Prices rose across the board in 2021, and inflationary pressures are expected to continue in 2022. Double-digit price hikes caused by supply-chain disruptions are hitting companies’ margins hard, particularly in the manufacturing, construction, and trade sectors. Rising input prices pose challenges to PE firms, both in running their portfolio companies and in vetting potential acquisitions.
The jump in inflation undermines PE buyer assumptions and threatens fund performance. Periods of volatile pricing call for extra discipline and planning—to reduce damage and vulnerabilities in existing holdings, as well as when doing due diligence of new targets.
To better understand the risks to future margins, there are certain tough, key questions PE firms can ask management of portfolio companies and targets:7
Do contracts guarantee supply continuity?
In a volatile period, suppliers may attempt to take advantage of circumstances to force price hikes. Smart buyers add more performance guarantees in their supply contracts: they may more narrowly define force majeure or remove allocation clauses to mitigate the damage of unforeseen disruptive events such as fire or flood. At the same time, such continuity guarantees should be coupled with a mechanism for price increases or decreases to manage volatility.
Is there price transparency for direct materials?
It is crucial to demand ongoing price transparency. In periods of volatility, budgets often uncouple from actual prices with disastrous results for profitability. Price transparency should be detailed, and buyers can retain the right to withhold payment where transparency is not provided for cost increases.
Are direct materials costs indexed?
Indexing might seem like an obvious remedy for price volatility, but it only makes sense for the buyer under certain circumstances—such as when the supplier has limited ability to control materials costs, and when these represent a high percentage of the buyer’s purchase costs.
Can suppliers meet buyer needs?
Another commonly overlooked risk is the supplier’s ability to scale supply. Whole sectors are being held back by commodity shortages—just look at the automotive sector’s current low inventories caused by the ongoing microchip shortage. Even if a supplier is resilient, it’s almost always a good idea to find a second source. Dual sourcing makes disruptions less likely, and introducing competition can help keep prices nearer to the market-clearing price.
Is the technical expertise to handle price spikes available?
With costs bouncing, it’s a good time to make sure that there is enough technical expertise on tap to limit materials price increases when contracts and other commercial levers fail. Companies might consider an audit of suppliers’ contracts to check that their price hikes are allowed under current agreements. In this environment, sellers are often tempted to push past the letter of the contract or manipulate a buyer into breaking it off.
Is there a structured price-management committee?
It’s important to have governance in place across procurement and business stakeholders to better understand why prices may increase, their impact on performance, and how to develop a mitigation strategy.
Thoughtful responses to these questions will help PE firms keep the supply chains of portfolio companies resilient and spot potential problems lurking in targets’ operations. In a highly uncertain price environment, “buyer beware” is an even sounder rule than usual.