Preparing Your Portfolios For Inflation
Tackling the biggest inflation in 30 years
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With consumer price inflation reaching 30-year highs in the US and Europe, one of the most important topics on the minds of Private Equity executives must be how the inflation environment will affect their existing portfolios and future deals. The value at stake is material: on average, 3 to 4 percentage points of the earnings before interest and taxes (EBIT) margin.

This is unknown territory for most management teams who have been used to modest and declining inflation rates over their careers. The last time US inflation was this high, in 1982, Spielberg’s "E.T." was topping the box office. 

Based on our global experience over the years, we have put together a checklist to manage this inflation. The following points could apply to existing portfolio companies or form the basis of questions about future deals.

  • Identify the components of the inflation impact: While the impact of inflation seems broad-based, the extent of its effects are very different for labor and different materials. For example, in a typical breakfast, oats have experienced more than double the recent inflation of milk; coffee almost double that of orange juice. And in insurance, we are seeing major increases in the costs of automotive claims as cars become more complex and difficult to repair, and parts are harder to source. Awareness of the mix of these components is critical to understanding the impact of inflation.
  • Understand contractual constraints and waivers: We often find that clients' contracts lack inflation adjustment clauses. Or they have a flawed metric, for example one that is linked to consumer prices while the costs have different exposures (such as much higher wages to attract or retain tech developers). Worse still, sales forces might waive inflation increases, rewarding customer loyalty by not applying price rises. It is critical to ensure inflation is written into new contracts, while also tightly managing the discretion exercised by sales forces.
  • Role-play competitive stances: Competitors may be exposed to different costs according to how their supply chains are set up or how they choose to provide goods or services. In addition, in some sectors such as auto and furniture, we are seeing widespread supply chain disruption – customers may be willing to pay a premium just to have access to the goods. If your competitors are supply constrained and customers have limited options, think about a strategy of higher pricing and locking clients in with longer-term contracts.
  • Customers like trade-offs, not ultimatums: Our recommendation here is to provide options to clients on how they can offset the impact of inflation, for example by consolidating spend in exchange for a discount. This encourages business-to-business customers to have an informed discussion on how to offset the inflation. It also gives you an opportunity to discuss an increased share of the wallet as well as other services you could provide, and it cements longer-term relationships.
  • Arm the sales force with professional collateral and external justifications: Being able to point to trade press and news articles about inflation provides the sales force with talking points and the confidence to stand up to high-pressure procurement situations. For example, we helped a food supply business gather information on commodity inflation, minimum wage increases, and fuel price rises; this informed the business about real-world cases and helped the sales force to understand why their food prices were going up. Remember: your client's procurement department is likely under a lot of stress right now, and they need hard evidence from within the business to justify higher costs.
  • Set a goal, monitor the exercise, and run it like a campaign: Between business and finance, everyone should be clear on the asks, targets, and escalation points in any inflation negotiation. The mix of inflation effects often muddies the water as well; for example, as customers shift their purchasing to cheaper products, the success of a price pass through may be hard to see. Setting up a small project office with senior oversight of the programme provides rapid payback.

In summary, consumer price inflation is currently trending at 3 to 4 percentage points above recent levels, and financial markets expect these elevated levels to continue for some time. This is very important in the context of corporate after-tax profit margins of 10 to 12%. Grasping the impact of inflation should be at the top of the agenda for private equity.