Table of Contents

How Interest Rates Affect Private Equity

By

澳洲幸运5官方开奖结果体彩网:Kushal Agarwal

Updated October 02, 2023

Reviewed by

Erika Rasure

Fact checked by

Ryan Eichler

The Federal Reserve, as well other other central banks around the world, change interest rates in an effort to keep the economy stable and inflation in check. When the economy is growing, interest rates may rise to clamp down rising prices - and interest rates may be cut when the economy slows and recessions loom. Amidst all this, what is the impact of interest rates on private equity funds and firms?

Key Takeaways

Private equity (PE) is a way of investing and managing privately-held companies using a great deal of leverage.
As a result of this leverage, PE funds are sensitive to interest rate changes and benefit greatly from lower interest rates.
PE activity tends to slow down when interest rates rise, and PE firms may hedge their interest rate risk accordingly.
PE activity (along with broader economic activities) tend to increase when rates decrease, leading to potentially higher hiring rates and start-ups.

What Is Private Equity?

澳洲幸运5官方开奖结果体彩网:Private equity (PE) is equity or an ownership stake that is not publicly traded. PE firms invest in large private or public firms with the aim of 澳洲幸运5官方开奖结果体彩网:delisting the companies and taking them private. The underlying 🌠basis is to find undervalued assets that have the potential for imp⛄rovement to churn out higher profitability.

PE firms focus on 澳洲幸运5官方开奖结果体彩网:the bottom line. The operations cost structure and organizational structure are lean, the strategy is reoriented toward higher growth, and management is aligned to h🀅elp the firm achieve more control. PE firms enter with an exit in mind as well with the goal of higher returns in short-to-medium turnaround time.

Interest Rates and PE

Interest rates have an effect on businesses because of loans and, on a broader level, interest rates determine economic activity and asset prices (lower interest rates mean that people have more money, which increases asset prices due to increased demand). Private equity firms are more reactive to interest rate changes because of the two main investment strategies involved in the PE business: 澳洲幸运5官方开奖结果体彩网:venture capital and 澳洲幸运5官方开奖结果体彩网:leveraged buyout.

In leverage buyout transactions, PE firms fund the takeover of companies using little capital and relying on debt (usually in the form of instruments from pension funds or investment banks that have a long-term horizon) to meet the cost of acquisition. This enables PEs to magnify their returns. However, it requires steady cash outflow in terms of interest payments. Hence, there is sensitivity to interest rates. The 澳洲幸运5官方开奖结果体彩网:internal rate of return (IRR) that the PE firm achieves when it exits the 🎐company depends highly on the interest rates at which it takes on debt.

PE firms look for target firms that have a steady 澳洲幸运5官方开奖结果体彩网:cash flow and minimum 澳洲幸运5官方开奖结果体彩网:capital expenditure and 澳洲幸运5官方开奖结果体彩网:operating working capital requirements. They use the steady free cash flow the firm generates to service the debt. What is left over 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 is a double-edged sword; it affects buyouts and ex🌜i👍ts differently. PE firms intending to sell and those intending to buy have contrasting reactions to a change in interest rates.

Fast Fact

A survey of 200 private equity managers revealed that nearly half thought their portfolio companies were moderately impacted or very negatively impacted by the pandemic. Note that this may indicate that the other half may have been positively impacted by lower rates and lower cost of capital.

Specific Economic Considerations

As discussed more in depth in the following sections, interest rates have a massive impact on a variety of economic concepts. These specific concepts are discussed more succintly below, and each directly relates to how easily or difficult private equity funds may be🎶 secured or traded.

Cost of Capital: In private equity, the cost of capital is a fundamental consideration. Interest rates significantly affect this cost. When central banks lower interest rates, it reduces the cost of borrowing for private equity firms. This has a direct impact on the IRR that can be achieved on investments, making deals more attractive and financially viable.
Valuation: The present value of future cash flows plays a crucial role in valuation. Lower interest rates mean that future cash flows are worth more in today's dollars. As a result, private equity firms may assign higher valuations to target companies when discounting their future cash flows at lower rates, which can lead to higher purchase prices.
Exit Strategies: When interest rates are low, it is easier for private equity firms to exit investments. This is because potential buyers or public market investors may find it more affordable to finance acquisitions or investments in companies being sold. Lower interest rates can stimulate demand for acquisitions or IPOs of private equity-owned companies.

Fundraising: Lower interest rates can make private equity investments more appealing to institutional investors, particularly those seeking higher returns in a low-yield environment. This increased demand for private equity investments can lead to successful fundraising efforts for private equity firms, resulting in larger pools of capital to invest.
Leverage: Private equity deals often involve significant leverage. Low interest rates reduce the cost of debt financing, making it more attractive for private equity firms to use leverage. This amplifies the potential returns on equity investments. However, increased leverage also raises the level of risk, as higher debt levels can magnify losses in the event of underperformance.
Macroeconomic Conditions: Changes in interest rates have broad 澳洲幸运5官方开奖结果体彩网:macroeconomic implications. For private equity-owned businesses, low rates can stimulate consumer spending through lower borrowing costs, potentially boosting demand for products and services. However, this can also contribute to inflationary pressures, impacting costs and pricing strategies.

Market Competition: Low interest rates can attract more capital to the private equity industry. Increased competition can drive up valuations, making it more challenging to identify attractive investment opportunities.
Currency Exchange Rates: Interest rate differentials between countries can impact 澳洲幸运5官方开奖结果体彩网:currency exchange rates, which in turn affect the returns on foreign investments. Private equity firms with international exposure must consider these exchange rate movements.

The Impact of Low or Declining Interest Rates

Though discussed above, let's specific look at periods of low or declining interest rates. Low or declining interest rates mean more funds available for PE firms as investors tend to look elsewhere, away from fixed income and credit securities.

This creates an opportunity for PE firms looking to buy. First, they have access to easy funds, and fund-raising 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. However, this may lead to capital superabundance, and this does not serve PE firms looking to buy. Easy capital and competition over buying assets can send prices soaring.

On t𓄧he other hand, capital superabundance is a boon for sellers. IPO activity tends to surge in a low-interest-rate environment. Thus, PE firms looking to exit have an opportune time when interest rates are low or declining as they can achieve higher valuation and much higher returns than anticipated.

Important

Interest rates and unemployment are often (but not always) positively correlated. As the Federal Reserve raises interest rates, tightened capital markets tend to lead to tightening labor markets and layoffs. As the Federal Reserve lowers interest rates, capital is easier to obtain and companies may be more likely t💧o expand and hire.

The Impact of High or Rising Interest Rates

An interest rate hike would have 🐈the opposite effect—investors flock to fixed income and credit securities as the yield on that security would increase. Thus, fundraising becomes a challenge. The other angle to this is investors flocking to more secure and less volatile assets; those looking shelter may find bond investments more suitable for their portfolio strategy during an economic downturn in which government policy may trigger by raising rates.

Also, investors and the public show decreased appetite for IPOs, and asset valuations dro♌p, which is problematic for PE firms that would have planned their exits around the same time. However, it is beneficial for PE firms looking for undervalued firms and assets. These firms can deploy the capital they have accumulated from the low-interest period and invest.

Also, PE firms have access to capital from large institutional investors that have a lo🔯ng-term outlook and diversification needs, and this ignites their interest and appetite for PE. A looming interest rate hike in the United States has many PE firms preparing to re-strategize. PE firms must lock in a lower interest rate or ensure that cash flow forecasts are intact and immune to the risks an interest rate hiꦑke would bring.

How Do Private Equity Firms Finance Their Acquisitions?

Private equity firms finance acquisitions using a combination of equity (investor capital) and debt. The specific mix depends on the firm's strategy, the target company, and the prevailing market conditions.

How Do Private Equity Investors Evaluate Interest Rate Risk?

Private equity investors assess interest rate risk by analyzing the sensitivity of their portfolio companies to interest rate changes. The👍y consider how rising rates could affect the cost of debt, 🉐cash flow projections, and the overall financial health of their investments. They construct complex economic models that not only analyze the impact of rates but how current dealings in the world may impact the future trajectory of those rates.

Are Floating or Fixed Interest Rates Preferred in Private Equity?

The preference for floating or fixed interest rates varies based on the investor's risk tolerance and market conditions. Fixed rates offer stability and protection against rising rates but may come at a higher initial cost. Floating rates can be more cost-effective in a low or decreasing rate environment but expose investors to interest rate fluctuations.

How Do Private Equity Firms Hedge Against Interest Rate Fluctuations?

Private equity firms may use financi𓃲al derivatives, such as interest rate swaps, to hedge against interest rate fluctuations. These instruments can help lock in favorable interest rates and manage risks associated with variable-rate debt. Note that these tools impact the financial securities they hold, but it much more difficult to mitigate the effects of changing interest rates in the broader valuation and fundraising context.

The Bottom Line

With increasing regulation, PE firms find it difficult to attract the amount of leverage in target firms. Most banks are reluctant to lend at levels above multiple times EBITDA or a high ratio of 澳洲幸运5官方开奖结果体彩网:Debt/EBITDA. However, in the United States, a hike in interest rates will excite PE firms keen to enter into deals. PE firms will need to tread cautiously as interest rates increase since they need to cover the hike with sufficient cash flow. Nonetheless, PE firms have historically achieved greater returns through innovative strategies, and they will most likely contin🌌ue to do so.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

National Library of Medicine. "."

澳洲幸运5官方开奖结果体彩网