In 2022 and 2023, following a long period of low interest rates, the U.S. Federal Reserve (Fed) fought the post-pandemic inflation shock with one of the most rapid rate-hiking cycles in history.
As that inflation normalizes and the Fed starts to cut rates, we explore, in two articles, the relationship between interest rates and private equity performance. Our second article will consider what has happened empirically, over the past 40 years, to private equity returns, distributions and manager performance dispersion as rates have fluctuated. In this first article we address the theory: How would we expect changes in interest rates to affect private equity?
We believe that, overall, private equity investments should be expected to perform better in a low-rate environment, but that, contrary to common assumptions, the valuations of lower-growth companies appear to be more sensitive to changes in rates than those of higher-growth companies.
Executive Summary
- This paper investigates the impact of interest rate changes on the enterprise and equity values of privately owned companies. Utilizing a discounted cash flow (DCF) model, the analysis focuses on two companies that are identical except for differing assumed EBITDA growth rates of 8% and 16%.
- Our findings indicate that, all else being equal, a reduction in base rates enhances the enterprise value for companies with either growth rate. Notably, companies with lower growth rates tend to exhibit greater sensitivity to interest rate changes, resulting in a more pronounced increase in enterprise value as rates decrease. However, this conclusion is dependent on the leverage ratio assumed.
- The equity value of lower-growth companies demonstrates longer duration compared to higher-growth companies across nearly all base rate levels. Unlike with enterprise value, this holds true even when leverage ratios are significantly reduced.
“Duration” and “Convexity” of Enterprise Values at 5x Leverage
Change in enterprise value given a one percentage point change in SOFR and a 5X debt-to-EBITDA ratio
Source: Neuberger Berman. For illustrative purposes only.
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