflation that probably will prevent price stability for at least the next several months.
Inflation also makes it hard to determine what’s driving cash flow, whether that’s sustainable, and what impact all of that will have on pricing. Depending on the company and industry, inflation-driven pricing shifts can make financial performance seem better or worse at a given point in time than it might actually be over the long term. In these cases, it’s important to spend more time analyzing and discussing vendor and customer relationships – and understanding why price changes are happening and if they’ll likely hold.
In an environment of rapidly rising prices in certain areas, higher-cost inventory can lead to lower gross margins after transactions. Under either the first in, first out or average cost inventory methods, rising costs can be buried in the inventory balance of target companies until sold, particularly in ones that don’t turn inventory rapidly.
This trend is particularly true in the following areas:
Additional inventory analyses can help firms understand both the current picture and quantify the potential future income effects of target companies. Frequently, these types of analyses can involve going into individual stock-keeping units (SKUs) – especially the ones that have high volumes or high dollar values – to understand the impact on balance sheets over the horizon.
For private equity firms willing to take on more complex transactions, the distressed market presents some unique opportunities. The fact is, companies can find themselves unable to refinance debt or cover rising interest payments for all kinds of reasons, and many still can hold value to a buyer.
Much of the complication comes with evaluating target distressed companies. Many of the standards normally used to assess an acquisition, such as working capital and quality of earnings, might not be particularly useful here.
Also, deal negotiations can go beyond the target company’s ownership to include other constituents such as secured lenders, subordinated lenders, and unsecured trade creditors.
One key recommendation: You need to work with a team – including specialized legal counsel and financial advisers – who have restructuring experience. Having people who understand the specific kinds of issues that routinely come up in bankruptcies and other distressed transactions can be the difference between a diamond in the rough and a rough road ahead.