Danger, Will Robinson – The 5 Major Risks on the PE Investing Horizon
2021 was a banner year for PE investing. Not surprisingly, as a result there is right now an upbeat mood throughout the industry. Deals are getting done, funds are being raised, virtually everyone in the sector is ‘right out straight’ – super busy, making money. Moreover, alongside the current euphoria, there seems to be a natural human instinct to believe that the future will continue to be bright as we move into 2022. All of which suggests that this may be a highly appropriate moment to raise the yellow flag of caution.
With this in mind, here are 5 of the most important clouds looming on the horizon – reasons to be extra cautious – and perhaps even a bit worried as we move into the new year.
- Even More Money Chasing Deals: During the past year, the total capital in the PE sector has now surpassed $2.5 Trillion, according to PitchBook. Most important, the amount of dry powder has grown to account for more that $500 Billion. With all this money sitting in funds and with a record setting fund raising year in 2022 predicted, there will be significant pressure to deploy this massive amount of capital.
- Fewer Deals – Supply of Deals Likely to Dwindle: Meanwhile, as the supply of capital is increasing the number of available deals (and especially, high quality deals) is likely to diminish. 2021 was a record setting year as more than 8,600 PE investment transactions were completed. This marked an increase over prior years by approximately 50 percent. For the immediately prior time period, 2018, 2019 and 2020, that number hovered steadily at around 5,700 such transactions in each of those years. Evidently, the combination of the pandemic and increasing multiples caused a cascade of owners to put their companies on the market in 2021 and cash in. Given this dramatic one-year increase, the obvious concern – and probability – is that there may be significantly fewer deals available in the coming year at precisely the same time that there are record amounts of dry powder available to bid up prices.
- Rising Inflation and Increased Interest Rates: Here’s an ugly combination. According to the CPI, inflation is currently at 7 percent. However, as we point out in another article in this edition of ‘The Winning Pivot,’ many economists believe that the real inflation rate, if measured in a way consistent with earlier standards, is actually approximately 15 percent and likely to go higher. Thus, causing potentially dramatic negative effects on the performance of specific companies. At the same time, given the likely level of inflation, interest rates are likely to increase. In which case and with increased costs of debt financing, it will be difficult for investors to stretch to some of the higher purchase multiples that will be required to ‘win deals.’ Nonetheless, there will be pressure to do so. Obviously, wise investors will need to proceed with special caution.
- Supply Chain Issues and Systemic Worker Shortages: Another important factor that will need to be taken into account in pricing deals will be the twin issues of supply chain disruption and workforce shortages. While many will see the current supply chain disruption as a temporary blip, where all will return to normal relatively soon, but in reality, it’s not so obvious. Large numbers of people have left the workforce through either aging into retirement or taking ‘early retirement’ in the pandemic, and thus many of those who left are not coming back. We are currently experiencing a systemic deficit of between 2-3 million employees in the United States and with the aging of the workforce, much of this deficit may be permanent. If this is the case, or even partially so, many businesses will be stretched to meet their performance metrics and as a result investment returns will also be difficult to achieve. The smart investor will build the necessary assumptions into financial scenarios with a cautious eye toward these headwinds.
- Rose Tinted Glasses: We all tend to believe what we want to believe. And, of course, we all pretty much want the party to continue. Bankers will be putting together pitch books with generous EBITDA ‘add backs.’ With the pressure to invest, some may find a more accepting view of these rosier scenarios. More and more speculative indicators of business stability will be treated as ‘ARR’ – annually recurring revenues – thus, arguing for higher and higher purchase price multiples. And, in the end, it is likely that many deals will get done. But at what future result – and what will the ultimate returns look like? Beware the temptation to believe that the future will unfold along a straight line extended from the past.
So, taken as a whole, 2022 would appear to be a time for prudence and caution. Nothing too good lasts forever. And, you always want to make sure to leave the party before the band stops playing. Good luck in the new year!