But I also think the rise in interest rates could help reverse this trend, at least somewhat.
Consider: Until recently, interest rates in the US and other developed economies had only declined, in fits and starts, since the early 1980's.[a]
Not coincidentally, the modern private equity sector was born in the 1980's.[b]
Until recently, private equity firms had benefited from interest rates that only decline and valuation multiples that only expand -- for four decades!
A lot of deals that "work" when rates only decline will stop working if rates don't. For example, there are a lot of private-equity-backed middle-market businesses, including plenty of roll-ups, that were financed before rates went up, with such high leverage that the companies are now at risk of insolvency if rates don't decline soon.
If rates stay at current levels or (gasp!) continue to increase, I'd expect to see a significant contraction in the number of private equity firms. Those private equity firms survive may have to become mainly lenders, i.e., banks in all but name, and sooner or later will end up being regulated as such.
The rise of private equity is also correlated with major drops in the top marginal income tax rate and the maximum capital gains tax rate in the US. When individuals become so wealthy they couldn't possibly spend all of their wealth, this creates an a new market of extremely wealthy clients with a risk appetite.
Financiers can cater to this clientele with exotic investments that feature more concentrated risk/reward and pay out exclusively to the uber-wealthy and institutional investors: Private equity, hedge funds, and venture capital.
Those companies are only at risk of insolvency if their debt is variable rate or has a balloon payment due soon. I imagine most PE firms are smart enough to avoid those risks. Banks are also incentivized to negotiate with debtors in those situations since the asset is worth more as a going concern than it would be in bankruptcy and banks don't want to operate a business (they have no expertise there).
Most PE deals would work (with lower returns) without any debt. The debt allows them to diversify into more deals (since they put less equity into any given deal).
> Those companies are only at risk of insolvency if their debt is variable rate or has a balloon payment due soon.
Actually, most LBO-type deals are financed with a combination of bank and bond debt. A shocking number of bond deals will be maturing within 1-3 years, and have to be refinanced. The bank debt, senior to the bond issues, is typically variable-rate and (depending on deal size) split into tranches that must be repaid at different schedules over time. Many PE-backed borrowers in recent years decided not to enter into swap contracts to fix their debt rates. My understanding is that things could get ugly quickly if rates don't come down soon.
> Most PE deals would work (with lower returns) without any debt.
Actually, if a deal returns less than the yield on corporate debt of similar risk, then the deal does not work. LP's in the PE fund will correctly view it as a failure. The raison d'être of PE funds is to earn returns above those yields. Moreover, if a portfolio company is already loaded with debt, finding buyers that will pay the old multiples given the new rates will prove difficult, if not impossible -- similar to the situation many US homeowners that locked-in ~2% mortgage rates a few years ago face today: They cannot sell their home at the old valuation because prospective buyers are looking at mortgages that cost ~8%/year. Higher interest rates make it hard to impossible to "exit" at valuations that generate decent returns.
I'll believe it when it happens. Banks/creditors don't want to operate these assets (no expertise there) and since the businesses are fundamentally sound for the most part there is no reason to force them into bankruptcy. "Extend and amend" (sometimes "extend and pretend") is what they called it after 2008.
If they had unlevered yields below the corporate debt yield they would have negative leverage and debt would reduce returns.
But I also think the rise in interest rates could help reverse this trend, at least somewhat.
Consider: Until recently, interest rates in the US and other developed economies had only declined, in fits and starts, since the early 1980's.[a]
Not coincidentally, the modern private equity sector was born in the 1980's.[b]
Until recently, private equity firms had benefited from interest rates that only decline and valuation multiples that only expand -- for four decades!
A lot of deals that "work" when rates only decline will stop working if rates don't. For example, there are a lot of private-equity-backed middle-market businesses, including plenty of roll-ups, that were financed before rates went up, with such high leverage that the companies are now at risk of insolvency if rates don't decline soon.
If rates stay at current levels or (gasp!) continue to increase, I'd expect to see a significant contraction in the number of private equity firms. Those private equity firms survive may have to become mainly lenders, i.e., banks in all but name, and sooner or later will end up being regulated as such.
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[a] https://fred.stlouisfed.org/graph/?g=1aNbC
[b] https://en.wikipedia.org/wiki/Private_equity#Private_equity_...