Shift in PE inevitable after Fed rate hike

Experts believe years of near-zero interest rates facilitated an overly confident behaviour in private equity that should normalise in the long term as the US Federal Reserve continues to gradually raise rates.

The Federal Reserve’s interest rate target hike by 25 basis points to a range of 0.25 percent to 0.5 percent is signaling a shift in financial markets after years of rates being near zero, but for the private equity industry, it’s likely the impact will be subdued in the short term.

In the longer term, it’s inevitable that the cost of debt will increase, making it more expensive for private equity firms to borrow and purchase companies, however, higher interest rates also typically prompt lower valuations, making some assets more attractive.

According to several experts, the Fed’s long-anticipated move will, at the very least, push PE firms to be more cautious in their investments.

The Federal Open Market Committee stated in its 16 December release that along with the “considerable improvement in labor market conditions this year,” inflation is expected to rise to the committee’s 2 percent target over the medium term, justifying its move.

Z Capital president and chief executive Jim Zenni told Private Equity International that central banks had created an environment in which investors felt comfortable to move into risky areas they were not familiar with. He believes that some companies with high leverage debt multiples could suffer from interest rate increasing in the longer term. This is especially true of distressed companies in the energy sector.

“What we have today is the beginnings of significant defaults going forward; significant restructurings,” he said.

The US high-yield default rate could be around 4.5 percent for 2016, according to Fitch Ratings’ forecast, with much of it due to weakness in the energy and metal/mining sectors, the credit ratings firm said in a statement on Wednesday.

“The energy sector default rate is projected to hit 11 percent in 2016, eclipsing the 9.7 percent rate seen in 1999,” Fitch wrote. “Removing energy and metals/mining from the index, the remainder of the high yield universe is expected to finish 2016 with a 1.5 percent default rate, which is below Fitch’s non-recessionary average of 2.1 percent.”

The leveraged loan default rate for its part will increase to 2.35 percent by the end of 2016, according to LCD’s latest quarterly survey conducted at the beginning of the month.

But in the short term, the cost of debt is still considered cheap by historical standards.

For M&A and debt advisory Livingston Partners managing director David Sulaski, a slight increase in the rate won’t affect the way PE firms invest too much.

“When money goes from being free to a nickel, it won’t impact people’s behaviour,” he said. “It won’t stop people from doing deals.”

A rate increase will also likely have a positive impact on valuations, making them more attractive to PE buyers.

“For our business it really isn't going to be that cataclysmic or really that dangerous because the truth is when interest rates go up, prices tend to go down in public markets. Therefore prices are less expensive and it's easier to buy things,” the Carlyle Group’s founder and managing director David Rubenstein told CNBC in September.

At present, many private equity firms are finding it difficult to purchase assets because prices are too high, and that will change as interest rates begin to rise, Rubenstein said.