There is a great deal of uncertainty surrounding the U.S. economy at the moment. On one hand, demand for workers is strong, planes are full, hotels are booked, rent is through the roof, and securing a reservation at your favorite restaurant is increasingly elusive. On the other, the stock market has retreated from record highs, consumer sentiment is waning, and business leaders are increasingly preparing for a new normal characterized by persistent inflation and tighter customer budgets.
Aggressive monetary and fiscal stimulus in the early stages of the COVID-19 pandemic led to a swift V-shaped recovery. Those policy tools appear to have been overextended and thus have been reined in over the last few months. Inflation will likely remain in the near term, affecting middle-market business owners as they strive to increase their cash flows in real terms. In this environment, the onus is shifting to operators to take steps to stem inflation’s effects through a combination of cost containment and price increases while also looking ahead to the next 18 to 24 months to adapt their businesses for the longer term.
Business owners will have to address various challenges proactively, including coping with a higher cost of capital, navigating higher raw material prices and maintaining productive workforces.
Operating in a World Where Capital Is No Longer Free
In 2020, negative real interest rates led to tremendous liquidity for companies and record valuation levels. The script has now flipped, with inflation surging and interest rates rising. The Federal Reserve has increased the benchmark federal funds rate in recent months (most recently by 0.75% on July 27) to a target range of 2.25% to 2.50%. This follows another 0.75% increase last month, which at the time was the largest one-time increase in almost three decades.1
Companies should evaluate their capital structures ahead of further rate increases to ensure they have the flexibility to weather a slowdown (e.g., prepare a covenant scenario analysis and evaluate the need for additional capital). Companies should also consider how higher rates will affect suppliers and customers, factor rate increases into longer-term bids and evaluate ways to increase inventory turns and reduce carrying levels. There is no one prescription for all companies to operate in a period of rising rates, but understanding the implications and proactively taking steps to mitigate them is incredibly prudent.
Interest rates also affect merger and acquisition (M&A) markets. 2021 was a record-setting year for U.S. M&A, both in terms of deal volume and value in dollar terms. In particular, U.S. middle-market private equity (PE) recorded its busiest year ever, closing 4,121 deals worth an aggregate $602.6 billion – around 50% above the previous annual records for both figures set in 2019.2 While the M&A sector in the first quarter of this year appeared active by historical standards, in reality it declined year over year as the overall market sentiment started to shift given soaring inflation, the Russia-Ukraine conflict, expected Federal Reserve interest rate hikes and greater regulatory scrutiny (e.g., antitrust reviews and updated special purpose acquisition company [SPAC] rules). While PE buyers, flush with capital to put to work, continue to pursue acquisitions, they are likely to fund transactions with less debt due to rising interest rates, leading to more conservative valuations.
Halfway through 2022, we are starting to see the impact of rising interest rates on middle-market activity and valuation levels, and the drop in transaction volumes and anecdotal evidence suggests a more cautious outlook in the M&A market for the rest of the year. What just a few weeks ago was perceived to be the M&A market catching its breath after the frantic activity of 2021 is now increasingly appearing to be the start of a more profound slowdown.
Managing High Input Costs
Commodity markets are globally integrated and efficient. Disruptions in one part of the world can quickly flow to the other side of the globe. For instance, Russia and Ukraine together supply more than one-quarter of the world’s wheat, and the invasion of Ukraine resulted in a disruption to the grain supply and a sudden increase in prices. Look also at crude oil prices, which increased from approximately $60 per barrel pre-pandemic to around $120 per barrel in June 2022 – and even collapsed temporarily below zero in April 2020 due to a complex confluence of demand (e.g., extreme weather events and industrial activity) and supply (e.g., OPEC production, Russia supply disruption and the release of U.S. strategic petroleum reserves) factors.
Unexpected changes in input costs can wreak havoc on the profitability or even viability of a business that has long-term fixed contracts and commitments. Large companies may have hedging programs or flexible contracts that enable them to control their input costs, while certain industries with more inelastic end-user demand are able to pass on price increases to customers. Middle-market companies must often be nimbler and more creative. In consumer products, certain businesses have resorted to “shrinkflation” – reducing the size of products while holding prices constant. Companies with advanced research and development capabilities are investing in identifying alternative input materials. With the lockdowns in China where many goods are produced, numerous companies have spent the past two years diversifying their sources of supply to other low-cost countries such as Vietnam and Mexico, or even “insourcing” work to reduce the reliance on overseas supply chains. While price increases may be unavoidable, it is important that business owners innovate and push the boundaries to manage input costs through a potentially long inflationary period.
Maintaining a Productive Workforce in a Dynamic Labor Market
A strong workforce is the foundation of every successful company. At the beginning of the pandemic, many people were let go as businesses, particularly retailers, reacted to strict lockdown regimes. Some employees voluntarily resigned as they became stay-at-home caregivers for children and sick family members or moved to other states for new opportunities. Government stimulus checks helped workers to cope with sudden job losses, but also allowed them to be more selective with re-employment opportunities. Companies like Amazon with booming pandemic demand started paying above-minimum wages and provided large sign-on bonuses to attract blue-collar employees to rapidly expanding warehouses. Many white-collar workers discovered the freedom and flexibility of working from home (or on an island!) and took the opportunity to work remotely.
The rapid economic recovery has driven down the unemployment rate. This is compounded by 40-year-high levels of inflation where paychecks don’t go as far, driving workers to unionize and demand better compensation and working conditions. With shifting power dynamics between employers and employees, not only are business owners struggling to find enough workers, but they’re also having to pay more to retain and attract talent.
While increasing pay is a short-term fix, it is no panacea in developing a productive workforce. Workers are aware of the changing world around them and have developed an increased sense of self-worth. This is prompting them to demand more personal satisfaction and purpose as the rigid boundaries between work and personal life disappear. Astute employers will acknowledge this truth and respond with benevolence and purpose-driven employment. Flexible work arrangements, improved healthcare coverage (including wellness allowances, behavioral health therapy, fertility and childcare benefits) and supporting employee involvement in charitable organizations in local communities are recent examples of benefits valued by employees.
Many companies have also decided to subsidize home workstations and taken the opportunity to renovate their buildings, creating an environment that is more supportive of remote working arrangements. Re-examining space requirements can be a cost-effective way to reduce the real estate footprint of a company while ensuring that employees that meet in person are excited to collaborate in a physical office environment. In some industries, this is also an opportunity to hire talented remote workers from out-of-state that were previously not considered. The key is to develop a corporate identity and culture that permeates space and time such that remote workers are as productive and invested in the organization as onsite employees.
Near 40-year-high inflation after two and a half years of COVID-19 has resulted in choppy waters for business owners. Are the dark clouds a passing thunderstorm or a hurricane leaving behind more long-term damage? It is hard to know for sure, but recognizing the changing environment and adapting your business in the short-term for what could be a more prolonged recovery is critical. While middle-market businesses can be more impacted by inflation, they are often in the best position to respond quickly. The pandemic has shown us what we can accomplish when we focus and take proactive steps to adapt. It’s all about staying one step ahead of the game.
1 Timiraos, Nick. “Fed Lifts Rates by 0.75 Point Again.” The Wall Street Journal. Dow Jones & Company, July 28, 2022.
2 “2021 Annual US PE Middle Market Report.” Pitchbook.
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