Until recently, private equity (PE) investors have thrived in an era of historically low interest rates. However, the landscape has shifted dramatically with significant interest rate hikes throughout 2022 and 2023. This new environment presents major challenges and opportunities for value creation in PE investments.
The impact of rising interest rates is threefold. Firstly, reduced debt capacity limits the potential for leveraged returns. Secondly, a larger portion of debt payments now goes towards interest expenses rather than debt reduction. Lastly, the higher cost of debt increases the required rate of return on investments, leading to a decrease in valuation multiples and portfolio company values, assuming no changes in growth or risk profiles.
Navigating from a low-interest to a high-interest environment can have the most substantial negative impact on value creation. Our created value attribution (CVA) studies reveal that capital markets (beta) face the greatest negative impacts in such scenarios. However, there is a silver lining: lower valuation multiples can also reduce entry costs for new investments in this high-interest-rate climate.
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