With this backdrop in mind, I am reminded of the famous quote from Warren Buffett: “Only when the tide goes out do you discover who’s been swimming naked.”
Slowing economic growth, a sharp increase in short-term interest rates, and tightening credit and liquidity conditions will likely lead to a challenging period ahead for investors.
The window for an economic soft landing following the current monetary tightening cycle has narrowed further as high inflation has been more stubborn than many expected, leading the Fed to be more aggressive with rate hikes relative to expectations earlier this year.
Our quantitative recession model now predicts a 65% chance the US will enter a recession in the next 18 months.
While inflation has started to slow, its path back to 2% remains highly uncertain as does the Fed’s willingness to accept anything significantly above that target.
Relative to past economic downturns, above-target inflation will force the Fed to be more conservative this time with respect to supporting weak growth and financial markets.
This environment could lead to a particularly difficult period for many areas of private equity given its reliance on leverage, the declining credit quality of PE-backed companies in recent years, and optimistic valuations that have led buyout funds to report record returns in the second half of 2020 and 2021.
With benchmark interest rates nearing 4% and credit spreads widening, the typical cost of new issue buyout debt financing has exploded from less than 5% to over 12% in less than 12 months, which will be a major hurdle for any new deals as well as refinancings.
Rising interest rates have also led to increasing liquidity risks for PE-backed companies. Based on a starting leverage ratio of 6x EBITDA, we estimate that a buyout deal that was completed in 2021 at the average new issue spread has seen its interest coverage ratio fall from 3.5x to 2.5x.
Further increases in benchmark interest rates combined with the potential for lower earnings in a recession could result in a material increase in defaults.
Allocators face their own unique set of challenges related to private equity that will likely lead to a slowdown in fundraising efforts in the near term. Most notably, the sharp drawdown in public markets (equity and fixed income) and lagged private market fund reporting have caused relative allocations to all private market asset classes in institutional investor portfolios to increase.
While it will depend heavily on the specific portfolio and target ranges, we believe that many investors are currently navigating around above-target allocations to private markets.
For more data and analysis, download our new Quantitative Perspectives report: When the Tide Goes Out
Read More: Continued market challenges reflected in our quantitative recession model