The past surge in interest rates dramatically altered the private equity landscape. For more than a decade, many private equity deals were financed with significantly lower interest rates. When the Fed signaled a "higher for longer" stance, various implications arose for the capital structures of existing portfolio companies, future acquisitions, and distressed acquisition opportunities.
Now, with the Fed's 50 basis point cut and possible further cuts in 2024, the cost of debt capital may still remain at an historically higher level than it has been for more than a decade.
Increased Cost of Debt
Interest rates climbed by 525 basis points from March 2022 to July 2023(1), marking the steepest rise in decades. This increase significantly elevated borrowing costs, impacting leveraged buyouts and refinancing for existing portfolio companies. As financing expenses grew, firms were compelled to seek deals with higher return potentials to justify the elevated costs. This shift, driven by the higher cost of debt capital, pushed GPs to be more selective and strategic in their acquisition targets.
Impact on Portfolio Companies
Portfolio companies were under pressure as interest expenses rose. Distressed debt among PE-owned firms surged, with interest coverage ratios dropping to their lowest levels since 2007. According to Bain, interest coverage ratios have dropped to 2.4 times earnings before interest, taxes, depreciation, and amortization (EBITDA), the lowest level since 2007. This environment has created both challenges and opportunities. Firms with significant debt loads risked higher default risks. Further, higher rates gave sponsors less debt capital to finance acquisitions. As seen in the chart below, debt multiples fell to a 10-year low as rising interest rates made it harder to pile on leverage.(1)
Higher interest rates have led to lower valuations due to increased discount rates. This has resulted in deal multiples compressing, necessitating a focus on operational improvements to achieve desired returns. Underwritten exit multiples forecasted during periods of low interest rates will face significant pressure, given the across-the-board rise in the cost of capital. Even accounting for the cut to rates in so far this year, the next buyer of assets will have to pencil a deal within a capital structure that has a significantly higher cost of debt relative to assets financed over the previous decade.
Years 2010-2023
The fundraising landscape has also been impacted, with PE fundraising dropping by 15% in 2023 to $649 billion as LPs dealt with slower distributions. This decline in fundraising made LPs more selective, often favoring established funds with proven track records. As seen by the chart below, top managers captured a greater share of PE fundraising in 2023.
Opportunities in Distressed Debt
The high interest rate landscape amplified opportunities in distressed debt. PE firms with expertise in distressed assets were able to acquire underperforming companies at attractive valuations, benefiting from economic pressures. This strategy required strong restructuring capabilities and a keen understanding of financial turnarounds, positioning these firms to generate significant returns from distressed investments.
Conclusion
The rise in interest rates undeniably reshaped the private equity sector. Although the Fed has committed to reductions in 2024, dealmakers will have to adjust their strategies to make deals pencil out.
Sources
(1)Bain & Company, "Private Equity Outlook 2024";
