Interest Rates Continue to Depress Valuations—Impacting Private Equity and IPO Markets

Current high interest rates have disrupted an investment environment that has benefited from low rates for more than a decade. Overall, current interest rates have translated into steeper valuation discounts and, therefore, depressed valuations. This results in increased valuation risk for companies raising subsequent rounds of financing or contemplating an initial public offering.

Today’s interest rates are not only increasing the cost of financing investments, but are also creating uncertainty and a new set of unknowns. Will the rates go up again this year or remain flat? Will they go down and, if so, how much? The hikes in the Federal Funds rate over the past 18 months have not followed historical patterns, so there’s no clear view on what the future holds. The more unknowns there are, the greater the impact on valuations.

Federal Chairman, Jerome Powell, recently brought some predictability to the situation when he announced that interest rates would likely be held steady for the rest of the year, with the chance of possibly one small rate decrease late in the year. While his statement imposes some stability on the rate outlook, it also confirms that interest rates will remain high for at least the next six months.

Similarly, the IPO market is depressed, with high interest rates affecting every segment of the market that involves valuation, whether public or private. The impact on IPOs is most prominent in the extended time it takes to go to market. If an IPO price is pegged at $35 per share, it may change significantly by the time the offering is launched.

It’s Not All Doom and Gloom

While the sensitivity of the current marketplace requires patience and caution, there are some positives to keep in mind

• Leverage levels: Leverage levels are not as high as they used to be. This means even though higher borrowing costs set a higher bar for returns, how much one borrows helps determine the height of the bar.
• Inflationary shocks: Private equity managers can take advantage of inflationary shocks. When interest rates go up, multiples tend to come down, and good assets tend to become available at a discount.
• Value creation: Private equity returns rely on value creation. Operational initiatives, revenue growth and margin expansion are poised to become the main determinants of success in the new regime.
• Denominator effect: Stock market decreases and climbing interest rates have caused sharp declines in the values of public market investments. By contrast, the private markets have remained relatively stable, as it typically takes two-to-three quarters for private asset markdowns to catch up with public market declines.
• We’ve been here before: Today’s high interest rates are actually below the historical average. The rates we have seen over the last two years are not exceptionally high if we look back to the 1970s and 1980s. But they feel exceptionally high compared to the below-2% Federal Funds rates we enjoyed between 2010 and 2018.

The impact of higher interest rates on valuations is being seen across most industry sectors, with one notable exception. The impact is much less significant on valuations of companies producing Artificial Intelligence (AI) technology, or those producing chips and other hardware necessary to run AI.

The biggest winner has been Nvidia, which has seen a recent 10-for-1 stock split. The growth of AI is outweighing the impact of interest rate fluctuations on valuations in that market.

What To Do Now

While interest rates and discounted valuations have slowed down private equity investment in many sectors, it hasn’t stopped things completely, and that’s a good thing. If individuals looking to make investments have concerns about the timing, consider the following:

• If there is a strong feeling about a company, think about the valuation first and don’t let the cost of capital drive the decision. If it’s not a short-term play, don’t make a short-term decision.
• Work closely with trusted advisors about the impact of any investments on the tax position. Likewise, consider the impact on the financial statement.
• Consider whether an investment in an AI company or related company could provide a bit of a shield against interest rates.
• Consult with an advisor about whether a change in valuation approach can be beneficial as investments that fit the portfolio are pursued. Many people are open to changing valuation approaches right now, particularly those who are using a weighting approach, where they can draw on multiple models. They’re looking for an approach that is less impacted by volatility. Try and build in as much variability in your approach as possible.

While fluctuating interest rates can impact private equity valuations, there are several strategies and factors that can help private equity thrive even in an environment of elevated interest rates. It’s also important to note that the impact can vary depending on specific circumstances and market conditions.

For further information and guidance on how to navigate the current landscape while maximizing tax savings and reducing financial risk, please reach out to David Horton or your Anchin Relationship Partner.