Interest Rates vs. Private Equity: Winners and Losers

The US central bank (“The Fed”) responded with an aggressive series of interest rate hikes. This upended an era of easy monetary policy that had been in place more or less since the aftermath of the financial crisis of 2008.

While the effects of these rapid hikes have yet to be fully understood in the broader economy, the impact on private equity (PE) has been much clearer. In this article, we examine the relationship between interest rates and PE deal activity, and what this means for investors.

Interest rates vs Private Equity

An age of low or near-zero interest rates creates a favorable environment for a certain type of private equity firm known as a ‘Buyout’ fund’.

In this approach, the fund borrows money to finance an acquisition, uses the purchased company’s cashflows to pay back the debt, and then either sells the company to another private buyer or re-launches it on the stock exchange.

Higher interest rates make this strategy less effective. In the first place, higher interest costs eat into overall returns. A higher interest rate also decreases the exit value of the firm, as the future buyer will discount its future cashflows at a higher rate. The mere availability of higher rates makes private equity a less attractive class for investors.

^{Source: Pitchbook}

Furthermore, higher interest rates can lead to a more depressed macroeconomic environment by discouraging spending and encouraging saving, leading to lower revenue growth. If labor costs are also rising (as is common in inflationary environments), this can compress margins as well, leading not only to lower profits but also potential defaults.

How PE firms can adapt

Many of the larger, buyout-focused PE firms are looking with anticipation to a return to low interest rates. But this is not the only ray of hope.

There are many ways in which PE funds can succeed besides cheap debt financing, and many of these approaches work better in a low-growth or higher interest rate environment. The World Economic Forum, in a recent report, labeled this strategy shift ‘fundamentals over financialization’.^[1]

 “Growth Equity” funds look for firms that are undervalued with respect to their growth potential. An environment with less deal activity means less competition for these firms.

Instead of simply applying leverage, the fund can oversee strategic and operational improvements to improve growth and expand margins.^[2] Exploring new lines of business, recruiting new talent, and expanding to new markets do not depend on easy monetary policy, and can lead to higher exit values despite a challenging macro environment.^[3]

Emphasizing this point further, private equity firms are increasingly focusing on operational efficiencies as a fundamental strategy for value creation. This involves a deep dive into the operational aspects of portfolio companies, seeking ways to streamline processes, enhance productivity, and pursue organic growth opportunities. Such a strategy marks a significant departure from reliance on financial leverage, underlining the role of intrinsic business improvement in building sustainable value.

How investors can navigate

Identifying the firms who will succeed in the future requires the ability to discern genuine expertise. This is by no means straightforward. Some firms destined to perform poorly in the new environment can point to healthy growth numbers in previous boom as evidence of their future success.

Moreover, some funds that are underperforming are employing any number of ingenious maneuvers to conceal their underperformance: borrowing to pay investor dividends, deferring interest payments on debt, selling to their own funds. Sifting the true value-creators in the current - still crowded market - is a challenge.

Conclusion

Since achieving true outperformance is always possible but never easy, we believe that going it alone is inadvisable. The support of a seasoned advisory partner, with experience in navigating the private equity environment, is the best safeguard against investing in a fund that is past its peak or failing to invest in the next generation of stars.

Book a consultation with one of our team to explore how private equity can enhance the resilience of your portfolio in 2024 and beyond.

^[1] WEF

^[2] Goldman Sachs

^[3] RSM