Inflation risk a top concern of private equity

Inflation is a key risk for the private equity industry, and the concern that it will continue to rise has been voiced by several firms including Brookfield Asset Management Inc., KKR & Co. Inc., EQT AB (publ) and Ares Management Corp.

Along with supply chains, the issue is "on all of our minds," Mark Weinberg, managing partner in Brookfield's private equity group, said at SuperReturn North America earlier this month.

"It feels like it should be temporary because we're coming out of this crisis, we hope, and things should normalize. But when you see what's going on in ports around the world and the cost of energy and the cost of commodities and the cost of shipping, it feels like it might not be transitory. So that feels like a real substantive issue," he added.

Limited partners also have inflation risk top of mind. A recent survey by placement agent Eaton Partners LLC found 89% of LPs interviewed are either somewhat concerned or very concerned about heightened inflation in 2022.

Interest rate risk

"The most critical impact of inflation is the effect it might have on interest rates," Cameron Joyce, vice president of Preqin's Research Insights, told S&P Global Market Intelligence. "It's really the longer-term interest rate that is more relevant to private equity and private capital given the long-term nature of investing."

"If we have a higher inflation rate environment, that might lead to a sell-off in longer-term bond yields. That impacts private equity valuations in a number of ways because … your discount rate and future cash flow are at a higher rate."

Technology companies are particularly vulnerable to changes in inflation because they are currently trading at high valuations and therefore sensitive to higher discount rates, Joyce added.

Pete Stavros, KKR's partner and co-head of North America private equity, speaking at the SuperReturn North America event, agreed that inflation is a major risk. He said that if it persists, interest rates will have to rise.

Stavros cited several factors driving inflation, including the rise in shipping rates and the cost of goods due to supply chain disruption; the labor shortage, which is driving up wages; and the shift to renewable energy, which is reducing oil production and pushing up oil prices.

"We're looking for core inflation to settle higher, maybe 3% plus versus what's been 1.5% historically," he added.

Joyce, from Preqin, said that private equity has so far shown no material signs it is holding back on activity. In fact, currently conditions appear favorable for the industry.

"Inflation is probably the single biggest risk we see at the moment, but the view on it is pretty divided. There are investors that think this is something that will resolve itself as we come out of the pandemic and all these frictional issues that we have in the economy [will] resolve [themselves]. But there are investors who see this as a start of a longer-term process."