The twenty-first century has experienced a range of different interest rate regimes - from the aperiodic near-zero interest rate environment of most of the 2010s to the fluctuations seen in the early 2000s, and now again (more sharply) in the 2020s. March of 2022 to July of 2023 saw the federal funds rate increase by 525 bp, faster than the rate increases seen in the early 2000s, and accounting for some of the sharpest increases in recent decades.
In 2024, however, the Federal Reserve announced a rate cut of 50 bp, while suggesting more cuts may be in store in Q4 2024 and 2025. While the medium to long-term effects on private market investors are still undetermined, the interest rate cuts, like the raises that preceded them, are sure to impact fundraising, deal throughput, debt servicing, and various other elements in the private markets for the rest of 2024 and 2025.
The article below will utilize historical data pulled from the CEPRES platform to analyze the impact of the federal funds rate on two items: first, EBITDA growth in the Industrial sector, and then, the impact on the default rate in buyout deals. From this, private market investors may be able to better understand and predict the future impact of changes in the interest rate environment on the various deal dynamics mentioned above.
How the Federal Funds Rate Affects Industrial Deal Growth
The chart above, derived from CEPRES data, showcases the changing federal funds rate, over the period observed, alongside the median EBITDA CAGR (Compound Annual Growth Rate) for deals in the Industrial sector based on the year of investment.
The relationship between interest rates and EBITDA growth in the industrial sector presents a nuanced picture that isn’t easy to categorize. While one might expect an inverse correlation between federal funds rate and EBITDA growth of companies, the data from 2000 to 2023 reveals a slightly different picture. The early 2000s exhibited this inverse relationship, with EBITDA growth for PE-backed industrial companies rising steadily as rates fell. However, the mid-2000s challenge this notion, showing both rates and EBITDA growth increasing in tandem, with EBITDA CAGR peaking at an impressive 33.18% for deals in 2006 amid higher interest rates. The financial crisis and its aftermath further complicate the picture, introducing volatility that obscures clear takeaways.
Following the aftermath of the GFC, there is a clear and benign environment for PE-back industrial companies, with solid EBITDA growth for deals between 2009 and 2016, correlating to the lowest interest rates in recent history. Then following the uplift in the federal funds rate from 2017, again we see a reduction in EBITDA growth.
More recently, with COVID in 2020 and the drop in the federal funds rate, these two events seemed to create perfect conditions for PE-back industrial deals with EBITDA CAGR soaring to a high of 36.24% for industrial deals in 2020. We then see a softening for EBITDA growth for 2021 deals and into negative territory as interest rate rise in 2022. Given the short time horizon for deals after 2022, these have not been included because is too early to tell how such recent deals will fare once interest rates again fall. One conclusion from the broader dataset could be that, as long as there is clear communication from the Federal Reserve as it pertains to future interest rates, PE-backed Industrial businesses are able to adapt, even in higher rate environments, and continue to grow their bottom line in an impressive manner.
Impact of the Federal Funds Rate on Buyout Default Rates
The chart above showing the default rate for North American buyout deals invested in a given year alongside the federal funds rate, yields key insights about how changes in the Federal funds rate affect private equity deals.
The data shows a clear correlation that higher interest rates are correlated to higher deal default rates, which makes sense given that private equity deals always involve a level of debt. Starting with the year 2000, one can see that the default rate reached a high of 40.46%, coinciding with a peak in interest rates of 7.03%. From 2000-2004, as interest rates dropped from 7.03% to 2.34%, the default rate also fell from 40.46% down to 20.45%. Then, from 2005, as rates started to rise again, one sees once again an increase in the default rate.
The near-zero interest rate environment from 2009 to 2015 corresponded with historically low default rates in the buyout space. By contrast, 2022 saw buyout default rates surge to their highest levels since 2000, likely driven by a sharp increase in interest rates.
Given default rate is calculated based on the lifetime of the holding, for 2023 it is too early to tell how many of these deals may subsequently default and lose money, so the lower value than 2022 is not yet a significant metric to rely on.
As the prospect of future interest rate cuts looms, it remains to be seen whether default rates will follow historical patterns and return to the lows seen during the 2009-2015 period, as historically, lower rates have been associated with reduced defaults. Alternatively, shifting market dynamics may lead to different outcomes. The response is likely to vary across sectors, each with differing levels of sensitivity to economic cycles and interest rate fluctuations. This sector-specific variation will be critical in determining whether the anticipated rate cuts will trigger a return to the historically low default rates or introduce new patterns in market behavior.
Impact in 2025 and Beyond
After examining the influence of the federal funds rate on EBITDA growth in the industrial sector and default rates in buyout deals, investors can approach 2025 and beyond with key insights that could enhance overall returns.
Interest rate fluctuations and their impact on sector growth rates, while significant, do not present a straightforward cause-and-effect relationship. The assumption of an inverse correlation between interest rates and EBITDA growth across sectors is not consistently supported by historical data. In the industrial sector, periods of high interest rates have coincided with strong growth, while lower rates have sometimes paralleled weaker performance. This suggests that growth is driven by a complex array of factors beyond just monetary policy, reinforcing the need for investors to consider a broader economic context when assessing sector performance.
In contrast, the relationship between interest rates and default rates in buyout deals exhibits a much clearer correlation. While higher interest rates tend to increase default risk and generally lead to more cautious deal activity, as higher capital costs prompt investors to adopt risk-averse strategies. This shift may result in more stringent due diligence, slower deal execution, and downward pressure on valuations, as heightened default risks are priced into transactions. Buyout fund structures may also adapt, placing greater emphasis on downside protection mechanisms or incorporating distressed debt strategies to mitigate risk.
Conversely, with interest rates now trending downward, the deployment of previously sidelined capital could lead to a resurgence in deal activity, IPOs, and rising valuations. Investors may anticipate a more favorable environment for buyouts as the cost of capital decreases, fueling growth across the sector.
Ultimately, while interest rates remain a key factor in fund performance, the most successful investors will likely employ diversified strategies. By leveraging comprehensive datasets across sectors, time periods, and economic variables, they can build resilient portfolios that perform across a range of macroeconomic conditions.
