We all know that private equity plays a central role in the corporate landscape. It fuels innovation, drives economic growth, and let’s face it, is addictive. The potential for high returns makes it the perfect compelling investment strategy, but also one of the riskiest.
The industry has seen several years’ worth of a boom, riding off of cheap money (referring to low interest rates) as well as “undermanaged divisions of large companies or private companies'' according to Marc Nachmann (head of Goldman Sach’s investment business). In other words, low interest rates (cheap money), reduces the cost of borrowed capital, which in the private equity world, is called leverage, making it easier to acquire funding for equity investments. Opportunities to invest were constantly turning up, especially poor performing branches of companies that quickly became the perfect target for acquiring new clientele in desperate need of financial assistance.
As of recently, numerous stakeholders, including young bachelor students looking for internships, have expanding doubts surrounding what once was private equity’s exceptional high. The industry has been slowly building up to a plummet, scaring off potential angels and investors. But what was the starting point of the caution that most investors now face?
Interest rates! The rates have substantially increased in just a few years, which is comparatively ‘normal’ after the pandemic that the world went through, and whilst they will eventually decrease, their temporary high is posing significant implications on private equity.
Circling back to leverage, higher interest rates raise the cost of the debt utilised when acquiring companies, which is the business model of leverage buyout investing (LBO). Naturally, investors have begun using less debt, leading to declining performance of LBO’s (since debt financing contributes an average of 30% to the growth of LBO’s). Simply, we see immediately that higher interest rates have reduced the efficient performance of leverage buyouts, which are strategies implemented by private equity firms to reduce the time frame within which they receive their returns. By connecting the dots, we can notice that the higher interest rates have led to feeble LBO’s, reducing their effectiveness at encouraging investment return growth for private equity firms, inevitably creating a drop in private equity success.
Now obviously not every firm will feel this fate in their balance sheets, some firms suffer less (smaller LBO’s) as they use limited amounts of debt and thus feel fewer repercussions of the higher cost. Makes sense right?
Shying away from the immediate short term, we can explore the effects of higher interest rates on private equity in the medium to long term. A rather ambiguous effect would be the increase in potential investment opportunities that may stem from higher interest rates. As corporations face constraints in their funding abilities, they are like to reduce debt through divestments; by unloading non-core assets, as well as forging corporate carve outs (the process of a business splitting from its parent company and enabling the management team to work in a new direction), private equity firms can salvage additional LBO deals and investments, to maintain their heads above water whilst riding out the instability wave of high interest rates.
Diversification of investments has always been a leap for private equity firms, if successful, these diversifications provide security for firms by maintaining a relatively stable stream of returns for angsty shareholders. However, portfolio diversifications tend to be on the riskier side of the spectrum, often failing due to cultural differences, poor management and lack of coordination amongst senior executives.
A recent example we have seen, rather publicly, is the acquisition of Global Infrastructure Partners (GIP) by the one and only BlackRock (a rather notorious bigshot player in private equity).
Larry Fink, CEO of BlackRock, and Adebayo Ogunlesi, Chairman of GIP, met several years ago as colleagues when they both worked at First Boston in the 1980s, and quickly shared a dream; infrastructure investments would become the fastest growing part of private equity, and that the private market was finally initiating a phase of consolidation (when an LBO acquires a series of companies in the same field to become a dominant player in that industry). And they were partially right…
Recorded growing demand for infrastructure, particularly from sovereign wealth funds, have made consolidation an expensive but beloved branch of private equity, and so its no surprise that larger independent firms are looking for partners to grow with, taking inspiration from the aforementioned merger especially. There have been previous private equity groups such as CVC Capital Partners and General Atlantic, who have outlined plans to go ‘public’. Such M&A’s are a sign that there is a potential wave of consolidation turning from just around the corner that may make or break the market. Smaller firms will have no chance at survival if large, dominating firms continue to partner up with their competitors, and drive out smaller players completely.
So what can we learn from consolidation?
Through combining with larger organisations, private equity firms are able to expand in debt (leveraging) or infrastructure investment. Infrastructure investment especially holds a growing demand and even benefits from higher interest rates, providing a temporary solution to the interest rate problem outlined above, at least until the rates die down again. Consolidation in general is a great way at avoiding corporate carve outs, which from the first sections of the article, we know are growing in cost.
Whilst the future of private equity remains unclear (a destiny that is more than common in the financial world), we know that whatever strain or peak the industry faces is more than likely to be temporary, and so all we can do is keep up with headlines, write a brief article about the industry and hope for a summer internship!