How Private Equity Can Thrive with Elevated Interest Rates

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Can private equity produce compelling returns even when interest rates are elevated? It’s a question that has been top of mind for many investors lately.

Though many market participants believe that interest rate cuts are coming this year in the United States and Europe, our Global Macro & Asset Allocation team says that larger forces such as the transition from traditional energy sources to renewables, labor shortages prompted by aging populations, and increasing global political tension could keep interest rates elevated for years to come.

Private equity purchases and investments are often funded with borrowed money, and some have questioned whether higher borrowing costs could make it difficult for managers to continue generating attractive returns. We see four reasons that this is not the case.

1. Today’s “high” interest rates are below the historical average.

2. Leverage levels are not as high as they used to be.

3. Private equity managers can take advantage of inflationary shocks.

4. Private equity returns rely on value creation.

1. Today’s “High” Interest Rates Are Below the Historical Average

The current rate environment seems unprecedented because it is a drastic change from the near-zero rates of the 11 years following the Global Financial Crisis. However, the rates we have seen over the last two years are not exceptionally high if we look back to 1976, which is the year KKR was founded. Using this date as a sort of proxy for the beginning of private equity (Exhibit 1), the average effective fed funds rate between 1976 and 2023 was 4.66% compared to 3.35% over the past two years. It could be argued that rates are just returning to more normalized levels.

EXHIBIT 1: Effective Fed Funds Rate Since KKR’s Founding Year

: Bar chart showing the effective Federal Funds Rate from 1976 through 2023 along with the average rate over time.
Source: Federal Reserve as of December 31, 2023. The Federal Reserve defines the effective fed funds rate as, “the interest rate at which depository institutions trade federal funds (balances held at Federal Reserve Banks) with each other overnight. When a depository institution has surplus balances in its reserve account, it lends to other banks in need of larger balances. In simpler terms, a bank with excess cash, which is often referred to as liquidity, will lend to another bank that needs to quickly raise liquidity. The rate that the borrowing institution pays to the lending institution is determined between the two banks; the weighted average rate for all of these types of negotiations is called the effective federal funds rate.(2) The effective federal funds rate is essentially determined by the market but is influenced by the Federal Reserve through open market operations to reach the federal funds rate target.”

2. Leverage Levels Are not as High as They Used to Be

Higher borrowing costs set a higher bar for returns, but how much one borrows helps determine the height of the bar. Overall, private equity managers are relying less on leverage than in the past. In 2013, debt as a percentage of total capital structures reached about 60%. Today, by comparison, that percentage is closer to 35%.

In higher-rate environments, it is critical that managers have the experience and the tools to manage the cost of capital. Knowing when to dial down borrowing and by how much based on the interest rate environment, refinancing debt when rates are lower, and ensuring that portfolio companies have the right capital structures are essential skills for successful private equity managers. We have found that a scaled presence and strong relationships in the capital markets can also help secure financing on attractive terms, particularly when capital is scarce.

3. Private Equity Managers Can Take Advantage of Inflationary Shocks

When interest rates go up, multiples tend to come down, and good assets tend to become available at a discount. Private equity has historically experienced strong relative performance when public equities falter. Exhibit 2 shows that the worse public markets performed (represented by the S&P total return ranges shown in the x-axis), the greater private equity outperformed (represented by the excess return of private equity versus the S&P 500 shown in the y-axis). The chart also shows our macro team’s view that we have been in a long period of public equity outperformance, but potentially headed toward more modest performance given slower economic growth in many large economies and higher-for-longer interest rates.

EXHIBIT 2: Relative Private Equity Performance in Past Periods of Complexity

Source: Cambridge Associates, Pitchbook, KKR Global Macro & Asset Allocation analysis as of November 30, 2022.
Source: Cambridge Associates, Pitchbook, KKR Global Macro & Asset Allocation analysis as of November 30, 2022.

Consider that the valuations of many public companies have declined under pressure from rising rates, creating attractive entry points to take some of them private. Indeed, valuations on leveraged buyouts, a common private equity transaction, are now below the post-Global Financial Crisis average (Exhibit 3). Likewise, as large companies look to shed non-core business lines to pay down floating-rate debt that has become more expensive, we anticipate more corporate carveouts. We see these as potential opportunities for buyers with scaled capital.

EXHIBIT 3: US Leveraged Buyout Multiples Have Declined

Bar chart showing the average purchase price multiple each year from 2007 through September 2023.
Note: EBITDA is adjusted for cost savings and synergies. Source: American Investment Council as of September 30, 2023.

4. Private Equity Returns Rely on Value Creation

The success of private equity investments hinges on partnering with good companies and creating value by helping them become great, and not on leverage, in our experience. The best and most experienced private equity companies are able to increase value through mergers and acquisitions, making companies more efficient, helping them expand into new lines of business or geographies, or hiring talented teams.

In Conclusion

We plan to explore our approach to value creation more fully in the future. For now, we leave you with the idea that higher-for-longer interest rates are not an insurmountable obstacle for private equity because (1) rates are not abnormally high, (2) managers rely less on leverage than they once did, (3) the dislocation caused by the rapid rise in interest rates could be an opportunity, rather than an obstacle, and (4) strong private equity managers rely on value creation, rather than leverage, to achieve returns.