The federal reserve raised interest rates an additional 0.75% last week, raising the federal reserve rates a total of 2.25% in 2022. The quickly rising interest rates are an effort to slow runaway inflation and housing prices before a recession hits.
However, the record jump in interest rates combined with record inflation is quickly stripping the market of cash for the first time in decades. So what does this mean for private equity investors and the near future of PE returns?
This article will cover why interest rates are likely to shake up investments in private equity and implications for PE investments into 2023.
How Interest Rates Effect Private Equity Investments
The federal reserve increases interest rates to slow spending during times of inflation in an effort to stabilize prices. The bottom line is the population spends more on needs and has less money on investments.
So what does this mean for private equity in particular?
Private equity firms make money by leveraging a significant amount of debt to purchase underperforming companies. They select these companies based on the amount of effort it would take to essentially flip them in a re-sell. PE firms fix management, production, and distribution issues to meet profitability goals, then sell for higher than they bought the company.
Since company valuation and leveraging debt are critical aspects of successful private equity returns, interest rates play a huge role in PE investments. A sudden increase in interest rates will quickly change what makes a PE investment strategy profitable– the question is which investment firms will be able to navigate in real-time.
Forecast for 2023
Until recently, the market has been relatively flooded with interested investors and cash. So it’s been an excellent environment for PE firms to sell their investments. However, it’s been a poor market to buy undervalued companies.
With the increased federal rates, we’ll likely see a reversal of the flow in PE strategy. As investors tighten their belts, there will probably be an increase in undervalued and underperforming companies. This will increase PE investment opportunities.
On the other hand, PE firms planning to sell their acquired companies now will likely suffer a hit to their earnings.
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