The Impact of Rising Interest Rates on Private Equity

Introduction

2022 has started with growing concerns about inflation, Covid-19 and the environment. Inflation hit a record high over the past several decades in the US, UK, multiple countries in Europe and around the world. As a result, central banks are taking measures to hike interest rates to avoid hyperinflation scenarios. At the same time, many authorities have started to roll back their financial stimulus implemented during the Covid-19 global crisis. These measures will have an impact on the financial markets and private equity (PE) firms.

Why are interest rates important?

Interest rates have an influence on everyone in the economy from people to businesses to entire nations. They are a tool of monetary policy and central banks, whose role is to keep price stability by controlling inflation, use interest rates to manage the macroeconomy by setting a benchmark for borrowing.

By determining the cost of borrowing and lending, interest rates actively influence demand. Higher interest rates make borrowing more expensive and slow down economic growth as demand decreases. While cutting rates stimulates consumer and business borrowing and investments. Governments generally prefer lower interest rates because it boosts economic activity, however, they eventually lead to a disequilibrium in the market where demand exceeds supply resulting in inflation.

Historical Interest Rates

Interest rates are at some of their lowest levels of the last 150 years in most of all advanced economies. We have experienced a decade of ultra-low interest rates, which was set to promote economic growth after the financial crisis. A prolonged period of low-interest rates has pushed investors towards alternative asset classes in the search of better returns. Cyclical and structural factors driven by low or negative-yielding bonds, along with alternative financing options, helped stimulate the shift in capital allocation to private markets benefitting private equity firms.

Historically, long term interest rates have been much higher. In the US, interest rates averaged 5.47% from 1971 until 2022, while in the Euro area interest averaged 1.72% from 1998 until 2022 which reflects two decades of low-interest rates.

Germany, UK, Italy and US long-term historical interest rates
Source: Macro History Database and International Monetary Fund

The expectations of increasing interest rates will have a profound impact on the economy and investment. All major asset classes will be impacted and more risky assets might suffer as investors will have bigger rewards for less risky assets. Moreover, the increasing cost of debt for businesses and individuals might result in less money allocated to alternative asset classes.

Current Market Situation post Covid-19

Governments and monetary authorities have slowly reversed their financial stimuli which have rolled out to mitigate the Covid-19 global crisis. Central banks have reached a record high level on their balance sheet and now they are looking to slowly lift off their purchasing programs starting from the Fed and the ECB and decrease their support by raising interest rates.

The bank of England has already hiked its rates twice in three months while the Fed is set to follow in March and more hikes are expected. The ECB has decided to leave interest rates at 0% for now and it is closely monitoring the situation. Inflation in the Euro area is still below the US level. The ECB believes high energy and oil prices are the main drivers of the rising consumer goods.

During Covid-19, central banks have implemented extraordinary stimulus packages to mitigate economic recessions as well as support a speedy recovery. The speed and size of the execution have been unprecedented. Central banks had little room to decrease interest rates, as they have been at low levels after the 2008 financial crisis, they relied on different monetary policies to lighten the global crisis, especially on quantitative easing (QE). This measure is often used to effectively stabilize financial markets during the early phases. At the same time, it supports initial recovery after a shock, by keeping borrowing costs low, especially for authorities. This helped governments to rollout large fiscal stimulus packages, keeping the cost of debt low in the short run. As these programs will be reduced and soon come to an end, we expect central banks to start selling off their assets as their balance sheet reached an all-time high as shown in the picture below.

Balance Sheet of major Central Banks around the world in trillion of $
Source: Reuters Graphics

Now, as most central banks are planning to hike interest rates, the International Monetary Fund warned investors for higher volatility, their decisions and communication will play a major role for the markets during the year.

Interest Rates and Influence on Private Equity

As explained previously, interest rates have an impact on businesses and, on a broader level, determine economic activity and asset prices (lower interest rates mean that folks have extra money, which increases asset prices thanks to increased demand). Private equity firms are more reactive to interest rates’ changes due to the two main investment strategies involved within the PE business: growth equity and leveraged buy-outs.

In leverage buyout transactions, PE firms fund the takeover of companies using little capital and counting on debt (usually within the sort of instruments from pension funds or investment banks that have a long-term horizon) to satisfy the value of the acquisition. This permits PEs to magnify their returns. However, it requires steady cash outflow in terms of interest payments. Hence, there’s sensitivity to interest rates. Higher interest rates mean higher debt repayments which directly decreases the interior Rate of Return (IRR) that the PE firm achieves when it exits the corporate.

PE firms search for target firms that have a gentle income and minimum CAPEX and OPEX requirements. They use the steady free income the firm generates to service the debt. What’s leftover is accumulated until exit, or paid as dividends (essentially the return to the PE firm and other owners). The impact of interest rates on PE firms may be a double-edged sword: it affects buyouts and exits differently. PE firms meaning to sell and people meaning to buy have contrasting reactions to a change in interest rates.

Low or declining interest rates mean more funds available for PE firms as investors tend to seem elsewhere, far away from fixed income and credit securities, to seek out attractive returns. This creates a chance for PE firms looking to shop. First, they need access to easy funds, and fundraising activity increases. Second, PE firms can enter into a transaction, lock in lower interest rates, reduce their periodic outflow, increase the IRR and, eventually, the return on their investment.

The current world economic scenario, where many countries have historic low-interest rates, has led to capital super-abundance. This doesn’t serve PE firms looking to shop for. Easy capital and competition over buying assets send prices soaring. High asset prices deter PEs from getting into a deal because companies are not any longer undervalued. On the opposite hand, capital superabundance may be a boon for sellers. IPO activity surges during a low-interest-rate environment. Thus, PE firms looking to exit have an opportune time when interest rates are low or declining as they will achieve higher valuation and far higher returns than anticipated.

According to the worldwide Private Equity Report by the service industry firm Bain and Company, in 2014, PE buyout-backed exits saw record highs both within the count (up 15% from 2013) and value (up 67% from 2013). In Europe, there was a doubling of buyout-backed IPOs both in count and value. Within the Asia Pacific, PE-backed IPO values were almost fourfold quite the previous year. However, the report also noted that buyers didn’t fare as well–global buyout investment activity was up by just 2% within the count and down 2% in value.

Any rate of interest hike would have the other effect—investors flock to safer assets like fixed income and credit securities. Thus, fundraising becomes a challenge. Also, investors and therefore the public show decreased appetite for IPOs, and asset valuations drop, which is problematic for PE firms that might have planned their exits at the same time. However, it’s beneficial for PE firms trying to find undervalued firms and assets. These firms can deploy the capital they need accumulated from the low-interest period and invest. Also, PE firms have access to capital from large institutional investors that have a long-term outlook and diversification needs, and this ignites their interest and appetite for PE. A looming interest rate hike has many PE firms preparing to re-strategize. PE firms must lock during a lower rate of interest or make sure that income forecasts are intact and resistant to the risks any rate of interest hike would bring.

With increasing regulation, PE firms find it difficult to draw in the quantity of leverage in target firms. Most banks are reluctant to lend at levels above sixfold EBITDA (or a ratio of D/E ratio above 6). However, within the use, a hike in interest rates will excite PE firms keen to enter deals. PE firms have to operate cautiously as interest rates increase since they have to hide the hike with sufficient income. Nonetheless, PE firms have historically achieved greater returns through innovative strategies, and they will presumably still do so.

Source: Preqin, Bloomberg Barclays as of end of 2020
Dry power in years of private equity buyout investment activity (adjusted for average equity contribution)
Source: Partners Group, Preqin (November 2021), S&P LCD (Q3 2021)

Conclusion

Private equity had an extraordinary decade. Low-interest rates, abundant dry powder and a strong fundraising environment all contributed to record activity levels. Despite rate hikes, the coming to an end of financial stimulus and eventual tax reforms on the horizon, the market fundamentals stand in place for a strong 2022. Looking ahead, the biggest challenges for private equity may be regulatory, rather than economic, as firms face increased antitrust scrutiny and more obligations in terms of disclosure.

Results from the 2022 Natixis Institutional Investor Outlook survey show they see potential challenges: 73% predict interest rate hikes, 75% anticipate higher volatility for stocks, 63% project more volatility in bonds, and 56% foresee currency volatility. But this group of 500 institutional investors is generally optimistic: only a few predict any dramatic shifts in allocation plans and most will continue managing toward an average 7% return assumption. In positioning portfolios for the unknowns ahead in 2022, institutional teams are watching five key themes that will shape portfolio strategy:

  1. Central banks hold the keys to investment success
  2. Covid is no longer the greatest threat to growth
  3. The hunt for yield leads to alternatives

While making little in the way of broad changes to allocation strategy, in 2022 institutional investors are making tactical moves to position themselves for a year in which they come to grips with rising inflation, low rates, and high valuations.

Nonetheless, Private Equity and Private Investments are likely to continue to grow.

Before the pandemic, investment in private assets had been growing among institutions. In 2018 just over three-quarters of institutions invested in private equity (77%), private debt (77%) and infrastructure (76%). In 2021 those numbers have increased to 84%, 81% and 81% respectively. Those who are already invested are not likely to dial back their exposure in the next year, as 91% say they will maintain or increase their investments in both private equity and private debt and 97% say the same for infrastructure investments.

Looking across private market sectors, institutional investors call for the best opportunities to include information technology (45%), healthcare (41%) and infrastructure (40%). Unique to the private markets is the infrastructure sector, which will be getting a boost of confidence from the recent infrastructure bill in the US and other key projects globally.

Authors: Alessandro Nora, Michele Giammarrusti

Sources:

Steven A. Cohen, et al., 2022, Private Equity 2021 Year in Review and 2022 Outlook, Harvard Business Review

Peter Wilson, Inflation and the Private Equity Dilemma, 2021, Fund Finance Insights, RBS International

Mercer 2021, Dry powder meets low interest rates – Time for a private market boom or bust?

Kushal Argawal 2020, How Interest Rates Affect Private Equity, Monetary Policy, Investopedia

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