If you have been following the news related to interest rates, you have definitely noted a lot of hikes in the past several months as well as general uncertainty around the near-term outlook for both long and short-term rates. The current Fed interest rates are in the 5.25% – 5.50% range, unchanged from the Federal Reserve policy meeting in late September. Mortgage rates still remain just below 8% and don’t show obvious signs of coming down drastically anytime soon. For the average person, rising interest rates are not ideal for those with significant amounts of debt, those looking to purchase a home with a mortgage, or many other use cases. For private equity investors, interest rate movements can have a very significant impact on the outlook of their investments since PE uses such a large amount of debt to finance transactions. In this article, we will focus on specific considerations PE investors care about when it comes to interest rates, how the view toward interest rates may change depending on whether an investor is buying or selling a current investment, and the general outlook for interest rates in Q4 2023.
Since PE firms rely on raising debt to cover the majority of a transaction and put in as little capital as possible, the investment itself must provide enough cash flow to adequately cover the interest payments required. PE investors must carefully balance how much debt they take on to finance an acquisition with the projected interest payments to make sure they won’t default on them. Therefore, ideal private equity target companies have steady cash flows and minimize variable or unexpected costs. Once the cash available is used to service the debt, whatever is left over is paid as dividends and used to calculate returns for private equity investors and LPs.
One of the first considerations private equity firms must make related to interest rates is their required rate of return. If interest rates rise, interest payments will also rise in many cases. At the same time, lenders may not be as amenable to lending the same amounts they were handing out in low-interest rate environments out of an abundance of caution, just in case firms are not able to meet their interest payment obligations. Therefore, private equity firms may not be able to use the same levels of leverage they would be able to obtain in a low-interest rate environment, leading to a high equity need from the fund to finance the transaction. This can reduce returns significantly. Thus, private equity firms must think about the ideal capital structure for a transaction in times of high-interest rates in order to maximize the level of debt they can obtain while also minimizing the amount of equity they will need to inject at acquisition.
Another item to consider is whether a private equity firm uses a fixed or floating interest rate for its debt. As the names imply, a fixed interest rate means that the investor will pay a fixed payment each period vs. a variable interest rate, which means that the investor will pay a lower payment when interest rates are lower and a higher payment when interest rates are higher. Some investors have tolerance for one type of payment over the other and may use one over the other in different situations. Fixed rates are stable and protect an investor against rising rates, but you may also lose out on the benefit if rates significantly decrease. On the other hand, variable rates allow you the flexibility of payments if rates have been fluctuating or there is a low-interest rate environment but they can expose investors to risk if rates instead rise. In most debt packages I’ve seen, we tend to prefer fixed-rate packages given they are more stable and predictable, but other firms with different investment strategies and levels of risk tolerance may opt for a financing package with a variable rate.
Given how sensitive private equity investors are to changing interest rates, you might be wondering if there is anything an investor can do to protect against significant changes in rates over an investment horizon. Many PE firms use financial instruments called derivatives to achieve this. These types of instruments might include interest rate swaps, which allow you to hedge against interest rate fluctuations. This is similar to hedges used for foreign exchange rates, which are also commonplace for private equity investments that involve operations in other countries or if the fund itself is investing out of its home currency. Hedges can mitigate the impact of interest rate or exchange rate fluctuations, but they don’t completely eliminate the risk, so investors must still keep a watchful eye on macroeconomic events that may impact the trajectory of their investments.
In today’s higher interest rate environment, some private equity investors are evaluating if there are ways to take advantage of this opportunity. Some firms may be able to do so by targeting distressed companies that may be struggling under the weight of their interest payments or other operational challenges. They can usually pick up these companies at a relative discount and help them recover while also making a profit for themselves. Additionally, higher interest rates usually create more uncertainty and overall less willingness to go after deals as compared to the mindset in a low-interest rate environment. Therefore, auction processes may be less competitive for those looking to buy, and those not actively looking to acquire new companies can spend that time growing existing portfolio companies. For sellers, a high-interest rate environment can be tough; for companies with existing or portable debt packages, this environment can be particularly attractive when marketing an asset.
Investors will be closely monitoring the next meeting of the Fed at the end of October to see if they will raise interest rates once again. Fed Chair Jerome Powell has stated there is a possibility of one more interest rate hike this year in order to mitigate inflation, as he is committed to bringing inflation back to 2%. If this hike does occur, private equity firms will have to deal with the consequences as we head into 2024.
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