Riding Out the Rate Volatility
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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The crowding out effect is an economic theory that argues rising public sector spending drives down private sector spending. While this theory is more commonly applied to government spending and its impact on private investment, it is equally relevant in the context of private market finance. For example, if the government increases its borrowing to fund large infrastructure projects, it can drive up interest rates, making it more expensive for firms in the private markets to secure deal financing. Crowding out can also decrease private sector investment in the short run because the higher interest rates discourage borrowing. The threat is reduced private market activity, as both investors and managers become more cautious about taking on additional debt.
While many forecast a 2025 decline in interest rates, the theory of the crowding out affect underscores the correlation between “fiscal condition[s] and economic outlook through the effect on private investment and interest rates” according to the Peter G. Peterson Foundation. For firms uncertain about the direction of rates, those best prepared to manage the rate rollercoaster will thrive.
The case for flexibility in systems and operational processes
In a volatile interest rate environment, adaptability becomes a competitive edge. Firms must design systems and processes that enable them to respond swiftly to changing conditions. Key areas of focus include:
- Dynamic modeling: Firms need financial models that incorporate interest rate scenarios, stress tests, and ways to monitor and manage liquidity. This helps in evaluating the potential impact on deal pricing, exit strategies, and portfolio performance.
- Agile tools: Flexibility in structuring debt agreements can provide a buffer against rate swings. Strategies such as hedging, refinancing, or laddering maturities ensure resilience.
- Enhanced data integration: Near real-time data on rate movements, market conditions, and portfolio metrics allows for proactive decision-making. Integrated systems facilitate quick adjustments to investment strategies.
- Investor communication: Transparent communication with investors about the implications of rate changes builds trust and confidence. Firms that demonstrate preparedness and adaptability are better positioned to retain and attract capital.
The outlook for private market finance
Despite the uncertainties surrounding fluctuating interest rates, the outlook for private markets is positive. The continued growth of alternative asset classes and the development of new financial technologies are expected to drive further innovation. Private market managers able to adapt their strategies and leverage technology to their advantage will be well-positioned.
By understanding the impact of interest rate fluctuations on the cost of borrowing, valuations, deal flow, and investment strategies, managers can make more informed decisions. Focusing on operational improvements, being selective in deal sourcing, conducting thorough due diligence, and using flexible financial structures are key strategies for success in a volatile rate environment.
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