Private Equity and Rates, Part II: Do Rates Really Matter for Private Equity?

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 begins to normalize and the Fed starts to cut rates, we explore, in two articles, the relationship between interest rates and private equity performance. Our first article addressed the theory: How would we expect changes in interest rates to affect private equity? In this second article we consider what has happened empirically, over the past 40 years, to private equity returns, distributions and manager performance dispersion as rates have fluctuated.

We find a complex relationship between rates and private equity returns and distributions, characterized by a notable change in dynamics around the Global Financial Crisis (GFC) of 2008 – 09. We conclude that, while rates clearly influence valuations and the cost of debt for private equity deals, private equity performance and distributions are primarily determined by the strength of the underlying economy. We do find a meaningful relationship between rates, loan spreads and manager dispersion, however, which suggests that top-performing funds may be able to capitalize even more on favorable economic conditions than lower-quartile funds.

Executive Summary

• Returns and Distributions
  - In data going back as far as 1985, we find surprisingly small, statistically insignificant correlations between private equity returns and different interest rate-related indicators.
  - Splitting the dataset into periods before and after the Global Financial Crisis (GFC) reveals patterns: Prior to the GFC, the yield-curve spread is negatively correlated with returns, reflecting this indicator’s role as a bellwether of the economy; after the GFC, it is the 10-year Treasury yield that is negatively correlated with returns—but this correlation is heavily influenced by the COVID-19 pandemic and subsequent inflation shock, and excluding this period results in insignificant correlations, similar to the pre-GFC patterns.
  - We observe the same pre- and post-GFC pattern in correlations between private equity distributions and the yield-curve spread; in addition, we see a strong negative correlation between distributions and both long- and short-dated interest rates after the GFC, which, unlike with returns, persists for long-dated rates irrespective of the COVID period.
  - Overall, the results suggest to us that private equity returns and distributions are primarily driven by the state of the economy rather than by the level of rates, yields or loan spreads in themselves.

• Performance Dispersion
  - The correlation between interest rates and the dispersion of performance among leading and lagging private equity funds is more consistent across both periods.
  - Favorable conditions—lower rates and tighter credit spreads—have tended to allow top-quartile funds to excel, whereas difficult conditions generally result in tighter dispersion among all funds.

• Outlook
  - Our analysis suggests that private equity returns depend a lot more on the general economic backdrop than on interest rates alone.
  - Our results therefore suggest that a continued soft landing for the U.S. economy would bode well for U.S. private equity’s near- to mid-term future. In particular, recent history indicates that lower rates go hand-in-hand with higher private equity distributions.
  - Finally, our analysis also suggests that top-performing private equity funds may be better able to capitalize on favorable economic conditions, lower rates and tighter loan spreads than lower-quartile funds.

Favorable Conditions Lift All Boats, but the Better Boats Are Lifted Higher

Illustrative representation of movements in the middle quartiles of U.S. private equity manager performance, based on annual returns, given declines in the calendar-year averages of three different rates indicators, 1985 – 2023

Source: Bloomberg, Burgiss, Federal Reserve Bank of St. Louis, Neuberger Berman. Data as of September 30, 2024. Maximum, 75 percentile, median, 25 percentile, and minimum are all for illustrative purposes and are not scaled to actual performance.