Anyone who watches the news or has a Twitter account is no stranger to interest rates. Every piece of the economy is affected by the rate of interest for some reason, whether direct or indirect, through loans, suppliers, real estate, consumer’s ability to spend, and virtually every other business decision can be traced upstream to be affected by them.
Since we are in the private equity business, the most pertinent question over the last few months is, how will that affect the private equity industry as a whole, and who experiences the brunt of these changes?
Interest rates are a core piece of the private equity business model because, with every transaction done, there is a level of debt that is taken on in order to increase returns and use the remaining dollars to fund the change and operational improvements necessary to achieve a high multiple on invested capital and IRR. Although it is advantageous to utilize debt to boost returns, it requires cash flow strong enough to fund the interest payments, showing an obvious sensitivity to interest rates.
Raising rates in any normal investment-centric environment will cause investors to flock to safer alternatives with more stable investment income, even if it can edge on the lower side compared to historical averages. When investors want to play it safe, they don’t like writing big checks to investment firms that can have a high variability in returns and proves difficult for many fund managers to raise money (alternatively, the largest LPs typically have mandated percentages they must invest within the private market every year, no matter if the market is bullish or bearish, and since they don’t have to answer to investors, the investment time horizon is much longer, and the risk appetite has flexibility).
If you are a smart investor, you know that when everyone is selling, it is the time to buy - this mantra is no different in the private markets since most companies will be undervalued. At the same time, business owners impatience grows if they believe their company's enterprise value is lowering by the day and will have a higher motivation to sell, enabling the investment firms to find better deals and obtain outsized returns.
No matter the market cycle, there is a reason private equity historically outperforms the market. If the debt becomes more expensive for the acquisition, there are plenty of strategies to extract more value and achieve the same return potential which was modeled out at acquisition, while still having the ability to service the debt facilities required to stay solvent and leave breathing room for GP fees and investor returns. There are hundreds of strategies we will get into over the coming months of how sharp private equity investors can extract that value, whether through financial engineering, inorganic growth, strategic talent acquisition, and much more.