How inflation, monetary tightening and volatility are impacting PE and VC

On May 12, 2022

Andrew Akers is an analyst on PitchBook’s Quantitative Research team. Click through to read his recent analysis of the state of the markets and the economy.

Inflation is running at its highest level since the early 1980s and well above the Federal Reserve’s target rate of 2%, driven by economic stimulus, supply constraints and geopolitical disruptions. To counter the price rises, the Fed has increased short-term interest rates by 75 basis points this spring, and markets expect a further 200 basis point tightening by the end of the year.

The Fed’s rate hikes and the sharp increase in market expectations for further tightening have been the biggest drivers of recent market turmoil, with most public stock indexes falling by double digits since the start of the year.

These dynamics fundamentally alter how the Fed is able to conduct monetary policy and carry implications for valuations, buyout deals and the economy as a whole:

The increase in discount rates corresponding with market volatility has led to a fundamental repricing of valuations and a sharp rotation away from stocks with relatively high implied growth rates toward stocks with relatively low growth rates.
Performance of VC-backed companies that have recently gone public suggest there has been a huge dislocation in valuations between private and public markets that will be hard to ignore any longer.
If the market is correct, and short-term rates do indeed increase by 200 basis points by year-end, this would result in the average interest coverage ratio for recent buyout deals falling to 2.2 times, assuming EBITDA is unchanged. For future deals, this means that leverage, which has magnified positive returns in recent years, or valuations will need to come down.

As these shifts play out, our economic modeling currently suggests about a 20% chance of a US recession in the next 18 months. We think there are three plausible economic scenarios for the months ahead, with distinct paths for inflation, interest rates and growth.

Soft landing: Supply constraints don’t worsen, or even improve moderately. The Fed is able to slow aggregate demand and inflation by raising rates to a level in line with what is priced into the markets—roughly 2.5% to 3%—without causing a recession. In this scenario, the most likely according to our view, there is no further shock to asset valuations due to higher discount rates. This is the best-case scenario for private markets as valuations find a lower equilibrium and inflation and increased borrowing costs remain manageable.

Deflationary recession: Inflation remains stubbornly high but does not worsen too much, and the Fed raises rates to restrictive levels. Tight monetary policy stymies demand, pushing down prices and growth and risk assets are hit with a new downturn as revenue and profits fall and risk premiums rise. Because of deflation, the Fed would once again be able to provide support and pave the way for a market rebound. Given the substantial amounts of dry powder in the private markets, PE and VC portfolio companies are well positioned to weather this scenario.

Inflationary recession (Stagflation): Global supply chain constraints worsen, commodity prices soar and inflation remains high or climbs further. In this scenario, which we consider the least likely, the Fed falls behind in its tightening campaign, and eventually has to raise rates well into restrictive territory. Higher rates push down demand and growth, but supply and production constraints result in a supply-demand imbalance. The resulting stagflation pushes up nominal discount rates and risk premiums while real growth rates fall. The Fed’s ability to support markets is hobbled by persistent inflation. This would be a challenging environment for LBO-backed companies as input and borrowing costs rise together. Revenue would need to rise at a faster rate than input costs to maintain EBITDA coverage ratios and avoid liquidity problems, which would be challenging given the corresponding drop in demand.

While the soft landing remains, in our view, the most likely scenario, the likelihood of a recession has been increasing in recent months, and will probably continue to do so in the near term as credit spreads and interest rates rise.

Markets may be nearing a bottom, but given the rise in discount rates and growth repricing we’ve observed, we don’t see a quick reversal in asset valuations. Private market investors should prepare for valuations to be marked down in the coming quarters, especially in VC.

Featured image of US Federal Reserve Chairman Jerome Powell by Jim Watson/Getty Images

This article originally appeared on PitchBook News