“Higher interest rates are surely bad for private markets” is a common belief. The reality is more nuanced: while existing investments are tested, new ones are expected to benefit from tailwinds in the form of lower valuations and better terms.
Venture capital: Experiencing a reset
Higher interest rates have ripple effects on venture capital. First, investors’ return expectations increase when they finance start-ups. Second, investors deploy less in venture capital and are more selective. As a result, investment activity has already started to decrease.
As a consequence, average valuations edge downwards, and investment terms are tightened as investors require higher protection such as liquidity preferences. This evolution is negative for investments previously done at higher valuations and that require more cash now. As a result, start-ups are currently reducing their cash consumption.
This evolution is however positive for investors now doing deals at lower valuations and better terms. In the long term, the performance of these investments will benefit from valuations eventually recovering along with economic growth.
Growth capital: Attractive opportunities expected
Higher interest rates put pressure on valuations in the short- to mid-term. Until new valuation levels are set, the deal flow might be lower than usual. Growth companies are prized assets, where the variation of valuation is expected to be moderate to low. Investors doing deals in the current environment will benefit from these lower valuations. The performance of investments will benefit as valuations will eventually recover.
Higher interest rates means that direct lending is more expensive. The macro-economic environment is also more challenging. Consequently, entrepreneurs in profitable and fast-growing companies look for more investor expertise and active support, even if this implies a dilution of their ownership. This should provide more opportunities for growth capital investments in the mid-term.
Leveraged buyouts: Mixed consequences
Higher interest rates increase the cost of the debt used to acquire mature and stable businesses, which is the business of leveraged buyout (LBO) investing. As a consequence, investors are using less debt (financial leverage). Since the financial leverage contributes on average to 30% of the performance of LBOs, this would theoretically imply lower performance of future deals. In practice, the impact is more nuanced.
Small and mid-sized LBOs usually use limited amounts of debt, so the increased cost of debt affects them less. The investment activity is more resilient and continues to offer attractive opportunities.
Large and mega LBOs use comparatively more debt. The increased cost should theoretically comparatively affect their performance more. However, in recent years, the main strategy was buy-and-build, the acquisition of smaller companies which then merged, to form larger companies. Leverage levels were not as high as for de-listings or plain vanilla large LBOs. This reduces the impact of higher interest rates on the performance of these deals.
Moreover, after the global financial crisis of 2007-2009, the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency jointly capped the level of financial leverage at six times the EBITDA of acquired companies in the US. The ECB did the same in Europe.
According to Pitchbook LCD, the average debt level in large and mega LBOs is below or at 60% (vs. 70%+ before 2008). The impact of higher rates is therefore comparatively lower. Some recent deals were even done without leverage, for example when KRR bought April Group initially without the use of any debt.
Higher interest rates increase the cost of debt for existing deals since rates are floating. This might lead to debt renegotiations, anticipated repayment, or restructuring. Until recently, the debt of larger LBOs was covenant-light. As a result, investors have more leeway to handle the consequences of higher rates. The impact of higher rates will also materialise progressively, making room for adjustments and negotiations with lenders. As rates decrease, the pressure on existing deals will rise as well.
In the short term, higher interest rates reduce distributions to investors since this decreases the frequency of dividend recapitalisation (which consist in re-indebting existing deals and distributing extra cash to investors). The sale of companies to industrial buyers (“trade sales”) or to other investors (“secondary LBOs”) usually involves acquisition debt and is thus less frequent. In effect, cash distributions to investors have slowed down.
In the mid-term, higher interest rates will increase investment opportunities. As corporations feel the pinch of higher interests, they will try to reduce their debt by divesting from non-core assets and executing corporate carve-outs. These will provide additional LBO deals.
As with venture and growth capital investments, higher rates will reduce valuations, and lower valuations will contribute to the performance of deals in the long term.