Both the ‘person on the street’ and financial markets are having to deal with a step change in risk free interest rates. For everyone the cost of borrowing has increased significantly over the last couple of years. The longer term consequences of this higher interest rate environment on private market investing is something that we plan to return to in due course.
In the meantime the transition to this higher equilibrium has introduced some challenges to private markets assets. Any short term downward move should be helpful. While interest rate cuts in the world’s major markets remain elusive, the downward shift that private market sponsors and investors are hoping for may be edging nearer.
Bank of England Governor Andrew Bailey struck a dovish tone after the Monetary Policy Committee kept rates at 5.25% in its most recent meeting, saying it was “likely that we will need to cut bank rates over the coming quarters” and by more than financial markets are currently predicting. The news helped push the UK equities (FTSE-All-Share) to a new high. The rate easing could start at the next MPC meeting in June, although continued strong wage growth may delay the easing.
The European Central Bank may also begin trimming rates as early as June in light of weak Eurozone GDP growth, noted Edmond de Rothschild group chief economist Mathilde Lemoine, with investors largely pricing in two possible further cuts this year.
How rate cuts could affect private markets
Having seen a sharp slowdown in fundraising and investment activity, a reduction in interest rates could help private equity and venture capital markets in a number of ways.
Cost of capital
By reducing the cost of debt financing firms use to acquire companies or fund expansions , lower borrowing costs should help invigorate investment activity. Cheaper financing may also encourage entrepreneurs to start new ventures, spurring increased VC and PE deal flow.
Valuations
Decreasing the rate used to calculate discounted cash flow models translates into higher present values for companies’ future cash flows and higher valuations. Lower interest rates may also promote economic activity and consumer spending, helping improve portfolio companies’ corporate earnings and enterprise value. As valuations strengthen and economic confidence returns, fund managers will be keen to put their dry powder to work.
Exit environment
Part of the reason for the slowdown in private market activity has been the uncertainty around company valuations, with buyers not wanting to overpay and sellers unwilling to crystallise markdowns on investments. Strengthening valuations will boost PE/VC firms’ return metrics, and incentivise them to explore fresh exits through initial public offerings or sales to strategic buyers. With public markets trading at record highs could start to pick back up. Momentum is building for PE backed IPO exits in 2024
Fundraising
Anything that adds to the liquidity to existing funds should help free up capital. This in turn can be re-deployed into new investment ideas. Existing funds being able to realise gains and return capital to LPs can help in recycling this capital into new fund raises.
Animal spirits return
Even without movement on the first interest rate cuts, optimism and activity in private markets is returning.
The US Federal Reserve had been expected to lead the rate-cutting agenda coming in to 2024. Faced with persistent inflation and strong economic growth, higher for longer is now the message, with markets hoping for one, or at best two cuts this year. Regardless, US private equity activity has accelerated, climbing 54% year-on-year through April, with nearly $132 billion of deal value, according to LSEG. Record amounts of dry powder are fuelling the deal flow.
And those investor allocations only look set to increase. State Street’s latest private markets survey shows macro challenges are not dampening demand, and that “the rotation from public to private assets within portfolio allocations will grow further in the coming years,” including among retail and DC investors.
Risks loom in the new world order, but so do opportunities
Yet the outlook is not all rosy. Inflation has receded but not been fully tamed. Interest rates have yet to fall – and could even go higher in the US – with a wall of refinancing looming. Global geopolitical tensions and deglobalisation are spreading. Economic growth in many markets remains fragile. And a rate cut in the EU before the US would reinforce the impression that the ECB expects further poor economic performance, denting sentiment and household and corporate investment, warned Lemoine.
Not all private fund managers will thrive in this more complex business environment, making proper investment due diligence ever more important.
Still, as Franklin Templeton Institutional’s senior vice president of private investments John Ivanac noted in a recent op-ed piece, “although the investment environment appears inhospitable, and many investors are rethinking their 2024 allocations, this may be a period when taking additional risk is warranted. A PitchBook analysis of fund returns across private market strategies by vintage year from 2006-2018 shows that some of the highest returns were achieved in the period of 2008-2010 following the global financial crisis, possibly the most difficult macroeconomic environment in a generation.”
In other words, you won’t want to miss the boat.
This content is for information purposes only. Treble Peak does not provide investment or tax advice, and information on this website should not be construed as such. Potential investors should seek specialist independent tax and financial advice before investing in any alternative investment. Past performance is not a reliable guide to future returns. Your capital is at risk.
