What Might Rising Interest Rates Do to Private Equity?

This straight-forward question matters because interest rates appear to be on their way up, coinciding with moderately decent private equity conditions.  Here’s what the raw empirical evidence would look like.  The figure below contains a measure of private equity conditions and the yield of the 10-year note on a monthly average basis.

As is shown, although interest rates appear to be on a long-run downward trajectory, interest rates during the most recent economic cycle are up since bottoming out in April 2013, with the 10-year T-note up almost 50 percent from about 1.8 percent to 2.6 percent.  It may be difficult to see, but the relationship between the two is, not surprisingly, negative.  The negative relationship means that as interest rates rise, private equity conditions generally deteriorate.

Here’s another look at the same issue, with private equity deal flow replacing overall private equity conditions.

Although volatile (even on a quarterly basis), the above more clearly shows the negative relationship between private equity deal flow and the ten-year note.  For instance, private equity deal flow was generally low during 2009 when the ten-year note was relatively high compared to the year before and the year after.

The figure also shows some lagged effects of rising and dropping interest rates.  For instance, the ten-year note dropped from an average of about 3.5 percent in the second quarter of 2010 to about 2.8 percent in the third quarter, a drop of about 20 percent.  Private equity deal flow didn’t respond immediately to the change, with deal flow actually declining over the same time frame from about $84 billion for the second quarter to about $70 billion for the third quarter.  The lagged effect showed up, though, with fourth quarter private equity deal flow shooting up to $127 billion.  These anecdotal stories are confirmed by econometric evidence.

With the well-known relationship between interest rates and private equity conditions stated, the question here is: how large of an effect might the rising interest rates have on private equity deal flow and overall private equity conditions?

Well, in doing some econometrics, the number comes out to about $4 billion per 10 basis point increase in the 10-year note. The $4 billion has a large margin of error in the short-run of around plus or minus 50 percent given the lagged nature of the effect interest rates have on private equity deal flow, although the effect continues to be negative.  Essentially, should the 10-year note go from the current 2.83 percent to 3.83 percent, one would expect private equity deal flow to decline by about $40 billion per quarter, all other things equal.  (As a caveat, the “all other things equal” is important here because economic growth could come in better than expected, which would put upward pressure on private equity deal flow even though interest rates would be putting downward pressure.)

Overall, with interest rates likely to rise in the near and long-term, private equity deal flow and overall conditions will experience downward pressure from such developments.  The size of the effect in the current economic environment and 10-year trading range results in a $4 billion reduction in private equity deal flow per 10 basis point increase in the 10 year- note yield.