How Interest Rates Affect Private Equity

The Federal Reserve announced plans to raise the fed funds rate to 2.5% in December 2018, 3% in 2019, and 3.5% in 2020 in an effort to combat inflation and a feared liquidity trap where people hoard cash instead of investing. The rates have been increasing gradually since December 2015, which was the first time the Fed had increased rates since June 2006. Since December 2008, rates had stayed between 0% to 0.25% to boost recovery after the Great Recession. 

However, the European Central Bank (ECB) is expected to cut rates again, or even extend the scale of its quantitative easing (QE), and Japan has seen its interest rates as low as ever—even negative real rates—to encourage people to spend and not save. Amidst all this, what is the impact of interest rates on private equity funds and firms?

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 delisting the companies and taking them private. The underlying basis is to find undervalued assets that have potential for improvement to churn out higher profitability.

PE firms focus on the bottom line. The operations cost structure and organizational structure are lean, strategy is reoriented toward higher growth, and management is aligned to help the firm achieve more control. PE firms enter with an exit in mind as well with the goal of higher returns in a short-to-medium turnaround time. (For more, see: A Primer on Private Equity, and also What is Private Equity?)

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: venture capital and leverage 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 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 cash flow and minimum capital expenditure and 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 exits differently. PE firms intending to sell and those intending 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 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, the current world economic scenario, where many countries have historic low interest rates, has led to capital superabundance. This does not serve PE firms looking to buy. Easy capital and competition over buying assets send prices soaring. High asset prices deter PEs from entering into a deal because companies are no longer undervalued.

On the other hand, capital superabundance is a boon for sellers. IPO activity surges 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.

According to the Global Private Equity Report by the management consulting firm Bain and Company, in 2014, PE buyout-backed exits saw record highs both in 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. In Asia Pacific, PE-backed IPO values were almost four times more than the previous year. However, the report also noted that buyers didn't fare as well--global buyout investment activity was up by just 2% in count and down 2% in value.

An interest rate hike would have the opposite effect—investors flock to fixed income and credit securities. Thus, fundraising becomes a challenge. Also, investors and the public show decreased appetite for IPOs, and asset valuations drop, 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 long-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 hike would bring.

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 six times EBITDA (Debt/EBITDA > 6). 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 continue to do so.