As central banks around the world fight one of the highest inflation rates in decades, global interest rates are rising at an exceptional rate. While several experts expect a slowdown in inflation and a stabilization of interest rates, it is expected that the inflation rate will remain well above the target level for some time. As a result it is prudent to examine the effect that this current inflationary environment will have on the Search Fund asset class.

In this article, we will explore current economic trends and the effect they may have on Search Funds and the Private Equity market as a whole.

Current economic trends

The European Central Bank (ECG) has increased interest rates by 75 basis points in September, the second such hike with the first of 25 basis points coming in July. 

In the UK, the Bank of England has increased interest rates by 75 basis points earlier in November and has planned another increase of 50 basis points in December. 

The US is facing a similar situation and the Federal Reserve has increased interest rates by 75 basis points this November with markets expecting a further increase in December. 

These hikes are expected to continue into 2023 with Goldman Sachs projecting the interest rate to reach between 5% and 5.25% the following year through basis points increases in December, February, March and May.

Why are interest rates rising? 

Worldwide interest rate increases are largely driven by soaring inflation which is caused by several factors. 

• Supply Driven inflation: This is when inflation is affected by imbalances between consumer demand and the supply chain. Recent events such as the COVID pandemic and the war in Ukraine have put severe pressure on supply chains resulting in a disrupted supply of various essential materials driving prices to inflate. 

• Money Supply Driven Inflation: According to the Federal Reserve Bank: Inflation can be caused when the money supply in an economy grows at a fast rate and the economy is unable to produce goods and services to meet the demand. During the pandemic, the Federal Reserve created new money at unprecedented rates printing nearly $5 trillion in COVID relief which increased the money supply by 27%​​. This had adverse effects on the inflation rate and resulted in one of the most inflationary environments seen in recent history. 

Governments and financial institutions around the globe are increasing rates in a bid to manage soaring consumer prices and tackle the issues caused by rising inflation costs. 

What effect does inflation and rising interest rates have on Private Equity? 

The inflation outlook has shifted dramatically in the aftermath of the pandemic and since the start of the conflict in Ukraine. Annual inflation in the Euro area has reached an all time high of 10.7% in October and is expected to remain well above the Central Bank target. 

Rising inflation costs will have a similar impact on Private Equity funds as rising interest rates. According to Validus Risk Management: “Should inflation continue to push higher, this will lead to higher borrowing costs, which, in the absence of suitable hedging, will drag down fund returns.”

Inflation is a key risk for the Private Equity market, and the most critical impact of inflation is the effect it might have on interest rates.

Private equity investors rely on leverage

Private Equity investors use a great deal of leverage (e.g. debt) to acquire privately-held companies. This allows investors to maximise their Internal Rate of Return (IRR). However, this approach requires steady cash outflow in terms of interest and principal payments.  

Higher interest rates result in higher debt repayments, which directly reduces the IRR that the investor receives when they exit the acquired business. 

Higher inflation due to supply chain shortages also has the potential to disrupt the operations of the companies that PE firms invest in.  

Take, for example, a car manufacturer facing supply shortages preventing them from producing at full capacity. Another example is a luxury goods brand that sees a decline in demand due to lower levels of disposable income levels with their target consumers.

How could rising inflation and interest rates affect Search Funds?

Similar to traditional Private Equity strategies, Search Funds require a lot of leverage to make an acquisition, sometimes up to 60% of the value. Rising interest rates could make it more difficult for Search Fund entrepreneurs to secure high leverage deals as creditors will be more cognizant of the higher cost of debt and higher risk of lending. 

This would suggest that Search Funds are highly sensitive to changes in inflation and interest rates, however Search Funds have inherent risk mitigation mechanisms that make them a safer investment during times of economic uncertainty.

Search Fund criteria

The Search Fund criteria helps keep Search Funds insulated from the impacts of inflation and increasing interest rates and they will likely remain a strong asset class despite the current economic uncertainties. 

High EBITDA margins 

Search Fund entrepreneurs look for companies with high EBITDA margins that are generally between 20% and 60%. Within these EBITDA margins, the risk of inflationary pressure on costs will not usually pose a significant threat to the business.

High FCF conversion ratio

Companies with a high FCF conversion ratio will not usually have issues paying off leverage used during acquisition, despite increases in interest rates. It also means that the company’s operations will not usually rely on large amounts of working capital debt, which further diminishes risk, as these companies do not have to take on debt to grow. 

Recurring revenue

Companies acquired through Search Funds tend to have a loyal customer base and long-term contracts in place e.e.g SAAS models. This reduces revenue risk as their revenue levels are stable and ensures that they will be able to consistently pay back debt even in inflationary environments.

Low CapEx

Search Funds focus on lower CAPEX businesses which reduces the cash flow risk. It also ensures that the business will not have to take on debt to pay CapEx in an environment with high interest rates.

Low customer concentration 

A company acquired through a Search Fund will typically have a large and diversified customer base. This ensures multiple revenue streams which means that no one client can have a significant impact on revenue. 

This is important in an inflationary environment as in times of instability, companies may lose clients for various reasons. Having a fragmented base ensures that the loss is not too impactful. 

How can Search Funds be further protected? 

Searchers should be mindful of the current inflationary climate and there are other criteria and constraints that can be looked at to further insulate themselves from the risks associated with rising interest rates and inflation. 

In addition, acquisitions that serve defensive Industries like education, healthcare, food, etc should be more heavily pursued. These industries are essential and generally provide more consistent returns even in times of economic recession and inflation. 

Furthermore, in the current environment with consistent supply chain disruption, searchers should target companies with localized and simple supply chains in order to minimize the risk of supply chain issues and price increases. 

In inflationary and recessionary markets, companies selling products that are affected by low disposable income levels should be avoided. This helps protect the Search Fund from negative macroeconomic trends and reduces its reliance on the performance of the overall economy. 

Dedicated support from Moonbase Capital

The partners at Moonbase Capital have a combined 50+ years of experience acquiring, scaling, and exiting small and medium-sized businesses (SMEs). 

We use our knowledge and expertise to help entrepreneurs identify the most robust SMEs with the highest growth potential. We also draw on the expertise of our advisory board, a network of 35 experts that has grown over the years and is still growing.

Bottom line

Global interest rates have been rising in response to soaring inflation costs caused by the pandemic and the war in Ukraine. Further increases are expected in the coming months and the current economic climate is hard for investors to navigate. Interest rates are high which makes leverage more expensive and means that some companies are more risky. 

The Search Fund criteria helps insulate the asset class from many of the impacts of the current economy. Search Funds are in a strong position to beat inflation, but investors should still be aware of the current inflationary climate and be more cautious of the investments that they take on.