For Private Equity Firms, Rising Rates Are a Double-Edged Sword

A rising interest-rate environment is negatively correlated to the business of private equity.

That's just a wonkier way of saying that bad things hurt. Rising interest rates equal bad things for private equity.

An increase in interest rates -- perhaps as early as later this month -- is widely anticipated. Friday's jobs report may change the timing of a rate hike, but not the likelihood.

Janet Yellen, the Federal Reserve chairwoman, speaking publicly Monday, said the central bank continues to "wrestle" with the jobs data -- a notoriously fickle indicator, but the best measure of economic expansion nevertheless -- and that the Fed may move on rates before the economic readings confirm that the economy is in a sustainable expansion. All of which says rather bluntly that the Fed is ready to move.

Rising rates translate to higher prices for government Treasuries and a stronger dollar in the currencies market. However, they're problematic for equities. And particularly bad for the private equity business.

Leveraged buyouts typically use as much leverage -- i.e., borrowings from the debt market -- as lenders will allow. Much of that is variable-rate debt, so when rates go higher, the portfolio companies spend more of their revenue on financing costs, which hurts profit margins.

"The business of private equity is levering the company to the highest level possible," said Marc Nadritch, managing director of Anchin, Block & Anchin, an accounting and consulting firm. "That way, they're not writing huge equity checks."

The easiest solution for private equity firms that are evaluating the impact of rising rates on the companies they own is to replace some of the debt on those companies' balance sheets with equity from the funds they have raised. That, however, is a non-starter for most private equity firms.

"I doubt PE funds will sell equity to pay off that debt," said David Brophy, director of the Center for Venture Capital and Private Equity Finance at the University of Michigan, "because I don't think that equity participants would be happy putting up money for that reason."

Putting more equity into deals simply won't sit well with the pension funds, insurance companies and endowments, as well as family offices, that finance private equity.

The more difficult option for the companies owned by private equity firms is to practice some financial engineering, by replacing existing variable-rate debt with other credit instruments -- usually by extending the maturities of their borrowings further into the future. (This is the equivalent of telling your bank you'll pay off your credit card balance in August instead of June. Or even next year. Your monthly payout is lower, but the interest payments continue to mount.)

Earlier this month, according to data collected by S&P Global Market Intelligence, Mobile Mini (MINI) , a specialty lender that's backed by PE firm Welsh Carson Anderson & Stowe, refinanced $200 million in borrowings that were issued in 2010, in order to extend maturities. Standard & Poor's, the credit rating firm, noting that it had been several years since Mobile Mini came back to the credit market for new financing, called the refinancing a "rarity."

Meanwhile, Zayo Group (ZAYO) , a portfolio company largely owned by PE firms Charlesbank Group Partners and GTCR, refinanced its debt in late March, and even increased the amount borrowed.

"Orchestrating (debt) swaps as a risk management tactic happens all the time," said Thomas Bonney, founder and CEO of CMF Associates, a Philadelphia advisory firm.

In reality, the impact of higher rates is a double-edged sword for private equity firms. One of the biggest stumbling blocks for PE firms in the past two years or so is that asset prices have risen very sharply. Rising rates may tamp that down. "On the positive side, you'll see a dose of fear in the minds of seller," Bonney said.

On the other hand, one truism of the private equity world is that lower prices hurt firms' returns when they get ready to sell an asset. "Look, the day you close on a deal is the day you think about exiting a deal," said George Teixeira, partner at Anchin, Block & Anchin. "But as the debt markets rise and equity markets fall, the options you'll have for exiting fall as well."

Risks are skewed. "The effects of interest rates will be heavier on the larger firms," Brophy said. Big firms, such as Kohlberg Kravis Roberts  (KKR) and Carlyle Group (CG) , have expanded beyond the conventional LBO investments that formed the basis of private equity.

They now operate debt funds that lend money to borrowers, meaning rising rates could affect both their own costs of borrowing and the transaction activity at those enterprises. Private equity firms "could be the owner of the debt and the owner of the company," Brophy said. "They've got a fiduciary duty to two different parties."

Ultimately, though, a rise in interest rates is more likely to nick -- rather than cripple -- the private equity business.

"When you look at the investors in alternative investments, you'll see that they're more worried about the lack of returns outside of their alternative investment portfolios," said Andrea Kramer, managing director at Hamilton Lane, an independent alternative investment management firm.

As equity values decline, the values of the investments that institutional investors make in, say, index funds, are likely to decline by a larger degree than the value of their private equity stakes, she suggested.

At the end of the day, Kramer added, private equity firms "are just going to have to become more creative" about fashioning deals. But having survived the financial crisis several years ago, the firms have shown their adaptability to changing circumstance.

See TheStreet'sfull coverage on the Fed's upcoming interest rates decisions.
See TheStreet'sfull coverage on the Fed's upcoming interest rates decisions.

See full coverage on the Fed's upcoming interest-rate decisions.

More from Stocks

The Bear Case on Microsoft's Record-Setting Stock

The Bear Case on Microsoft's Record-Setting Stock

Facebook's Price Target Is Raised Ahead of Second-Quarter Earnings

Facebook's Price Target Is Raised Ahead of Second-Quarter Earnings

Dow Tumbles as Trump Ramps Up Trade Fight With China

Dow Tumbles as Trump Ramps Up Trade Fight With China

How to Trade General Electric's Stock After Earnings for Superior Gains

How to Trade General Electric's Stock After Earnings for Superior Gains

Top Strategist Reveals the Stocks to Focus On For the Last Half of 2018

Top Strategist Reveals the Stocks to Focus On For the Last Half of 2018