Private equity yet to adjust to the new reality already digested by public markets

Over the past two decades, a confluence of forces created the impetus for institutional investors to increase their allocations to private markets. For private equity, one driver was low interest rates. In addition to the reach for yield that compelled investors to increase allocations toward riskier asset classes, low rates incentivized the shift toward private equity by reducing the financing cost of the highly leveraged transactions that underpinned these vehicles. Furthermore, a lower discount rate raised the value of future cash flows expected from these long-duration assets, boosting valuations and making the asset class all the more appealing.

This model proved lucrative as long as interest rates remained low and a plodding economy elevated the appeal of investments that offered hard-to-come-by earnings growth. The resetting of interest rates, however, has the potential to upend the private equity returns machine. With the cost of financing having increased, the possibility of a stalling economy calls into question the ability of debt-laden businesses to cover their obligations. Similarly, higher discount rates will likely result in valuations compressing further, following the trajectory of what occurred in public markets in 2022. That possibility is compounded by private equity having become more growth – and technology – focused in recent years.

The evolution of private equity has altered its historical relationship with publicly traded equities. Valuations attached to corporate buyouts used to trade at a discount compared to public companies. But, for well over 10 years, private valuations have commanded a premium. Especially puzzling has been investors’ willingness to forego a liquidity premium despite their funds being locked up for as long as a decade. Our view is that current private equity valuations are not sustainable in a higher interest rate regime, leaving the asset class vulnerable to a meaningful correction.