Higher interest rates are no reason to pass on private equity
Higher interest rates are no reason to pass on private equity
Private equity has always attracted more attention than other parts of the investment world. Today, as an unprecedented era of low-interest rates comes to an end, and the global economy slows, the industry is once again under scrutiny. Do private equity returns depend solely on cheap debt? And how will deals struck in more exuberant times fare in a recession?
While the current environment will pose challenges, this is not the first time the industry has been through tough times. It successfully navigated the financial crisis of 2008 and the pandemic of 2020 – and many periods of stress in between. Our expectation is that the industry will also emerge from the coming slowdown in good shape. If history is any guide, this may in fact turn out to be when some of the most successful deals are struck.
The challenge of higher interest rates…and lower growth
There’s no getting away from the fact that the combination of rising interest rates and lower growth are a headwind for private equity. It is reflected in the stock market performance of the largest-listed private equity managers – such as KKR and Blackstone – whose shares have fallen by close to a third this year.
This environment is particularly difficult for “buyout” strategies, typically focused on mature businesses generating steady cashflows that can support high levels of debt. All other things being equal, it is much easier to make a deal work when you can borrow money at 1.5% than when it costs 5%. Valuations of deals struck during the bull market of 2021 could well be cut as managers are forced to accept that the outlook for economic growth and interest rates now look very different.
It's important to bear in mind that it is the transition to a higher interest rate environment that is particularly difficult for this strategy. Buyouts can still work in a higher interest rate environment – and did so for years before the financial crisis of 2008. Borrowing costs may be higher, but valuations across public and private markets are likely to be lower. And if, as now looks likely, the economy does go into recession as a result of higher rates, it could create opportunities for private equity managers to buy assets at very attractive valuations.
The current environment is also proving challenging for venture capital investments focused on earlier stage, high-growth companies. The Nasdaq Composite index, which is heavily weighted towards the technology sector, is down by more than 30% from its peak. While private technology investments may not be marked down by quite as much, the move lower will inevitably be reflected in private market valuations. As investors become more cautious, there is also less appetite to invest in still unproven firms, making it much harder to exit previous investments in these companies.
The importance of diversification
When investing in public markets, we typically look to diversify investments by geography and asset class. Private equity investors can and should also be using these sources of diversification. The huge growth of the industry in recent years means that there are now talented managers focused on a very wide range of geographies and industry sectors. The latter could be particularly important in today’s more difficult environment, allowing investors to tap into longer-term trends – such as the adoption of new technologies and energy transition – that are less dependent on the overall direction of the global economy.
The nature of private equity investing gives investors exposure to another powerful source of diversification – time. Investments in a fund involve a commitment to provide capital over several years, which is likely to include periods of economic strength and weakness. This structure helps to reduce the cyclicality of investing in the asset class and should create opportunities for skilled managers to take advantage of periods of market stress. Historically, funds that are invested during downturns have often proved to be some of the best performers.
We advise clients to pace their allocations into private equity systematically over time – typically four to five years. These allocations will be called over a further period of three to five years, meaning that it could take ten years to be fully invested.
Company size is another important driver of diversification, with managers tending to focus on very different segments of the market. The biggest private equity firms have raised such huge amounts of money that they have to focus on very large buyout deals – such as last year’s acquisition of Wm Morrison. Competition amongst the largest private equity firms means that valuations in this part of the market have tended to be relatively high. While these buyers look to make operational improvements to the companies that they buy, the success of a large buyout may depend to a significant extent on broader trends in capital markets and the economy.
At the other end of the spectrum are managers focused on smaller companies. Deals tend to be struck in less competitive situations and there are usually more avenues to increase the value of a business. To give just one example, private equity investors can provide smaller companies with the expertise and capital to make acquisitions that transform their strategic position. This is rarely an option for large companies.
We are tilting our private equity allocation towards managers focused on the smaller end of the market as well as sector specialists.
This preference is based on the belief that private equity managers need to add meaningful value to the firms that they are acquiring. In general, today’s private equity firms do not expect to make returns simply from cost-cutting. They are looking to find ways to grow revenues, expand margins and improve the resilience of a business. These objectives are more achievable with smaller companies and those with a deep focus on a particular sector.
We have limited exposure to buyout funds. The exposure that we do have was acquired at an attractive valuation through "secondary funds" – another area of focus for us. These are funds that acquire investments in existing fund interests, often at discounted valuations. We believe today’s market environment offers an opportunity for these managers to buy high-quality businesses at reduced valuations, as discounts often widen in times of market volatility. Secondary funds can also accelerate the deployment and return of capital compared to traditional (primary) funds, as they typically acquire funds that are mature and well-invested.
Our third area of focus is venture capital. 2021 was one of the strongest years on record for venture capital returns, particularly for investors in later-stage businesses that benefited from a strong IPO market. This was followed by a sharp reversal in 2022 as investors’ concerns over growth, inflation and geopolitics triggered sharp and indiscriminate falls in valuations. History tells us that this environment could present attractive opportunities for skilled managers to invest in transformational businesses at attractive valuations. Some of the best-performing venture funds were raised after the dotcom bubble burst.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 1 London Wall Place, London EC2Y 5AU. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.