Are businesses’ cost inflation forecasts keeping pace with reality?

Despite sky-high valuations and limited access to targets for private equity investors, the second half of 2021 saw a surge in deal activity.

Although such activity is expected to remain strong in 2022, a host of factors make it much more challenging for PE to build accurate investment theses. COVID-19-led disruption has made it difficult to obtain reliable information about normal business performance through due diligence – as we discussed in our recent Private Equity webcast.

A key challenge right now is that many businesses are struggling to understand – and therefore accurately forecast – the true impact of cost inflation.

Procurement teams often have sight of cost changes only at the point of contract renewal, and these contracts are typically retroactive and index-based, which means there is a significant risk of cost changes being missed out in projections. In turn, for PE firms, this leads to a risk of significantly overstating EBITDA on acquisitions.

Are hedging arrangements papering over the cracks?

Many businesses, particularly larger corporates, have had hedging arrangements in place which have fixed elements of their cost base. However, as those arrangements roll off and come up for renewal, the underlying costs are now being fixed at far higher levels.

We are seeing businesses adopt a number of other strategies to manage inflation risk. These include passing prices through to customers, introducing energy and freight surcharges; reengineering products (design to value), and establishing partnerships with suppliers that move beyond price alone (e.g. joint innovation) in order to secure healthy long-term relationships at a time when some suppliers are deprioritising customers or reneging on contracts. However, the ability to manage inflation risk ultimately hinges on how well the problem is understood.

While inflation may be considered a transitory risk, it isn’t going to go away quickly. Globally, we are continuing to see significant supply chain disruption, with shutdowns of key ports and factories among the factors leading to higher input costs. In the UK, factory input and output costs are rising far higher than inflation as measured by the Consumer Price Index.

Supply chains aren’t expected to begin normalising until 2023 and many businesses may be underestimating the sheer scale of what is coming their way over the next 12 to 24 months.

For PE, there will need to be increasing emphasis and scrutiny on forecasts, including:

• Understanding how much cost inflation has been factored into P&L forecasts, and assessing whether the figures accurately reflect inflation projections
• Testing assumptions around how much cost can be passed through to customers – do they anchor to businesses’ actual experience of what customers are willing to accept?
• Ensuring the working capital implications have been modelled correctly

Inflation risk is not just theoretical – it is material and significant. We have worked with a number of corporates on identifying costs and inflationary issues within their forecasts and projections. The amount of missing inflation we have identified equates to about one-third of the cost of goods sold.

So what needs to happen? First and foremost, there is a need to ensure that forecasting as a tool isn’t just kept in its own box. It needs to become an integral part of business planning – used proactively and continuously updated. And, of course, the decisions that a business makes must be continuously readjusted in line with what those forecasts show.