Since the beginning of 2022, interest rates have increased significantly. While public equities have adapted to this new reality, private equity valuations have remained largely unchanged. The question is whether this is realistic.
The higher interest rates have led to double-digit losses in pension funds’ investment portfolios in 2022. This is because higher interest rates result in future cash flows being discounted at a higher rate, making a company less valuable.
Growth firms, which have become increasingly popular with private equity firms in recent years, have been particularly affected. For instance, Amazon’s share price has dropped by approximately 40% since the start of 2022.
There is a dichotomy in private equity funds in which pension funds invest. These funds have the flexibility to determine the valuations of their investee firms, and they do not necessarily have to base them on public market equivalents or changes in interest rates.
Since the start of 2022, interest rates have risen considerably. Public equity valuations have adjusted to this new reality, but private equity valuations have remained relatively high. This discrepancy is a point of contention between buyers and sellers. One reason for this is that most of the deals that have been concluded this year have involved high-quality companies that are relatively unaffected by inflation and the current market dynamics.
According to Ken Kencel, CEO of Churchill Asset Management, a financier to private equity-owned firms, valuations in private markets have remained higher than expected. In addition, private equity investors often contend that they do not need to adjust valuations as much because they invest in more resilient, defensive industrial sectors that benefit from long-term secular tailwinds.
While privately-owned companies tend to adjust their valuations only when they need to raise more cash, lower valuations and capital losses are not one and the same. Growing profitability can to some extent compensate for lower market valuations, according to Vahit Alili of Schroders Capital.
The rise in interest rates since the beginning of 2022 has led to significant losses for pension funds in their investment portfolios, due to future cash flows being discounted at a higher rate, reducing the value of companies. While listed equities have adjusted to this new reality, private equity valuations have remained high and have not mirrored valuations in public markets.
According to Ken Kencel, CEO of Churchill Asset Management, valuations in private markets have remained higher than expected, but most deals that have been concluded this year involved high-quality companies that are relatively unaffected by inflation and the current market dynamics.
Private equity investors argue that they do not need to adjust valuations as much because they invest in more resilient, defensive industrial sectors that benefit from long-term secular tailwinds, which are less affected by macro factors such as rising interest rates. However, lower valuations and capital losses are not one and the same, and growing profitability can to some extent compensate for lower market valuations.
While private equity returns may still be positive in the current high-interest rate environment if the managers of the companies in question succeed in growing their profitability enough to compensate for lower valuations, private equity funds with high leverage and that use bank loans to boost returns may face difficulties due to higher financing costs.
Private credit firms like Churchill AM that lend money to private equity stand to benefit, with the private credit market providing attractive investment opportunities with excellent risk-adjusted returns.
