Perspectives 2016: North America's interest rate challenge

At a time when LPs are hoping to shake off the effects of the global financial crisis, looming economic concerns in the US are pushing some investors to new strategies.

A period of record-low, near-zero levels of interest rates imposed by the Federal Reserve has paved the way for cheaper loans that have stimulated many in the private equity industry to easily close deals funded in part by debt. Deals are a good thing to keep the industry vibrant, but the amount of leverage, among other factors, has made the purchase price multiples soar.

This is a phenomenon that has not gone unnoticed by private equity investors in the US. Almost 80 percent of North American LPs questioned in Private Equity International’s Perspectives survey indicated that “extreme market valuations” are a top-three concern to them, with almost half saying it was their most important macro issue.

Lowery Asset Consulting vice-president Matt Rowland said interest rate hikes are the biggest issue facing North American LPs, followed by slowing economic growth in US and overseas.

Portfolio Advisors managing director Peter Schwanitz echoed those sentiments, remarking that North American LPs are facing “the potential impact of an interest rate increase on the markets, with effects on pricing and valuations”.

Hoda Abou-Jamra, founding partner of TVM Capital Healthcare Partners, which has an office and a network of partnerships in Boston, told PEI that, while predictions on market valuations are difficult to make, perhaps another bubble in buyouts is looming. 

Abou-Jamra added that “higher entry valuations by definition cause a trend towards lower overall returns”.

LPs are aware of this and shifting their private equity investment strategies from buyouts to other types of funds.

Indeed, in a September/October survey of endowments and foundations by consultant NEPC, 58 percent of respondents said valuations were their biggest concern.

“Potentially in response to these concerns, co-investing appears to be of growing interest as endowments and foundations look for strategies that come with the potential for higher returns, lower fees and offer them greater control over their underlying investments,” NEPC partner Kristin Reynolds said.

This holds true for Pantheon’s co-investments, according to Pantheon partner Jeffrey Miller, who told PEI in August that the firm’s co-investment deal flow for the previous 12 months had been at an all-time high. He cited the high valuation environment as a reason for GPs needing more equity in a deal to seek co-investing.

And co-investing is not the only strategy popping up on the radars of LPs seeking better returns.

“LPs are getting more sophisticated, with many of them pursuing direct investing,” says Debevoise & Plimpton partner Jonathan Adler, adding that the private equity industry as a whole is becoming institutionalised, with GP consolidations and the search for niche financial sponsors.

In fact CalPERS, one of the largest pension funds in the world, has indicated it will focus on customised investment accounts and co-investments, each of which currently accounts for roughly 5 percent of its portfolio, according to its Private Equity Annual Program Review Report.

Another strategy LPs seem to be pursuing is a portfolio with more focus on the mid-market and smaller funds.

The Perspectives survey found mid-market buyouts was the preferred strategy of 87 percent of North American LPs, compared with 75 percent of Asian LPs and 73 percent of European LPs.

The New York State Retirement System, one of the 10 biggest pension systems in the US, said in its latest annual report that it will move away from large and mega buyouts to obtain more exposure to small and medium-sized buyouts in North America and Europe along with sector-focused funds.

“At a time of near-record high purchase price multiples and exceptionally high valuations for quoted public market comparables, investors – even fund managers – previously focused more on large buyouts are significantly upping investment in the middle market,” says Antoine Dréan, chairman of fund advisory Triago and founder of online marketplace Palico.

Ridgemont Equity Partners, which recently closed its second fund, REP II, on $995 million, has noticed this LP appetite.

“There continues to be a high level of interest in the mid-market,” says Ridgemont partner John Shimp. “This suggests investors from larger funds, where so much capital has been deployed, have been rethinking their strategy.”

Another, non-economic, factor lies in politics. Presidential elections are set to take place in November 2016 and several of the candidates, including Jeb Bush, have taken aim at private equity taxes as a campaign issue.

Bush detailed his tax proposals in The Wall Street Journal, including his aim to eliminate tax shields for interest on business loans. This implies threats to the leve-raged buyout market, which S&P Capital IQ recently warned has debt levels mirroring pre-crisis levels. Once tax deduction on loan interest is removed – should Bush win and pass legislation – private equity funds would have a difficult time with an increase in cost of capital, at a time when prices are already high.

If this does go through, it “would require a massive repricing of assets throughout the global economy”, Debevoise tax lawyer Peter Furci told PEI’s sister publication Private Funds Management in September.

Next year may be one of shifts and refocusing in the North American private equity landscape, and the smarter LPs seem to be already making progress in that direction.