The end of the zero interest era: how the new reality is going to impact the Private Equity- and the Private Debt industry

How increased interest rates impact the Private Equity industry?

After an unprecedentedly long period of close-to-zero interest rates, central banks have been aggressively hiking interest rates to control inflation. This has impacted the global markets, and the private equity industry is no exception.

In general, higher interest rates result in lower returns and lower competition, which leads to lower asset prices in Private Equity. In theory therefore, this should be a zero-sum game for the investors over a long period, as increasing interest rates should be balanced off by lower multiples and visa-versa. The market corrections may however take years. In the short run therefore, increasing interest rates may have the following impact on the private equity industry:

Lower returns: Private equity firms often rely on borrowing money to finance their investments, and higher interest rates can increase the cost of borrowing. This can result in lower returns on investment, as more money is required to service the debt.

Reduced deal activity: Higher interest rates can make it more difficult for private equity firms to finance acquisitions, leading to reduced deal activity. This can lead to fewer investment opportunities and slower growth for private equity firms.

Portfolio company performance: Higher interest rates can increase the cost of debt financing for portfolio companies, which can put pressure on cash flow and profitability. This can negatively impact the overall performance of the private equity firm’s portfolio.

Decreased competition: As borrowing becomes more expensive, private equity firms may have fewer competitors, which can lead to lower valuations for assets and decreased returns on investment.

Impact on exit strategies: Higher interest rates can impact exit strategies for private equity firms, as it can be more difficult to sell assets in a high-interest-rate environment. This can result in longer holding periods and reduced returns on investment.

Who is impacted?

Strategic PE players vs. leverage-driven

The devil is in the detail. Some of the traditional Private Equity competitors noticeably struggle in the current environment.  “The key decisive factor is the source of the value-creation. We keep seeing our competitors entering deals with up to 80% leverage with adjustable rates and basically no growth plan. Obviously, they are in trouble now”, says Fabian Kröher, Executive Director at Winterberg Group.

Meanwhile, more hands-on PE players, implementing a wide range of organic and non-organic growth drivers, for instance via a buy-and-build strategy, are not expected to be negatively impacted in any significant way by the current turmoil. Key growth drivers for more hands-on Private Equity funds mostly include strong growth plans, extraction of synergies between multiple entities, access to new markets, value-add expertise in more efficient management, and others. As a result, the return rates are much less sensitive to any changes in interest rates.

Large-cap vs. Small-cap

We at Winterberg Group also see a big disparity in how the changes in interest rates differently impact larger-cap transactions vs. the smaller-sized environment.

Larger acquisition targets with an established track record have a much larger debt-carrying capacity. As a result, we saw ridiculously high multiples in the past, which were purely justified by vast debt amounts at low interest rates. Those funds also face minimum IRR thresholds, which are now becoming more and more difficult to achieve. As a result, we see funds being forced to hold onto assets much longer, due to min. return thresholds, which are not going to be realized in the event of an exit. Strong competition on the buy-side at the same time is not fully compensating for the valuation multiples correction, forcing the buy-side participants to overpay for the assets. As a result, we see less deals getting to the market at acceptable prices.

Smaller-cap Private Equity deals, in contrast, feature lower leverage in the capital stack, limiting the impact of the overall interest rate hikes on the returns. In combination with lower competition, the current market conditions create a much more buyer-friendly environment.

Shifting credit landscape (alternative credit providers vs traditional banks)

The combination of increasing regulatory standards (Basel I – IV) with very low-interest rates made the credit leverage finance business for traditional banks extremely unattractive. Especially in the lower-size segment, the transaction execution expenses on the bank’s side often exceeded the potential interest rates, they would get in return. In addition, increasing KYC requirements and strict risk policies made banks very slowly in their processes, becoming a potential bottleneck of a transaction from the Private Equity’s point of view.

All of the above created an unprecedented growth of private debt providers emerging. Indeed, the global Private Debt market has more than tripled in the last 7 years. The USPs of Private Debt providers are clear: quick execution, less strict credit policies, and high leverage amounts in exchange for a higher interest rates, compared to a traditional bank. Given the overall ultra-low interest rate environment, this seemed like an attractive trade-off for the Private Equity industry.

Source: Reuters

However, we believe that the competition between traditional banks and Private Debt providers is expected to intensify in the coming years, as Private Debt providers will have to adapt to growing delinquency rates and as a result, adapt their credit policies. At the same time, the spike in interest rates makes traditional credit leverage finance more attractive for the banks, who are expected to ramp up their deal-sourcing efforts soon. “We already see the competition between different lenders intensifying. We’ve never seen that many players proactively reaching out to us with very flexible financing solutions”, says Fabian Kröher, Executive Director at Winterberg Group.

Moreover, with the increasing difficulties to generate attractive returns in a high interest environment, Private Equity funds will need to put a larger emphasis on the overall cost of capital, which shall favour the traditional banks.