The ‘L’ in ‘LBO’ is becoming more expensive. At the time of this issue of Private Equity International going to press, the US Federal Reserve’s federal funds rate stood at between 3.75 percent and 4 percent. In the UK, the Bank of England raised rates by 75 basis points in early November to 3 percent. Expectations are that rates could shift even higher in 2023.
The cost of borrowing going up affects private equity dealmaking in many ways, and ultimately could mean lower returns for LPs.
Industry executives that PEI has spoken to over the last few months say they are bracing for higher borrowing costs in multiple ways. Robert Knorr, managing partner at MidEuropa, says that leverage becoming more expensive affects the type of leverage his firm takes on, and from whom they borrow.
“You can’t just rely on traditional lenders… You have to look at private debt, you have to look at alternatives,” Knorr says. In the past, there were situations where MidEuropa secured unitranche financing from a sole private lender, but in this higher rate environment, it is going to consider borrowing from multiple sources.
The cashflow profile of businesses that private equity firms are looking at will be a little different compared with the past, as more of the cashflow must go to service debt in a higher interest rate environment, according to Fahim Ahmed, chief operating officer at BC Partners.
“If you look at the private equity market overall, there have been many businesses that have been levered with relatively low cashflows,” Ahmed says. “Those cashflows at the margin will have to get eaten away by these rising rates, so there will, by nature, be an impact on the degree of leverage available for those businesses.”
Changing the portfolio
Some LPs say they will respond to the higher cost of borrowing by considering changes to their portfolio allocations. Jim Pittman, global head of private equity at British Colombia Investment Management, says public pension plans may not need to have as high exposure to private asset classes as they had in recent years if they can make decent returns from fixed income.
“With an increasing interest rate environment, we don’t need to have as much private assets per se. In that mix, if you can get more bonds, and investment-grade bonds in particular, and other government fixed income paying 2, 3, 4, 5 percent, you can actually dial down the risk of your portfolio slightly.”
A decade and a half ago, the 60/40 equity/bonds portfolio split was the norm for many pension plans. Today, many pension funds have private markets allocations as high as 55 percent, Pittman says.
Play the alpha
For Philippe Roesch, managing partner at multi-family office RIAM Alternatives, manager selection is going to be even more important in an environment where managers can’t rely as heavily on cheap debt to fuel returns.
“In such times, it’s more important than ever to really play the alpha – meaning, to select carefully and be able to access the best GPs,” Roesch says. By “best GPs”, Roesch says he means sponsors who have been able to benefit from previous downturn cycles in terms of new investments, or can show they maintained the value of their portfolios, prepared exits and delivered consistent net returns to their LPs amid those downturns.
For Roesch, one key way RIAM will try to minimise the effects of rising interest rates on its portfolio is by reducing manager risk altogether.
“We will do all the re-ups for all the [current] GPs, but in terms of new GP relationships, definitely we will do this… less than what we would do in normal year.”
– Graham Bippart, Robin Blumenthal, MK Flynn, Craig McGlashan, Andy Thomson and Chris Witkowsky contributed to this report.