Inflation
How rising prices affect PE entry multiples, portfolio company margins, real returns, and the hidden benefit of debt erosion
~15 min read
Inflation is the sustained increase in the general price level of goods and services over time. For PE investors, inflation is not an abstract macroeconomic concept. It directly affects the price you pay for a company, the operating performance of that company during the hold period, and the real purchasing power of the returns you ultimately generate.
The US experienced low and stable inflation (1-2% annually) from roughly 2010 to 2020. Then, in 2021-2022, inflation surged to levels not seen in four decades, reaching a peak CPI reading of 9.1% in June 2022. This spike forced PE practitioners to re-learn a set of skills and considerations that had been dormant for a generation.
Inflation and Entry Multiples
Inflation affects PE entry valuations through several channels:
Higher interest rates. Central banks raise rates to combat inflation, which increases the cost of leverage and reduces the amount buyers can borrow. This mechanically lowers the price PE firms can pay. If a company's cash flow can support 5.5x leverage at a 7% borrowing rate but only 4.5x leverage at a 10% rate, the buyer either pays less or accepts a lower return.
Multiple compression. When discount rates rise (because interest rates rise), the present value of future cash flows decreases. This pushes valuation multiples downward across the market. A business that traded at 12x EBITDA when rates were 2% might trade at 9-10x when rates are 5%. For PE funds that bought at peak multiples, this compression can erase years of operational improvement.
Nominal EBITDA inflation. On the flip side, moderate inflation can increase a company's nominal EBITDA if it can pass price increases through to customers. This partially offsets multiple compression: you may sell at a lower multiple, but on a higher EBITDA base. The net effect depends on the company's pricing power and the severity of the multiple compression.
Impact on Portfolio Companies: The Pricing Power Test
Inflation creates a stress test for every PE-backed company: can the business raise prices as fast as its costs are rising? The answer determines whether the company's margins expand, hold, or compress.
Companies with strong pricing power can pass input cost increases through to customers with minimal demand loss. These businesses share common characteristics:
- Mission-critical products or services that customers cannot easily substitute
- Contractual price escalators tied to inflation indices
- Strong brand loyalty or high switching costs
- Fragmented customer bases with limited negotiating leverage
Examples include enterprise software companies with annual subscription renewals, waste management services, and specialized healthcare providers.
Companies with weak pricing power absorb cost increases in their margins. These are typically businesses in commoditized industries, those selling to sophisticated procurement organizations, or those facing intense competition. A contract manufacturer selling to Walmart, for example, has very limited ability to raise prices.
During the 2021-2023 inflationary episode, the spread between winners and losers in PE portfolios widened significantly. Companies with strong pricing power saw margins hold or expand, while those without it experienced painful margin erosion that directly reduced enterprise value.
Real Return
The real return is the inflation-adjusted measure of what an investor actually earns in purchasing power terms. If a PE fund generates a 20% nominal IRR during a period when inflation averages 6%, the real IRR is approximately 14%. During the low-inflation decade of 2010-2020, the difference between nominal and real returns was negligible (1-2%). During the 2021-2023 inflation spike, it became a meaningful factor in evaluating PE performance. LPs increasingly scrutinize real returns, especially pension funds whose liabilities are tied to inflation-linked obligations.
The Hidden Benefit: Debt Erosion During Inflation
Inflation has one significant positive effect for leveraged investors: it erodes the real value of fixed-amount debt obligations.
When a PE firm borrows $500M to finance an acquisition, that $500M is a nominal obligation. If inflation runs at 5% annually for three years, the real value of that debt decreases by roughly 14% in purchasing-power terms. The PE firm repays the lender in dollars that are worth less than the dollars it originally borrowed.
Meanwhile, if the portfolio company can raise prices and grow its nominal revenue and EBITDA in line with inflation, the company's enterprise value (in nominal terms) may rise even without any real operational improvement. The combination of debt erosion and nominal value growth can boost equity returns.
This is a key reason why moderately leveraged, inflation-protected businesses are attractive PE investments during inflationary periods. The leverage acts as a natural inflation hedge: the asset values rise in nominal terms while the debt stays fixed.
However, this benefit is partially or fully offset if the debt carries a floating rate (which resets higher with inflation-driven rate hikes) or if the company lacks the pricing power to grow its nominal cash flows in line with inflation.
| Low Inflation (1-2%) | High Inflation (5%+) | |
|---|---|---|
| Entry multiples | Higher (low discount rates) | Lower (high discount rates, multiple compression) |
| Borrowing costs | Low (accommodative monetary policy) | High (central banks tightening to fight inflation) |
| Portfolio company margins | Stable (input costs predictable) | Depends on pricing power (winners vs. losers diverge) |
| Real returns | Close to nominal returns | Significantly below nominal returns |
| Debt erosion benefit | Minimal | Material (real value of fixed debt declines) |
| LP behavior | Overweight PE for yield | Scrutinize real returns; demand inflation-hedged strategies |
Inflation is not inherently good or bad for PE. It creates a more complex environment where company selection and pricing power become critical differentiators. Firms that can identify businesses with durable pricing power and appropriate leverage structures can generate strong real returns even in inflationary periods. Those that overpay for commoditized businesses with floating-rate debt will find their returns eroded on multiple fronts.
In the next lesson, we will examine what the shape of the yield curve tells us about economic expectations and how PE firms use this signal in their deal-making and portfolio management.
Quiz: Inflation
5 questions · ~3 min