Interest Rate Decrease and the Impacts on Private Markets

At the Jackson Hole Economic Symposium in August 2024, U.S. Federal Reserve Chair Jerome Powell, made a significant statement signaling that the federal funds rate is expected to decrease in the near term.

"The time has come for policy to adjust,” Powell said. The direction of travel is clear.

The fed fund rate reduction impacts various interest rates and will have a significant impact on investors in private assets. Private equity exits have dwindled post Covid. A key contributor to the dearth of exits is the increase in interest rates over the past two years. As interest rates ease, the pent-up demand for exits or liquidity is expected to drive significant deal activity through the end of 2024 and into 2025.

Concurrently we are seeing an increasing number of private debt and equity managers launching “retail” investment vehicles which provide the ability to invest in private assets on a daily/weekly/monthly basis and provide limited opportunity for monthly or quarterly distributions. As more capital is raised by these evergreen vehicles, the demand for private investment products and underlying investments correspondingly increases.

The decrease in interest rates combined with the increasing demand for private investments provides a perfect storm for increased deal activity. Since the financial crisis of 2007/8, the United States Securities and Exchange Commission has sought to provide greater transparency and oversite of private investment vehicles. The Dodd/Frank Act became law in 2009, giving the SEC greater oversite of private fund managers. More recently, the SEC has sought to further regulate private investments.

Some actions of the SEC, such as the issuance of rule 2a-5 in 2020 provided a welcome update to regulations covering the determination of fair value. Other regulatory activity, such as the issuance of the private funds rule in 2023, have subsequently been vacated by a federal court. Yet, given the increasing number of investors in private funds, including investors in funds with greater liquidity, the need for transparency in transaction pricing and rigor in valuation estimates is ever increasing.

As more and more investment capital is directed to private markets- and as new investors are exposed to the nuances of private investments- it is clear that private fund managers must enhance their approach to reporting increasingly complex transactions and complying with an expanded regulatory environment.

Exiting investments directly through an initial public offering, or to a corporate or financial sponsor may prove difficult in the current environment given the macro uncertainty driven by the election cycle, global conflicts, and continued inflationary pressure. Lower interest rates provide the opportunity for private fund managers to offer their investors liquidity through recapitalization transactions. Recapitalization transactions allow underlying investee companies with strong economic performance and cash flows to refinance existing debt and increase their debt load. The proceeds from such recapitalization can then be distributed to investors. To ensure the debt load placed on underlying portfolio companies is not overly burdensome, it is sound practice to obtain a solvency opinion from an experienced independent provider of solvency and transaction opinions.

As the hold period for underlying investments is extended, for those investments where an exit or recapitalization may not be appropriate, a fund manager may transfer aged investments to a new or continuation fund. The SEC’s private funds rule would have required investors to be provided with a fairness opinion for such transactions. Even though the private funds rule has been vacated, many reputable managers are likely to obtain an independent fairness opinion to help ensure that investors are treated fairly, both in the prior fund and in the continuation fund.

Additionally, with the advent of new retail funds, many managers warehouse investments or transfer existing investments from existing portfolios to seed the new evergreen vehicles In order to provide investor transparency, an independent fairness opinion can assure the general partners or investors of the value of the investments. The expansion of retail funds offering private investments with greater liquidity also places significant demands on the rigor applied to valuing private investments on a more frequent and timely basis. For most private funds, the investment manager, or general partner, reports fair value of underlying investments on a quarterly basis in arrears; as much as 90 to 120 days or more in arrears for some quarters. This phenomenon creates a paradigm where many believe that private investments cannot be valued more frequently than quarterly or possibly monthly.

The answer to this problem lies in the accounting guidance provided by FASB in 2009 for valuing fund interests and in the basic provisions of FASB Accounting Standards Codification Topic 820, Fair Value Measurements. The value of a private investment is generally driven by three factors: market conditions, performance/risk and idiosyncratic impacts. Further, fair value is based on information that is known or knowable as of a measurement date. Therefore, a rigorous approach to valuing private investments includes a new paradigm where fair value on a daily or monthly basis is determined by taking into account the following: the last reported fair value, adjusted by a market adjustment factor, adjusted for cash flows if any, incorporating updated performance metrics and manager assessments of value and idiosyncratic or judgmental factors, to arrive at the current dates fair value. This valuation paradigm requires the application of informed judgment and a consistent process to estimate fair value on a frequent and timely basis.

Interest rate movements, global geopolitical conditions, inflationary pressure, global election cycles, SEC regulation, investor demand for new products with the ability to enter and exit more frequently, investor pressure to provide liquidity, are all converging to give rise to transparent transactions and the need for robust valuations. Independent opinion and valuation support, helps provide investors with the transparency needed as deal and investment activity accelerates through the end of 2024 and into 2025.