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The Inflation Edition
This edition of Here's the Deal will take a close look at the impacts of rising prices, both real and expected, across many industries. Prior to the Russia-Ukraine conflict, inflationary pressures have been felt across the U.S. economy with rising car prices, rent increases, soaring energy prices and supply chain bottlenecks all exerting pressure on economic growth. Indeed the latest key gauge of inflation is at a 40 year high. Recent geopolitical events have certainly amplified these stresses.
Read on to discover the perspectives from some of our thought leaders in finance, infrastructure, consumer, cleantech, life sciences, technology, and restructuring about the impacts of inflation on their sectors.
Mid-Market Financial Services Companies Will Feel Inflation’s Impact
The financial services sector is incredibly broad and forms the foundation of the U.S. economy, representing more than 20% of GDP in any given year. This complex ecosystem of capital and service providers operates along an expansive continuum of sub-sectors and areas of focus, ranging from niche consumer and commercial finance businesses, to real estate, to more traditional participants including banks, asset managers and insurance providers.
The degree to which inflationary dynamics impact the core operations and strategies of each of the respective sub-verticals can vary dramatically. Nonetheless, we expect to see businesses across the mid-market feel the most impact. Asset managers and investors continue to search for yield and assets that hedge inflation.
Business development companies, alternative credit providers and commercial finance companies are likely to benefit from having predominantly floating rate assets with further earnings accretion through acceleration of prepayment fees as borrowers pay off higher priced loans. Consumer lenders will likely experience headwinds in the short term as increased funding costs outpace existing fixed rate assets, which will eventually be neutralized by higher rate originations over time. Finally, P&C insurance carriers will be faced with higher relative claims costs in the near term given the time lag between the current inflationary pressure and eventual pricing increases, while life insurance carriers generally exhibit strong performance in a rising rate environment due to higher spreads.
Shifting dynamics and changes due to inflation, like other forces we have observed in the past, spark inertia to consider strategic alternatives while also creating great opportunity for participants across the financial services sector. Initiatives to add scale, diversify product lines or retool capital structures are just a few of these alternatives. We therefore fully expect financial services firms to partake in healthy deal-making and continue to play in the capital markets in order to mitigate – or capitalize upon – the current environment.
For the Rental Services Industry Inflation Represents a Double-Edged Sword
2021 marked a period of substantial activity and robust valuation levels across the Rental Services market following the initial slowdown in deal volume during the early months of the COVID pandemic. Today, rental companies are experiencing the impact of inflation on their businesses. For the equipment rental industry, inflation represents an intriguing double-edged sword. On the broader scope, as the prices for steel and other components continue their climb, operators are seeing increases in the cost of new equipment. While this increases the level of capital expenditures for the business, it also increases the value of the owned equipment already in the operators' fleets. Equipment rental companies have witnessed a significant shift in the selling price of their owned equipment and the replacement value of the existing rental fleet.
This increase in the value of owned equipment is beneficial to achieving higher appraisal values for the operators' fleets, leading to greater collateral levels which support debt financings. The higher equipment pricing environment represents a potential opportunity for select operators to sell underutilized assets for attractive values to generate additional, supplemental cash flow.
Inflation Expected to Have a Low Impact on Long-Term Cleantech Trends
There are several key macro trends driving the Cleantech sector. Most importantly, country and corporate commitments to greenhouse gas reductions and zero net-carbon commitments continue to increase. The recent dramatic rise in oil prices may serve to exacerbate the move to renewables. There has also been a shift in consumer sentiment towards sustainably-sourced products and ingredients, which is driving corporate behavior towards what is commonly referred to as the “circular economy.” Lastly, the declining cost of information, information technology, and advances in artificial intelligence are allowing for low-cost resource allocation technologies to be applied to different verticals like industrial efficiency and agricultural technology. These long-term trends will require trillions of dollars of annual investment for the next few decades.
So far inflation is viewed as a transitory phenomenon that won’t affect long-term industry trends. However, in the short term, inflation and related uncertainty are affecting renewable energy project financing which in turn impacts the yieldco and sustainable finance stocks. The end-customer and end-market demand for renewable power is strong. In many markets, the marginal cost of renewable power is at or below traditional power. In the near term, increases in interest rates and the cost of labor are causing investors to question project economics. At this point, we view inflation as a short-term headwind and therefore most of the uncertainty around project economics is also short-term. Other effects of inflation on the cleantech sector are mostly derivative.
Inflation is the Top Consideration for Recalibrating Consumer Business Plans
Here in 2022, we look back on the past two years in the consumer world as historically unique – when some companies experienced exponential growth, while others saw dramatic declines and realignments of operations. This was followed by a phase of stabilization to attain satisfactory post-COVID or COVID-adjusted performance levels. The consumer banking world initially experienced low deal volume at the start of COVID, which recovered to robust levels in 2021.
In 2022, we expect continued cost increases for suppliers and consequently for the consumer. This will be most evident in the elasticity of demand for “larger ticket” items versus daily consumables. Whether through the anticipated interest rate increases or the sheer cost metrics of raw materials, inflation is now squarely the top consideration for all players in the industry who are recalibrating their business plans to reflect this new reality.
As a result, expectations for lower topline growth and/or profitability may lead to a realignment of valuation expectations. Some companies will likely seek to restructure their platforms as well as their balance sheets and capital needs. We will likely see the impact on deal volumes in both public and private markets as sellers and issuers potentially delay funding plans. The silver lining is that given the continued very high levels of capital still required to be deployed, we expect to see an increase in structured transactions in the world of consumer.
The Outlook for Technology M&A is Robust, Despite Inflationary Pressures
The expectation of persistent inflationary pressures is one of the most impactful variables on the outlook for technology stocks and issuance. The supply shortages and disruptions from the pandemic are currently lingering and exerting pressure on pricing across the board. Now, given geopolitical risks, these pressures are increasing. However, many technology companies are in an enviable position with well-funded balance sheets, given the significant capital markets activity over the last 18 months. Therefore, we believe many tech companies will be looking to put that capital to work – to grow inorganically as well as organically.
We expect M&A intensity will increase and we are ready to advise our clients on these transactions. For private companies that haven’t been fully capitalized or for emerging disruptive players in the venture world, we expect more conversations with larger strategic buyers about ways to identify partners to create beneficial synergies in an M&A exit.
These methods will include finding partners for distribution, or identifying a more powerful sales channel, or pursuing other strategic synergies. We also expect to continue to see a lot of activity from the private equity community where acquisitions and investments in high-growth businesses will continue across the tech landscape. As a result, while we expect tech issuance to slow in light of inflationary pressures, the outlook for technology M&A is robust.
Life Sciences Exhibit Healthy Immunity to Inflation
Life sciences is not the first sector one thinks of when pondering the impacts of inflation. In theory, higher interest rates lead to lower net present value calculations as a result of higher presumed costs of capital. However, in practice the vast majority of companies in the space rely on equity financing rather than debt making their true cost of capital much less sensitive to rising interest rates. That said, we believe a substantial amount of the downside has been absorbed by the market already, given that multiple rate hikes have been priced in.
We've looked closely at past interest rate cycles and there does not appear to be a strong correlation between actual rates and biotech performance, with the anticipation of rate hikes often having a worse impact than the actual implementation. Ultimately, we continue to expect that data and sector money flows to continue to be the driving influences of cost of capital and valuation for life science companies.
Well-Positioned to Provide Restructuring Advice During Market Challenges
The expansion of the Debt Advisory & Restructuring Group with the addition of Co-Heads, Eric Scroggins and Joe Stone, and Managing Director, Lance Gurley represents Oppenheimer’s efforts to provide tailored expertise and advisory services to companies and investors needing help as the U.S markets become increasingly volatile. The Group will utilize the strengths of Oppenheimer’s industry verticals and research capabilities to address the nuances and complexities of an industry or specific company when providing restructuring advice.
The debt advisory and restructuring business is somewhat countercyclical to the broader market. The prospect of higher interest rates may change the recent lengthy cycle of low-cost capital fueling the extension of maturities and the procurement of relaxed covenants based on bullish growth expectations. With this experienced, senior team of restructuring professionals, Oppenheimer is well-positioned to help clients solve for their related capital market challenges as the current market dynamic changes.
The Group is optimistic about its future prospects given its access to a platform that allows for creativity, experience, and deep knowledge to drive these discussions.
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