Rate Cuts Will Provide a Tailwind to Private Equity ActivityRate Cuts Will Provide a Tailwind to Private Equity Activity
The changing rate environment should create a more attractive exit environment for existing private equity investments, as well as fuel new acquisitions.
The Fed’s move to lower interest rates should be good news for advisors with private equity allocations, especially with the promise of more cuts to come. The private equity industry has been struggling with stagnant deal volumes over the past few years, as higher rates have made it more difficult to secure attractive financing for new acquisitions and find exits for existing assets that would deliver expected returns. Industry experts said that this month’s 50-basis-point cut should help restart that activity.
A 2023 survey by alternative investment platform CAIS and consulting firm Mercer found that 33% of financial advisors allocate between 6% and 20% of their clients’ portfolios to private equity, making it one of the most popular alternative assets for the industry. The majority (65%) allocated investments to private equity to enhance returns: no other asset class came even close to matching private equity in that function, according to the survey results. Another 31% of respondents said private equity helped them diversify risk. When the survey took place in September and October of 2023, 68% of the advisors CAIS and Mercer surveyed planned to increase allocations to private equity and/or private debt.
However, the state of the private equity sector year-to-date in 2024 has been less than ideal. According to data from S&P Global Market Intelligence and London-based research firm Preqin, in the first half of 2024, only 704 private equity funds closed globally, compared to 2,590 funds that closed during the full year 2023. Private equity fundraising also looked on track to be 20% down for the full year, reaching only $365.75 billion between January and June 2024.
Deal valuations also took a hit. Private markets research firm PitchBook estimates that valuations on middle-market private equity deals in the U.S. fell from a high of 12.3x in 2021 to 10.8x in 2023.
Higher interest rates made it challenging for private equity managers to finance deals in a way that would allow them to meet their return targets, wrote Dan Fletcher, portfolio manager within the private markets platform at investment solutions firm Russell Investments, in an email. This was particularly true for larger private equity shops that rely on high leverage to drive returns.
As a result, “We expect rate cuts will provide a boost to overall private investment activity,” Fletcher wrote.
“As the industry continues to build up a backlog of investments in funds that are nearing the end of their terms, we expect that lower financing costs will encourage more buyers to enter the market and spur an uptick in deal activity in the coming quarters,” he added.
Even before last week’s interest rate cut, sentiment at large private equity shops suggested there would be a pick-up in mergers & acquisitions and IPO activity this year as interest rates stabilized, S&P researchers found. The promise of further interest rate cuts only bolsters this outlook.
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Coupled with greater availability of credit and more positive investor sentiment, interest rate cuts should allow private equity deals that were previously too expensive to execute to become viable again, according to Christopher Zook, founder and CIO of global alternative investment manager CAZ Investments. This should help push transaction volumes higher.
“Interest rate cuts should absolutely benefit private equity investments,” Zook wrote in an emailed response. “As a result of the cuts, we would expect transaction volume to increase—not only because the bid-ask spread between buyers and sellers is likely to narrow, but also due to the greater availability of credit.”
However, Larry Swedroe, former head of financial and economic research at wealth management firm Buckingham Wealth Partners, cautions that the reasons the Fed is cutting rates also need to be closely examined to understand the potential impact on the private equity sector. If the impetus is primarily that the Fed feels it has inflation under control, that would be a net positive for private equity. But the Fed may also have concerns about the broader economy, and if it fails to achieve a soft landing, that would negate any benefits from lower interest rates. In addition, since interest rate cuts have been expected for some time, the market has likely already priced in those.
The bottom line is that “Financial advisors should not try to time markets, period,” said Swedroe, the author of 18 books on investing. “You should have an allocation to private equity if you want an allocation to private equity for whatever reason. It should be a long-term allocation, and you shouldn’t be trying to go in or out because the odds are that you’d get it wrong.”
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