Private equity as an asset class and a fund structure has come under intense scrutiny since interest rates began to rise, but what is the real impact, away from the sentimental factors?
Market participants worry about the impact of higher interest rates and question the integrity of valuations, just as the PE industry grapples with slow fundraising and slower deal-making.
Here we seek to address some of the most pressing concerns for investors, including shareholders in listed PE trusts.
High interest rates will hurt returns
High interest rates can make it harder for all businesses to generate returns, whether they are owned by private equity or not, though perhaps not for banks and other lenders.
Higher rates translate into higher borrowing costs, reducing the amount of money available for investment.
Expensive debt can also make it harder for private equity investors to do deals in the first place, forcing them to put more equity in, but that is not necessarily a bad thing.
Higher borrowing costs also force PE firms to focus more on good old-fashioned ‘alpha’, or exceeding their cost of capital, largely through value creation.
The era of cheap money may have led to some misallocation of capital into businesses of limited growth potential. Higher rates increase the focus on companies that are doing the right things, rolling up their sleeves to create value by launching new products, expanding into new markets and digitising their businesses.
Key questions to consider are whether the underlying portfolio has sustained robust earnings growth over the past five years, and also what the average net debt-to-EBITDA ratio is, a key leverage metric.
You cannot trust the valuations
Listed PE trusts currently trade on a hefty average 32 per cent discount to their net asset value. This could be because investors do not trust their valuations, and wonder how PE-owned businesses could be immune to the same macro fears that triggered steep stock market corrections in 2020 and 2022.
The NAVs of PE investment trusts are comprised of the valuations of unquoted companies; many investors may be sceptical about the pace and extent of any downward revisions to the valuations of those companies in order to reflect the changed economic climate.
In addition to looking at the earnings growth during this period, investors should look to a trust’s valuation process for reassurance – how often is the portfolio is revalued?
The gold standard should be a review of the entire portfolio every quarter, a year-end external audit, and adherence to the International Private Equity and Venture Capital Valuation Guidelines (IPEV), which set out best practise for the valuation of private capital investments.
Also consider whether investments are sold for more than their carrying value, this should provide further reassurance about the integrity of valuations. Data shows the average exit premium across PE trusts is more than 30 per cent over the past five years.
