As inflation remains high and stubbornly above the Government’s official target of 2%, for the first time since the early 1990s investors are feeling its effects on their holdings.
A ‘traditional’ investment portfolio, with allocations into equities and conventional bonds for example, is not inflation-resilient and sitting on cash during times of high inflation means you are losing money in real terms.
Protecting against high inflation is a challenging task for investors and there are few ways to safely preserve wealth, let alone to help it to grow.
Low-risk investments such as cash and government bonds will generate a return similar to the base interest rate. However, with inflation at 7.9% (as at 27 July 2023) and the base interest rate at 5%, these types of investments are unable to keep pace with cost of living.
There is no denying that investors might feel nervous and discouraged about investing during inflationary periods. In such volatile times, people may prefer to see out periods of low growth without investing.
We often worry about whether we’re taking too much risk with our investments, but we should also consider whether we’re taking enough risk when many traditional asset classes are seeing shrinking returns in this inflationary environment.
Investing in alternatives could be one way to keep money in line with, or even beat, inflation. For many, investing in private equity and real estate are no longer considered alternative, and now form a key part of a modern investment portfolio. Yet for others, alternatives may never have been considered as part of their asset allocation.
One of the best courses of action to beat inflation is to diversify. Private equity’s historic performance and lower correlation to traditional investments allows investors to benefit from the principle of diversification, so a well-diversified exposure to the asset class, as part of a balanced investment portfolio, could offer an effective way to hedge.
Private companies are less susceptible to market fluctuations than their listed counterparts
Of course, these companies are still likely to feel the pinch of rising costs and the consequences of low-growth periods, but private equity investments are typically based on longer-term metrics, and do not experience the same level of volatility as the stock markets.
Private Equity firms favour investment into disruptive and innovative companies
While not impervious, they do tend to have characteristics that can reduce their vulnerability to inflationary forces. Fast growing emerging companies, for example, have a smaller turning circle than their larger counterparts.
Factors such as concentrated ownership enables these businesses to be nimble. Their ability to adapt, disrupt, exploit and pivot quickly are key strengths. In turn, this allows them to move swiftly accordingly as market conditions change, navigating uncertain inflationary periods with more confidence and resilience.
Many of these businesses are also at the forefront of developing products that meet evolving demands while adapting to changes in the supply lifecycles. Those underlying strengths endure no matter the macro-economic environment.
Private equity firms find opportunities in low growth
Strategies for existing investees, such as buy and build, also come into their own as a decline in company valuations enables platforms to buy other businesses at more favourable prices, to achieve scale and create a larger more valuable organisation where they become an attractive target for potential acquirers.
Of course, a decline in company valuations may affect some existing portfolio investments, but private equity firms are often in the position where they can be patient with capital and wait for better economic conditions before exploring an exit opportunity.
This approach helps reduces the pressure for an early realisation and in turn, means the founders can prioritise sustainable business growth and initiate careful exit planning.
The active approach taken by private equity firms in managing their portfolio companies also means that they can influence strategy to help mitigate against any negative impact.
Mergers and acquisitions, geographic expansion, restructuring, improving efficiencies, implementing cost controls, negotiating better terms with suppliers, and refinancing amongst others, can all be leveraged.
Private Equity firms carefully select investments where they can see the potential to fundamentally improve or even transform the business. It is about creating value rather than just picking winning companies. This has helped private equity consistently outperform public markets throughout different economic cycles.
This active management could be an attractive feature for investors who see this greater flexibility as an effective tool for countering the uncertain economic environment.
While not a risk-free option, and there is the potential for loss of capital along the way, alternatives do display several appealing characteristics which have the potential to hedge against high levels of inflation in ways traditional investments cannot.
An investment directly into an unquoted or private company or into property carries a higher degree of risk than many other forms of investment. It may also be more difficult to realise, as shares in private companies are not publicly traded. The value of shares in a private company, including the level of income derived from them, may fall as well as rise, and investors may not get back the money originally invested. Past performance is not a guide to future performance.
Suzanne Lupton is Director of Co-investment at Maven Capital Partners. She has overall responsibility for managing the Maven Investor Partner business.