After an extended period of low interest rates, central banks around the world have been aggressively hiking rates in an attempt to control rising prices and prevent hyperinflation from taking hold. These increased rates have had a negative impact on global markets, but what effect do they have on the private equity industry?
Private equity firms use a substantial amount of leverage, which makes them particularly sensitive to changes in interest rates. In a typical leveraged buyout, firms rely on debt issuance to fund a significant portion of the transaction.
Lower interest rates produce larger returns, while higher rates require additional cash outflows to service the debt. Furthermore, lower rates mean that there are more funds available to private equity firms, which can result in increased competition and higher asset prices. When it comes time to exit an investment, firms can benefit from the lower rates with higher asset valuations, more buyers, and larger returns.
Rising rates have the reverse effect. As borrowing becomes more expensive, private equity funds generate lower returns. Overall competition decreases and asset valuations drop, which can hinder returns for firms planning exits, but also provides increased buying opportunities for firms looking for undervalued assets. In addition, higher interest rates also make it more expensive for businesses to take on debt, which can stifle growth and reduce private equity returns. At the same time, rising costs and inflation might cut into profit margins and make businesses less profitable.
The new interest rate environment is causing private equity firms to change their strategies and creating additional pressure to generate returns and ensure that cash flows are sufficient to service debt. Turning a profit in this environment will become more difficult, but firms that have produced excess cash during the extended period of low interest rates could benefit from more affordable valuations and lower multiples.
With inflation and high interest rates stifling returns, private equity firms will need to rely on value creation, innovation, and genuine business growth in order to generate cash flows and keep investors happy with steady returns.
About Schneider Downs Private Equity Firm Services
Schneider Downs provides all the traditional audit and tax services needed by private equity firms and their portfolio companies, as well as specialized services including accounting advisory, investment valuations, equity incentive structuring, benefit plan analysis, operational efficiency and risk assessments, cybersecurity and technology solutions.
To learn more, visit our dedicated Private Equity Firm Services page.
