While it’s possible higher-for-longer rates may not have a significant impact on the US economy overall, the private equity (PE) business model and PE-backed businesses could come under pressure.
US policy rates have increased from 0.25% to 5.5% over the past two years, the fastest pace of rate-hiking since the early 1980s. Yet 30-year fixed-rate mortgages have protected US households and supported consumption, corporate profits and employment: unemployment remains near record lows. The tight labour market, meanwhile, has led to above-average wage growth.
In addition, US listed corporates enjoy relatively strong balance sheets and have refinanced debt at favourable long-term borrowing costs. With inflation falling, the peak of the tightening cycle may already be over.
However, challenges remain. While inflation is trending down, core inflation may plateau at 3% in the middle of the year due to upward pressure on rental costs. If the Federal Reserve cuts interest rates against this background, inflation could reignite. Consequently, we believe investors should remain open to the possibility of interest rates remaining higher for longer.
Alert to the threat to private equity
It’s possible that a higher-for-longer rate environment may not impact the US economy in a meaningful manner. However, PE-backed businesses do appear vulnerable – and consequently, we are monitoring this closely.
The leveraged loan market has ballooned over the past two decades: it now accounts for around half of the total US$2.5 trillion leveraged loan and high-yield market. It is four times larger than it was during the 2008 financial crisis, and the percentage of lower-quality debt within the sector has also grown. Today, around 75% of leveraged loans are B-rated or lower, compared with a reported 35% in 2000.
Around US$700 billion of the stock of leveraged loans is held by PE-backed companies. Most of this debt is floating rate and the cost of servicing this debt has risen from 4% in 2021 to 10% today. The median interest burden is around 40% of EBITDA. However, if PE-backed companies with a net cash balance sheet are excluded, the interest burden rises to nearly 90% of EBITDA. This situation is clearly unsustainable should interest rates remain higher for longer or should the economy weaken and EBITDA fade.
We do not believe this situation represents a systemic risk. The vast majority of high-yield and leveraged loan debt needs to be refinanced over the next three to five years, and falling interest rates can act as a release valve. Some businesses will be able to negotiate with stakeholders so that they can continue to operate until borrowing costs fall meaningfully. Private credit and other white knights can also help fill the financing gap. Warren Buffett, for example, famously bought US$250 million worth of Tiffany & Co’s bonds in 2009.
IT and professional services vulnerable to PE stresses
However, the scale of this debt is vast relative to history, so a stressed scenario could emerge even if levels of default don’t reach distressed levels. PE-backed companies employ around 12 million Americans, or around 10% of the US workforce, excluding agricultural, financial and government employment. However, some sectors are particularly vulnerable. PE is an important provider of capital for the technology and professional services areas. So, while PE-backed firms account for just 10% of the overall workforce, they account for a disproportionate share of the IT and professional service industries – at 25% and 20% of jobs, respectively.
Moreover, a higher-for-longer rate environment clearly raises the cost of capital: debt is no longer free. This situation has important implications for the PE business model, which relies on leverage to buy weak and underperforming businesses, gear these businesses up to help them grow, and then exit at a profit. In a high-interest-rate environment, the economics of this business model make far less sense, which could have wider implications for financial markets in general.
Read our Quarterly Report for further insight into our market outlook, strategy and performance
Subscribe to receive the latest news and insights from Antipodes