On March 20th, 2019, the Federal Reserve announced what markets had for the most part been expecting: no interest rate hikes for the remainder of 2019. Currently sitting at 2.5%, the Fed’s target for the federal funds rate impacts the global economy and influences the rates at which all debt can be issued at. A lower interest rate means that money is “cheaper”, and capital is more readily available in financial markets. While the most recent announcement was expected immediately before its release, it was very different from what many expected only a few months ago. With the most recent rate hike of 25 basis points in December of 2019, the general consensus was that rates would continue to rise in 2019 as the central bank looked to keep the economy stable. However, with volatility and uncertainty in the economy in late December and moderate inflation numbers, the Federal Reserve changed course and is now taking a slower approach to rate hikes. There was also pressure from the executive branch to slow the increases although it is unclear if this had any impact on the central bank’s actions. Regardless of the cause, a stoppage in rate increases in the near future means money is more readily available to all borrowers, including private equity firms.
While rates at which borrowers can obtain credit impacts the entire economy, it especially impacts later stage private equity firms. Leveraged buyouts by definition require a large amount of debt, and often this debt is based on a floating rate. As interest rates rise across the economy, firms have to pay higher interest rates on their loans which means less cash going to pay back principal and generating equity. Rising rates not only have the ability to lower a firm’s returns but also pose greater risks to deals as a whole. Often loans have covenants that require the company’s cash flows be a certain threshold above their interest expenses. With rising rates, a deal that would otherwise be a solid investment in the long term can be jeopardized by violating a covenant that could put the firm’s target in immediate default.
In addition to affecting how firms can borrow, interest rates impact how private equity shops are able to exit their buyouts. Lower interest rates typically mean higher valuations for companies across the economy. Exit prices for private equity firms are another key determinant of the funds return on investment for any given deal and rates determine when firms close out their positions. For example, 2015 was the last year before the Federal Reserve began to raise rates from the almost 0% target that stood for several years after 2008. 2015 was also the year with the greatest number of private equity exits, both in terms of the number of exits and their total value. With lower rates looking stable for the remainder of the year and likely beyond, the resulting higher valuations into the future may give firms an opportunity to continue with investments rather than needing to get out early before these valuations decline.
While interest rates matter to everyone across financial markets, they impact almost every key variable in private equity investments. With more moderate rates prevailing into the near future, it likely that deal volume will remain steady without premature exits, as investments look promising with lower borrowing rates.