US rate raise prompts PE caution

Over the longer term, the US Federal Reserve’s decision to raise the Federal Funds Rate by 25 basis points will put pressure on firms with high leverage multiples.

The US Federal Reserve’s decision to raise interest rates by 25 basis points taking the Federal Funds rate to a range of 0.25 to 0.5 percent, will at the very least push managers to be more cautious in their investments, market participants said.

Z Capital president and chief executive Jim Zenni told Private Equity International in November that some companies with high leverage debt multiples could suffer from interest rate increases over the longer term. This is especially true of distressed companies in the energy sector, he believed.

Central banks have created an environment in which investors felt comfortable to move into risky areas they were not familiar with. “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 and mining sectors. “The energy sector default rate is projected to hit 11 percent in 2016, eclipsing the 9.7 percent rate seen in 1999,” Fitch said in statement.

Overall, the impact is likely to be subdued in the short term as the cost of debt is still considered cheap by historical standards. In the longer term, it’s inevitable that the cost of debt will increase, making it more expensive for private equity firms to borrow. However, higher interest rates also typically prompt lower valuations, making some assets more attractive, experts say.

The Fed also increased the discount rate by 25 basis points to 1 percent. The Federal Open Market Committee stated in its 16 December release that its decision was based on the “considerable improvement in labour market conditions this year,” and the expectation for inflation to reach its 2 percent target over the medium term.

For mergers and acquisitions 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.

In September, commenting on the long-anticipated rate raise, The Carlyle Group founder and managing director David Rubenstein told CNBC: “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.”

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.