How Rising Interest Rates and Economic Downturns Affect Private Equity Firms
Introduction
Tightening monetary policy and expectations of a possible recession in the near future pose risks to private equity (PE) firms who need to re-strategize in order to overcome the impacts of rate hikes and economic slowdown. PE firms are primarily affected by two main factors — rising interest rates and on broader scale, slowing economic activity.
Leveraged Buyouts
PE investors utilize leveraged loans and high-yield bonds to fund their buyouts through leveraged buyouts (LBOs). LBOs allow PE firms to purchase larger companies, and seek a greater return on equity and internal rate of return (IRR), all while spending less of their own money and utilizing a seller’s assets to pay for the financing. These advantages make LBOs one of the most popular methods of PE funding. However, as interest rates rise, debt becomes more and more expensive for PE firms, negatively impacting a PE firm’s IRR, as interest payments eat into the cash flow that is generated by target companies. This also makes it harder for PE firms to get underwriting for LBOs from large institutions like banks.
With recent examples such as Bank of America, Credit Suisse, and Goldman Sachs accepting $700B in losses after selling $8.6B in discounted loans and bonds that backed the Citrix Systems LBO earlier this year, and with Barclays and Bank of America’s attempt and failure to offload $3.9B in debt associated with the Brightspeed buyout due to lack of investor demand, banks are now increasingly hesitant to extend funding commitments in the current economic climate, especially when it comes to larger deals that are beyond the reach of most private credit alternatives. With funding much harder to come by, this has led to a significant decrease in PE deal activity.
PE Markets
According to a Neuberger Berman report, historical PE returns during economic downturns experienced less drawdown, and a quicker recovery, than public equities. However, capital calls (fund collection from limited partners) followed a more lagging pattern, while distribution patterns were more immediate during periods of public market distress. The first observation may be attributed to the greater insulation of PE to public market sentiment due to the control that many PE firms have over their portfolio companies. For the lagged effect of capital calls, the initial stability is due to previously agreed upon commitments by investors, while the overall decrease in capital calls was due to drops in deal flow and deteriorating economic and market conditions. Unlike capital calls, distribution declines mirrored public market sell-offs. Effectively, the lagging decline of capital calls along with the more immediate decline in distributions caused negative net cash flows at the onset of economic weakness, which typically carried on until economic and market conditions recovered.
PE Firm Strategy
In the face of worsening economic conditions, PE firms have had to adapt to these changes. With the repricing of asset valuations and decreased investor demand for initial public offerings, firms that had planned exits around the next few months will be greatly disadvantaged; however PE firms that have accumulated capital through the low interest period before rate hikes can look to take advantage of those same drops in asset valuations. Buyers that are looking to raise additional funds can look at alternatives such as private credit as opposed to public markets, as traditional institutional partners have grown increasingly wary of the risks associated with extending funding commitments. Finally, PE firms with well established portfolio companies that possess steady cash flow, lower capital and operating costs, and resilience in the face of economic challenges ahead, will likely prove to be more well prepared in the upcoming months.
