Interest rate volatility has become a defining feature of today’s financial landscape, reshaping the dynamics of private markets over the past decade. As central banks work to manage inflationary pressures and global economic uncertainty persists, fluctuations in borrowing costs and investment valuations present both challenges and opportunities for market participants.

In the private markets, volatile interest rates can affect the cost of borrowing for leveraged deals, influence the valuations of portfolio companies, and potentially impact deal flow. What’s more, changing interest rates can require firms to adjust investment strategies in response to changing market conditions, particularly in areas like private equity and private debt where leverage is often utilized.

Rising rates can increase the cost of debt financing, affect the valuation of portfolio companies, and reduce the availability of credit. Conversely, falling rates can spur deal activity by lowering borrowing costs and increasing investor appetite for higher-yield opportunities.

For private equity, venture capital, and real asset managers, the implications of rate changes are far-reaching. From recalibrating investment models to managing portfolio leverage, firms must be ready to quickly mitigate risks and jump on emerging opportunities.

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What changes as interest rates rise and fall?

As interest rates stay volatile — moving up and down quite unpredictably — private market managers want to come armed with the steps they will take as rates rise and fall. Things like financing costs, valuations, and deal flow can quickly change based on the direction of the rate.

Cost of borrowing

When interest rates rise, the cost of debt financing increases, which can significantly affect the profitability of leveraged buyouts. For private market firms, managers may become selective with deals or adjust their investment thesis to focus on companies with strong cash flows and less reliance on debt. Say a leveraged buyout is profitable at a 3% interest rate; when rates hit 5%, the increased cost of borrowing can erode margins and reduce the overall return on investment. When rates decline, the cost of borrowing decreases, making leveraged deals more attractive. Private market managers can take advantage of lower rates to secure more favorable financing terms, potentially increasing the profitability of their investments.

Valuations

Fluctuating interest rates can lead to revaluations of portfolio companies, as changing market conditions can impact the discount rate used to calculate present values. This can lead to markdowns in portfolio values during periods of rising rates. As an example, a portfolio company valued at $100 million with a 4% discount rate might be revalued at $90 million with a 6% discount rate. Markdowns can have a significant impact on the net asset value of private equity funds, affecting investor confidence and the overall performance of the portfolio.

Deal flow impact

In a rising rate environment, deal flow can decelerate as lower valuations create hesitancy among potential sellers and buyers grow cautious about taking on additional debt. A bottleneck in the market can make it more difficult for managers to find attractive investment opportunities. As interest rates decrease, deal flow tends to heat up competition for sellers and buyers actively exploring deals in the market.

Investment strategy adjustments

Private market managers may need to adapt their investment strategies to focus on sectors or asset classes more resilient to rate volatility, such as companies with strong balance sheets, floating-rate debt instruments, or steady income streams. For example, cash-generative businesses in sectors like healthcare or technology may stand out. Similarly, in private debt strategies, managers may turn to floating-rate loans to better align with interest rate movements, reducing the risk of rate mismatches.

Investor expectations

With higher interest rates, investors may expect higher investment returns, putting pressure on managers to deliver competitive returns in a more challenging environment. This can lead to a more intense focus on value creation and operational improvements.

How private market managers can respond to the rate rollercoaster

In a volatile environment, managers may prioritize value creation through operational improvements. This can involve investing in technology, streamlining operations, and enhancing management practices.

Stay selective in deal sourcing

Managers may become more selective when evaluating potential investments, focusing on high-quality companies with strong fundamentals and lower leverage requirements. Some may choose investments with robust cash flows and a track record of consistent performance. Other firms may choose asset classes such as collateralized loan obligations that deliver a stable revenue stream. Or perhaps volatility reignites interest in real estate or M&A activity. However firms decide to approach rate and economic uncertainty, technology becomes a necessity to help firms price assets, understand valuations, and quickly capitalize on opportunities.

Increase due diligence

With higher interest rate risk, thorough due diligence becomes even more important to accurately assess a company's ability to service debt in a changing market. This involves a deep dive into financial statements, market conditions, and competitive positioning. For example, a private debt manager might conduct extensive credit analysis to ensure that a borrower has the financial strength to meet its debt obligations, even if rates rise.

Diversify

The diversity and granularity of different asset classes and strategies can provide allocators with new sources of uncorrelated return, downside protection, and a steady income stream. Asset-based lending, for instance, is appealing during periods of volatility because of its exposure to a variety of sectors and geographies.

Manage liquidity

Firms will need to manage liquidity more carefully during periods of volatility and fluctuating interest rates to ensure they can swiftly respond to interest rate shocks, rebalance portfolios, or quickly access cash. A proactive approach to liquidity management includes closely monitoring cash flows, maintaining adequate reserves, and deploying sophisticated models to anticipate potential market shifts.

Focus on operational improvements

As firms diversify investments and investment structures grow more complex, challenges in recordkeeping, accounting, and reporting only increase. Modernizing your middle- and back-office operations can offer transformational potential. Firms willing to adopt flexible systems that unify data and aid in simplifying operations can help teams better measure fund performance, synthesize attribution, and conduct meaningful analyses.

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