No more free lunch: Impact of higher interest rates on private equity strategies

While there is no crystal ball for predicting how long US inflation will stay elevated above the US Federal Reserve’s (Fed’s) 2% target, consensus near the end of 2023 (the time of this writing), appears to be that interest rates will stay higher for longer, as the central bank aims to keep rising prices in check.¹ Like most macro developments, the impact of interest-rate changes tends to hit public markets first and flow through to private markets over time; however, we think it is important for investors to understand the varying degrees of rate exposure across the diverse private equity landscape. In this article, we explain the direct and indirect impacts of higher interest rates on the primary private equity strategies of buyout, venture capital, growth equity, secondaries, and fund of funds.

Direct exposure: Buyout funds

When US inflation hit its highest levels in 40 years in June 2022, central banks around the world tightened monetary policy. This raised the cost of debt and created a more challenging environment for buyout funds. Because buyouts rely on leverage to finance transactions, interest rates affect them directly. In the US, buyouts’ exposure to rates reached a peak in 2022, with an average seven times leverage.² This level, the highest it had been since the global financial crisis, was a byproduct of two decades of historically low rates. Because the effects of moderate inflation and higher interest rates could linger, investors may want to consider a variety of factors when deploying capital in buyout funds: 

1. Deal activity: With fewer companies able to bear the cost of higher leverage, the number of buyout investments may decline, limiting the selection for investors (Figure 1).
2. Returns: Buyout managers who have relied on leverage to generate returns may be negatively affected in a higher-rate, slower-growth environment. 
3. Defaults: Businesses that took on significant debt in a leveraged buyout may struggle to service it, resulting in a partial or complete loss of investment. 
4. Exit opportunities: Higher interest rates have not only slowed deal activity, but they have also led to adjustments in transaction loan-to-value ratios. More moderate deal pacing may constrain the volume of financial or strategic acquisitions, limiting exit opportunities. 

Figure 1

Overall, higher rates suggest that buyout funds can no longer rely on a low cost of debt and growing valuations. This is problematic, given that most returns in recent years have been driven by multiple expansion (Figure 2). Increasingly, we believe managers will need to rely less on financial engineering and instead look to revenue growth and operational improvements to drive returns.

Figure 2

Figure 3

Indirect exposure: Venture capital and growth equity funds

Venture capital and growth equity funds rarely finance their investments with leverage and, therefore, tend to avoid the challenges associated with direct interest-rate exposure. They do, however, experience indirect impacts, primarily through shifting valuations. 

To estimate what an illiquid private company is worth, it can be instructive to look at the multiples of similar publicly traded companies. One such metric, popular in the venture capital industry, is forward-revenue multiples. Figure 4 shows this metric, as applied to public companies in the software-as-a-service (SaaS) industry. Free-cash-flow-negative (FCF-) SaaS companies traded for over 20 times forward revenue in 2020 and 2021, when rates were still at historic lows. The steep rate hikes in 2022 coincided with a precipitous drop in valuations for these same companies, which now trade below five times forward-revenue estimates. While free-cash-flow-positive (FCF+) companies directionally experienced the same devaluation, the decline was less severe, highlighting the insulating effect of cash reserves on interest-rate risk. 

Overall, today’s higher interest rates mean steeper discount rates and, therefore, depressed valuations. This results in increased valuation risk for companies raising subsequent rounds of financing or contemplating an initial public offering. Conversely, lower valuations often benefit venture capital and growth equity managers with new capital to deploy.   

Figure 4

Summary

After more than a decade of historically low interest rates, today’s higher-for-longer environment highlights the importance of a diversified private investment allocation. Specifically, investors need to understand the varying degrees of interest-rate exposure — both direct and indirect — that exists across the private equity landscape. Leveraged buyout funds, typically considered to present a moderate risk profile relative to other private equity strategies, have the most direct exposure to interest rates. While leverage can be a powerful tool for enhancing returns during favorable rate environments, these benefits diminish when borrowing costs remain elevated, changing the calculus for investors concerned about interest-rate risk. 

Allocations to venture capital and growth equity — which typically employ all-equity deal structures — target fast-growing companies and avoid costly debt expenses. These strategies and the fund of funds and secondaries that invest directly in them may provide diversification benefits and complement strategies like buyouts that have direct exposure to interest-rate risk. Historically, venture capital has been difficult to invest in at scale for allocators who need to put significant capital to work, but the establishment of the late-stage growth space may provide an opportunity for allocators to seek venture-capital exposure in greater amounts and with a differentiated risk profile.  

¹ Tobias Adrian, “Higher-for-Longer Interest Rate Environment is Squeezing More Borrowers,” IMF Blog, 10 October 2023. | ² Pitchbook, as of 7 December 2023. Median debt/EBITDA of US buyout transactions.