Private equity returns persist in higher rate environments
Leveraged buyout (LBO), or purchasing a company using mostly debt to improve it and sell it for a profit later, is a term and strategy most investors view as synonymous with private equity. If the sole tool for fund managers is balance sheet re-engineering, then a simple rise in rates would negatively impact performance as the cost of debt increases. However, this is not what the research on long term performance data shows.
- Returns for private equity have a low correlation to 10-year treasury yields over time, as economic changes, market factors, industry trends and manager adaptability are also important variables.
There are two sides to the story for managers using LBOs as a key component of their strategy in a high interest rate environment. While their lines of credit may be more expensive, their acquisition targets are often purchased at more attractive valuations from corporate sellers. Along with this favorable entry pricing dynamic, managers tend to pivot away from financial engineering during times of higher interest rates, and lean into more heavily equity-weighted deals which require other value creation methods to drive returns, including:
- Business transformation - purchasing a company with high growth potential or areas where a strategic partner (the fund manager) can add value, whether that be through operational improvements, personnel optimization, brand management and marketing, or separating business segments.
- Business expansion - otherwise known as “buy and build” involves purchasing a category leading company with the intent to acquire a number of smaller players in their industry (often in a specific region), ultimately maximizing market share, synergies, scale, margins, and earnings of the parent company.
A temporary shift in borrowing costs isn’t enough to sway the entire private equity industry away from leverage. Managers have been diversifying their toolkit since the 1980s to mitigate the effects of rate changes. According to Hamilton Lane, excess leverage was estimated to contribute 46% of average investment value creation for GPs prior to 2000 but has fallen to 22% in the last decade as revenue and margin growth have become more prevalent areas of focus.
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