How Interest Rates and Inflation Impact Private Equity

It’s not hard to understand that interest rates would have an impact on private equity. The same would hold true for inflation impacting private equity as well. Any changes in the financial landscape or in financial policy will affect investments across the board. So “How do Interest Rates & Inflation Affect Private Equity?”.

One way interest rates affect businesses is through the cost of loans. The fact that two of the main investment strategies involved in Private Equity, venture capital and leveraged buyouts, makes PE firms sensitive to interest rate changes since both strategies heavily consider the cost of the loan in their financial modeling.

PE firms seek target companies with a consistent cash flow and low capital expenditure and operating working capital requirements. They service the debt using the firm's consistent free cash flow. What remains is either accumulated until exit or paid out as dividends. The influence of interest rates on private equity firms has two sides for both buyouts and exits. The reactions to a shift in interest rates of PE firms intending to sell versus those intending to acquire are diametrically opposed.

To get a better understanding of how these factors affect private equity we’ll cover these three topics

• Declining Interest Rates vs Increasing Rates
• Inflation's Effect on Portfolio Company Operations
• How Business Valuations are Affected by Rising Inflation

Declining Interest Rates vs Increasing Rates

Low or declining interest rates mean more capital available for private equity businesses as investors shift their focus away from fixed income and credit instruments. This presents a buying opportunity for private equity groups. For starters, they now have easy access to finances, and fundraising activity has increased. Second, private equity firms can enter into a transaction, locking in lower interest rates, reducing their monthly outflows, increasing the IRR and, finally, the return on investment.

An increase in interest rates would have the reverse effect, causing investors to flock to fixed income and credit assets. As a result, fundraising becomes difficult. Investors and the general public are also less interested in IPOs, and asset valuations are falling, which is problematic for private equity firms that scheduled their exits around the same time. It is, nonetheless, advantageous for private equity firms looking for cheap companies and assets. These companies can invest with the funds they have accumulated throughout the low-interest period. These firms also have access to cash from major institutional investors with a long-term perspective and a desire for diversification, which piques their interest and hunger for PE. Many private equity firms are ready to re-strategize in the face of an impending interest rate hike in the United States. PE businesses must either lock in a lower interest rate or ensure that cash flow predictions are intact and resilient to the risks associated with an interest rate hike.

Inflation's Effect on Portfolio Company Operations

Running a business in an inflationary environment is very different from running a business in a stable/low inflation one. After investment opportunities are identified and closed, the value of 'forgotten' – or at least undervalued – skill sets such as successfully managing inventories, accounts receivable and payable, and cash will increase. In a climate of high inflation, effective working capital management could mean the difference between survival and failure. PE sponsors must guarantee that their management teams are appropriately encouraged to hone and deploy these talents in order to optimize investment returns.

How Business Valuations are Affected by Rising Inflation

Inflation has an impact on valuations in addition to the cost of debt. The heuristic known as the 'Rule of 21' in the public markets states that the market's P/E multiple and CPI inflation should add up to 21 (note: by that metric, the market appears slightly overvalued now, with a P/E multiple of 18x and inflation just north of 4%).

We might be able to think of a comparable 'Rule of 12' in private markets. In the mid-2000s, for example, with inflation hovering at 3-4 percent, EBITDA multiples were around 8x. Multiples surpassed the 10x barrier as we reached the 2010s, with inflation falling to the official target of 2% in the aftermath of the Global Financial Crisis. Then, as inflation approached zero in the latter half of the last decade, multiples hit the 12x level.

Such guidelines are, at most, a rough guideline. However, for private equity managers wanting to invest at today's multiples, it is worth addressing the consequences of a return to mid-single-digit inflation and what this might entail for future valuations.

With rising loan rates and increased regulation, PE companies are finding it challenging to attract the degree of leverage in target firms. Nonetheless, private equity firms have traditionally produced higher returns and at GenX Capital our Velocity3X fund you can triple your money in 4 years.