SUMMARY: Interest rates play a significant role in the global financial system, impacting everything from inflation control to investment incentives. Over the past few years, we have witnessed a series of rapid interest rate hikes by central banks worldwide in response to inflationary pressures. However, these interest rate changes don’t just affect public markets as they are also pivotal for private equity (PE) and private company securities.
Why Do Interest Rates Change?
Central banks adjust interest rates to manage the economy by targeting inflation and stimulating growth. When inflation rises, central banks increase rates to cool down the economy by making borrowing more expensive, thus reducing consumer spending and business investments. Conversely, lowering rates is a strategy to stimulate economic growth, making it cheaper for businesses to access capital and encouraging spending.
As global inflation showed signs of easing in 2024, the Fed recently opted to lower rates by 50 basis points, while other major central banks also implemented modest cuts, like the European Central Bank’s reduction to 3.5%. This shift in policy reflects an attempt to balance economic stability with inflation control, paving the way for looser credit conditions that could spark increased financial activity.
Effects of Interest Rate Changes on Global Markets
Interest rate adjustments reverberate across markets. When rates rise, borrowing costs increase, leading companies to cut back on spending and investment. In public markets, higher rates often depress valuations as investors seek higher returns to offset the increased cost of debt. Conversely, lower rates drive investor optimism and tend to boost asset valuations, particularly in sectors dependent on leverage. Lower borrowing costs fuel economic activity, making it cheaper for companies to access capital, stimulating growth and generally supporting higher valuations.
Impact of Interest Rates on Private Equity and Private Company Securities
Interest rates are also critical in private markets, where investments typically have longer holding periods and rely on debt-financed deals. Changes in rates significantly impact the cost structure, valuation and exit strategy of these investments.
- Buyouts and Leveraged Transactions
In the realm of private equity, buyouts are a primary investment strategy, heavily reliant on leverage. Higher interest rates raise borrowing costs, increasing the difficulty of financing buyouts profitably. Between 2022 and 2023, higher rates constrained leveraged buyouts (LBOs), with a sharp decline in the issuance of LBO loans. This limited deal-making as private equity (PE) funds became cautious, with many shifting to higher equity contributions and reduced debt levels.. For instance, in 2022, KKR chose to acquire April Group using all equity, only adding debt when conditions allowed.
- Valuation and Return Adjustments
In private markets, valuations are highly sensitive to interest rates. A drop in rates can enhance valuations, particularly through the discounted cash flow (DCF) model, which values companies based on future cash flows discounted at the current rate. Lower rates decrease the discount rate, thereby increasing present values and boosting valuations. This effect is especially pronounced in venture capital and growth equity funds, which generally rely on DCF models to value early-stage companies with limited immediate cash flow.
Higher valuations are advantageous for private equity, enabling firms to exit investments at favourable multiples. This not only maximizes returns but also enhances the attractiveness of private markets for investors seeking yield in a low-rate environment.
- Private Market Liquidity and Exits
The recent rate cuts may improve liquidity and exit opportunities in private markets. Higher rates from 2022 to 2023 significantly slowed PE exits due to tightened lending and limited buyer appetite. As a result, the value of unsold private assets reached unprecedented levels, with roughly $3.2 trillion in unsold PE assets globally as of early 2024.
Secondary buyouts, where one PE firm sells a portfolio company to another, became a notable exit strategy in Q1 2024 as sponsor-to-sponsor deals offered liquidity amid low IPO activity.
Lower rates also create favourable conditions for refinancing. During periods of high interest, portfolio companies may struggle to cover debt obligations, impacting cash flow and jeopardizing long-term performance. With rates now lower, refinancing options could ease these pressures, freeing cash flow for reinvestment, operations and growth.
- Venture Capital and Growth Equity: A Distinct Impact
Unlike buyouts, venture capital and growth equity are less dependent on debt financing, making them less sensitive to direct rate changes. However, these sectors experience indirect impacts from shifts in valuation norms. Lower rates enhance the attractiveness of growth-oriented investments, as investors are drawn to the potential of future earnings. This is especially relevant for high-growth industries like technology, where high valuations are often based on the promise of substantial future cash flows.
For companies seeking additional financing rounds or planning to go public, the lower rate environment could result in stronger valuations. However, despite this, the general macroeconomic uncertainty encourages more cautious valuations, pushing venture capitalists to maintain stricter terms and protective measures in investments, such as higher liquidation preferences.
Interest Rates and Private Company Securities: Risks and Opportunities
Private companies—those not listed publicly—are therefore significantly affected by interest rate changes. When rates drop, capital becomes more accessible as private equity investors offer better valuations and terms. Lower rates also ease debt management for private companies, freeing up cash flow and potentially increasing their value.
The potential rise of secondary markets for private company securities would create new opportunities, allowing everyday investors to trade shares in private firms. This would provide greater liquidity and transparency, making private markets ‘behave’ more like public ones. As these platforms emerge, the effects of interest rate changes on private companies could become more predictable and widely understood, aligning with patterns seen in public markets.