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Private equity is under pressure as the Federal Reserve began raising interest rates last year

Autor: Article based upon analysis from Reuters Breakingviews | Link: Private equity is being squeezed from all sides
Timp de citit: 2 minute

The private equity boom came to an abrupt end last year when the Federal Reserve began raising interest rates. Still, Bain & Company’s latest Global Private Equity Report remains upbeat about the industry’s prospects.

The consulting firm says previous market downturns have produced juicy takeover bargains. This time, however, could be different. In its four-decade history, private equity has felt the tailwinds of easy money and lax regulation.

Both conditions are unlikely to be present in the future.

The modern private equity industry got its start in 1981, when former Treasury Secretary Bill Simon acquired the card company Gibson Greetings for $80 million and sold it sixteen months later for a fabulous profit.

That same year, the great bull market in U.S. bonds began. Since then, private equity has recovered from several market downturns, helped by increasingly cheap financing.

After the Federal Reserve cut interest rates to zero following the collapse of Lehman Brothers, financing buyouts became more attractive than ever.

Low-income investors snapped up leveraged loans that were free of their traditional protection clauses and purchased junk bonds at the lowest yields in history. Ultra-low interest rates also drove up equity market valuations, further pushing up returns for investors in leveraged buyouts.

Private equity has never been more popular, with the industry’s assets under management increasing by nearly $10 trillion in the decade following 2012, according to Bain.

During the pandemic market rush, the value of global private equity deals surpassed $1 trillion for the first time. Companies controlled by buyout firms raised billions of dollars at low cost to fund dividend payments to investors.

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At the same time, private equity funds raised more money than ever before, leaving the industry with $3.7 trillion in so-called dry powder.

But, the music stopped in mid-2022, when the Fed began raising interest rates and banks became more cautious about lending.

The value of U.S. buyout deals fell to half of last year’s level in the final quarter of last year and has remained at low levels since.

The current market downturn will likely lead to bargains. But this time around, there is much more private equity money chasing a limited number of opportunities.

Moreover, it’s unlikely that financing conditions will ever be as easy as they have been in recent years. Bear markets for bonds tend to last decades. So private equity funds could face the prospect of an extended period of higher borrowing costs, lower valuations and lower investment returns.

Global buyout deals peaked in 2021 – then dropped

The buyout industry faces another, potentially more serious threat. Regulatory cycles, like bond market cycles, can last decades. The birth of private equity coincided with the Reagan administration’s policies of regulatory loosening and tax cuts.

The U.S. Department of Labor had allowed pension funds to make riskier investments in the 1970s. Congress cut taxes on capital gains. Antitrust enforcement was also relaxed.

As a result, private equity could acquire multiple companies operating in the same sector. So-called industry rollups consolidated a variety of U.S. sectors, from dental practices to prison telephone services.

More than two-thirds of North American acquisitions last year consisted of so-called „add-ons,” according to Bain.