Private Markets in a Higher Rate Environment

Executive Summary

Private markets, encompassing private equity, private credit, venture capital and unlisted real assets, expanded considerably during the extended period of historically low interest rates that characterised much of the decade preceding recent years. As interest rate environments have shifted, the operating conditions for private market participants, and the considerations relevant to investors allocating capital to these strategies, have evolved as well. This article provides a general, educational overview of how a higher rate environment tends to affect private market dynamics, without forecasting the specific future path of interest rates.

The Link Between Interest Rates and Private Market Valuations

Private market valuations, much like public market valuations, are influenced by the discount rate applied to expected future cash flows. In a lower interest rate environment, lower discount rates generally support higher valuations for a given set of expected cash flows, all else being equal. Additionally, lower borrowing costs during such periods have historically made debt-funded transactions, such as leveraged buyouts, more attractive, as a larger proportion of a transaction's total funding could be financed at comparatively lower cost, potentially enhancing returns to equity investors, assuming the underlying business performed as expected.

As interest rate environments shift higher, both of these dynamics generally operate in reverse: higher discount rates can weigh on valuations for a given set of expected cash flows, and higher borrowing costs generally increase the cost of debt-funded transactions, which can reduce the potential contribution of leverage to overall equity returns and increase the debt servicing burden on portfolio companies.

Financing Structures and Deal Activity

The availability and cost of debt financing plays a particularly significant role in private equity transaction structures, given the historical reliance of many buyout strategies on meaningful leverage. In a higher rate environment, lenders may also apply greater scrutiny to the cash flow stability and overall financial resilience of borrowers, which can affect both the amount of leverage available and the terms attached to it. These dynamics have historically contributed to reduced transaction volumes and, in some cases, a wider gap between buyer and seller price expectations during periods of higher rates, as sellers anchored to valuations achieved during lower rate periods, and buyers adjusted their return expectations to reflect a higher cost of capital.

A higher cost of capital tends to shift the emphasis in private markets from financial engineering toward genuine operational value creation.

Private Credit in a Higher Rate Environment

Private credit strategies, which typically involve direct lending to companies outside traditional bank or public bond markets, can behave somewhat differently from private equity strategies in a higher rate environment. Many private credit instruments carry floating rate structures, meaning the income generated for investors can rise as benchmark rates rise, potentially enhancing the income component of returns from these strategies during a period of higher rates, though this must be weighed against the potential for increased credit stress among borrowers facing higher debt servicing costs of their own.

Considerations for Real Assets

Unlisted real assets, including infrastructure and real estate, are similarly sensitive to the prevailing interest rate environment, given their typically long-duration cash flow profiles and frequent reliance on debt financing. Higher rate environments can weigh on valuations for these assets in a manner conceptually similar to their effect on other long-duration assets, though the specific effect varies depending on factors including lease structures, the extent to which cash flows are contractually linked to inflation, and the amount and structure of debt used to finance the asset.

Illustrative Example

As a purely hypothetical, illustrative example: consider a private equity transaction historically funded with a meaningful proportion of debt financing at a relatively low interest rate. If that same transaction were structured in a higher interest rate environment, the higher cost of debt would generally increase the ongoing interest expense borne by the acquired business, all else being equal, which could reduce the residual cash flow available to equity holders and place greater importance on the underlying business achieving genuine operational improvements to sustain attractive equity returns. This example is illustrative only and does not reflect any actual transaction or forecast outcome.

Key Considerations for Investors

• Understand how a given private market strategy's return drivers, whether leverage-dependent or operationally-driven, may be affected by the prevailing interest rate environment.
• Distinguish between the effects of a higher rate environment on private equity, private credit and real asset strategies, given their differing structures.
• Pay close attention to fund manager track records across different rate environments, rather than relying solely on performance achieved during a period of historically low rates.
• Recognise that private market investments generally carry reduced liquidity and longer investment horizons, which warrants careful consideration alongside interest rate sensitivity.
• Maintain realistic expectations about the role leverage can play in driving returns across differing interest rate environments.

Conclusion

A higher interest rate environment generally alters the operating conditions for private market strategies in identifiable ways, from valuation discipline to financing structures and the relative attractiveness of income-generating private credit exposures. Investors considering an allocation to private markets should factor these dynamics into their assessment, alongside the broader illiquidity and due diligence considerations inherent to this asset class. This article is general information only and does not constitute personal financial advice; investors should consider their own circumstances and consult a qualified adviser before making investment decisions.

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Information contained within these insights is provided for general information purposes only and does not constitute personal financial advice, an offer or recommendation to acquire or dispose of any financial product. Investors should consider their individual circumstances and obtain appropriate professional advice before making investment decisions.