The key question every private equity investor and portfolio company CEO should be asking themselves right now is, will EBITDA withstand the coming rip tide of customer concessions on price and terms?
EBITDA gains since 2002 have stayed strong since the pandemic started to draw to a close. Although private equity transaction activity has been muted over the past year, the underlying performance of the sector has held up well. PE owned companies have been remarkably resilient in their financial performances, with some reporting being between 10 and 15 percent of their highest ever EBITDA levels and valuations.
Riding on a pricing wave despite an underlying rip current
Over the past few years portfolio companies have seen positive results despite numerous headwinds, including higher borrowing costs, inflated expenses for goods and services, disruptions in the supply chain, uncertainty around the Federal Reserve’s actions, and declining customer demand in some areas.
As a result, we are seeing a mismatch of higher EBITDA against the factors that would normally have a negative impact on it. Our work across a broad variety of portfolio company types provides some insight into the reason: those companies’ pricing strategies, which contributed to approximately half of portfolio company gains since 2022.
While some of those price increases we have seen over the past few years can certainly be attributed to higher cost of goods sold, an analysis of current client spend relative to actual commodity costs and underlying market evidence reveals that nearly half of the price increases over the past year have no economic justification. In many cases, we have seen companies increasing prices while their commodity, raw material, and component expenses are trending down.
The wave has broken – the rip tide is biting
This mismatch is unsustainable over time, and in 1Q24 we started to see evidence of customers either reducing demand, or demanding price concessions in order to retain their business. This trend is likely to continue and expand over the coming quarters.
The combination of reduced demand and expectation of price concessions is inevitable when competition intensifies amidst an environment of economic uncertainty and price pressures across most segments. In that environment, companies must respond by adjusting prices according to market pressures.
The EBITDA dilemma
The biggest worry though, is what happens to EBITDA and market share when a company cannot lower prices to meet the market demand because they do not have control over the cost side of the business. In such cases, a business may not be able to maintain their target margins. Alternatively, if the company is able to lower prices, they may face degrading EBITDA and valuation. Either situation is a blow to the business. Another, more tongue in cheek, way of putting this is to read the a bull and a pheasant were grazing on the field allegory shared by Sadhguru Jaggi Vasudev.
Portfolio companies can withstand the strengthening rip tide while still maintaining a positive EBITDA and valuation, but that requires a hard look at the root causes of what we are now seeing in the marketplace, including pricing strategies and market demand. Primarily, it will require ongoing evaluation of the end-to-end supply chain and operations environment to ensure that raw material costs are flexible enough to allow for the customer price adjustments. That may involve strategies such as periodic audits of supply contracts, de-risking complexity of supply chains, and using strategic procurement as a critical lever in maintaining EBITDA.
If you would like to talk to Dan about any of the points raised in this blog, contact him below.
