Private equity, the darling sector of the financial world, is affected by lots of things. Among the many important factors that influence private equity is one very critical factor – interest rates.
There are two things central banks around the world are doing that paint a rosy next two years for the private equity business – lower interest rates and more money printing. The latter is addressed here.
How Do Interest Rates Affect Private Equity?
Before delving into the interest rate discussion, one needs to understand how interest rates affect private equity.
Interest rates, both long-term and short-term, can affect private equity through the cost of loans. There are two main avenues in which private equity firms invest – venture capital and leverage buyout – and both, particularly the latter, are heavily affected by the cost of borrowing.
When a private equity firm is involved in a leveraged takeover, the private equity firm typically has little financial capital. Instead, they usually rely on debt. Debt requires consistent cash flow to make interest payments, and when interest rates are higher, the likelihood of a takeover being profitable drops. In private equity speak, the internal rate of return that the private equity firm strives for is lowered for every increase in the interest rate.
When Interest Rates Are Declining?
In practice, when interest rates are declining or low, debt is only one avenue through which private equity firms benefit. Another effect comes through fundraising. When interest rates are low, investors look for other ways to make money. One such way is to put money in private equity investments. Thus, low interest rates increase fund-raising activity.
What is Going on Now That’s Positive for Private Equity?
Having established that low interest rates are good for the private equity business, what is going on now that suggests the next two years will be good for private equity?
The answer: More money printing, to lower long-term interest rate costs.
The following figure has the balance sheets of nine central banks around the world.
Notice anything?
Fascinatingly, virtually every central bank around the world is printing money. The one exception to this was the U.S. Federal Reserve, which was shedding its Treasury holding. In recent weeks, though, that has changed.
All of the nine central banks shown – Australia, Bank of England (BOE), Bank of Japan (BOJ), Canada, European Central Bank (ECB), the Federal Reserve, India, the People’s Bank of China (PBOC), and Russia – are all trying to keep short-term and long-term interest rates low to boost economic growth. By acting in such a way, central banks are creating healthy conditions for private equity simultaneously.
Conclusion
Overall, with central banks around the world printing more money, the private equity business should be a heavy winner. Unless a recession materializes, which would be highly, highly unlikely with the incredibly low interest rates pretty much everywhere, conditions for strong private equity performance over the next two years are quite good.
Comments on this entry are closed.