PE battles the higher interest rate environment: Story of the Year

The cost of borrowing became more expensive in 2022, resulting in both challenges and opportunities for the industry.

Private Markets and the End of Cheap Money – that’s the title of a cross-publication podcast series PEI Group began publishing at the end of 2022.

The choice of words is significant: for the first time in more than a decade, the ‘L’ in LBO is becoming more expensive, changing the nature of one of the main levers private equity uses to generate returns over public markets.

The cost of borrowing going up – at the time of writing, the US Federal Reserve had just raised rates for a seventh time in a year, with the Bank of England and European Central Bank following suit – played out in various ways throughout the year.

On the deal front, investors have retreated, leaving large M&A processes suffering from problems with leveraged loan syndication. A prime example was the $16.5 billion buyout of software company Citrix by Elliott Management and Vista Equity Partners, agreed in January. As of September, the banks who underwrote the leveraged side of the transaction were reported to still be holding billions of Citrix debt on their books, despite having offloaded almost $9 billion of bonds and loans at knockdown prices.

Capital markets have been rocked since the start of the year by events including Russia’s invasion of Ukraine and plummeting tech valuations, with successive rises in interest rates exacerbating headaches.

“The debt availability of traditional lenders has decreased,” said Robert Knorr, managing partner at MidEuropa, a Central and Eastern Europe-focused mid-market specialist. Traditional banks are either less willing to lend, increasing their lending rates, or simply decreasing the amount of leverage they’re prepared to lend at, impacting deals and deal pricing, he added.

“It also has an impact on what kind of borrowing you would be going for. You can’t really just rely – as we have not been relying – only on traditional lenders.”

In the mid-market, however, transactions have been a little more insulated from broader volatility and rate increases due to traditionally lower levels of debt usage, as Michelle Handy, managing director and head of portfolio and underwriting of First Eagle Alternative Credit’s direct lending platform, told us for our podcast series in December.

“For middle market transactions, you’re talking about less than maybe 4.5 turns of leverage – you’re talking about LTVs that are less than 50 percent, transactions that get structured with fixed charge coverages that are north of 1.5. And so the structure itself lends to cushion in general for the overall transaction as interest rates increase.”

The rising cost of leverage also began to force LPs to reconsider the role that private equity plays in their portfolios. According to Jim Pittman, global head of private equity at British Columbia Investment Management Corporation, alternatives exposure is likely to drop in favour of less risky strategies such as fixed income. With investment-grade government bonds paying as much as 5 percent, an institutional investor can “dial down” the risk of its portfolio, he said.

“You will see that happen for sure in many of the pension plans, if the interest rates stay mildly high,” Pittman said. “Right now, you see many pension plans [with] 50 percent, 55 percent allocated to private markets. I’m sure that will probably come down 5 percent… if there’s an expectation that [interest rates] will stay in the 3, 4, 5 percent rather than the 0, 1, 2 percent range.”

With more rate rises expected in the New Year, private equity firms tell us they are increasingly focusing on other levers, such as operational improvements, to drive returns. As such, 2023 is set to be a year like no other seen in at least a decade and a half.