Advisors weigh PE allocations in face of rising rates

Matthew Rubin of Cary Street Partners and Stephen Kolano of Integrated Partners

If the typical PE firm employs leverage and the cost of borrowing rises, it would make sense that higher interest rates would cut into its returns.

If rates remain high, or climb even higher, should advisors pull the plug on PE? When both legs of the 60/40 portfolio – stocks and bonds, that is – wobbled back in 2022, advisors found refuge in private equity products, whose liquidity is typically more like syrup dripping from a jar than water cascading off a cliff.

A more viscous, stickier investment if you will. Perfect for stemming the flow of fast money moving in or out.

Two years ago this week, when all that craziness was going on, the yield on the 10-year Treasury note was 2.83 percent. It finished the year at 3.75 percent.

Fast forward to today, and after a hotter-than-expected March CPI report and a disappointing Treasury auction this week, the 10-year Treasury is now loitering near the 4.5 percent mark. Moreover, Wall Street’s forecast for six Federal Reserve rate cuts last year has plummeted to 2 or less, so the outlook for lower rates ahead has grown even dimmer.

That’s generally a bad thing for PE investors – at least according to conventional wisdom.

If the typical PE firm employs leverage and the cost of borrowing rises, it would make sense that the higher interest rates would cut into its returns. Furthermore, the debt on the balance sheets of the PE company’s portfolio companies would be hit, and the earnings of those companies could be negatively impacted by higher interest costs as well.

Longer term, a growing economy allows for innovative companies to increase their sales and earnings at a rate high enough to offset the incremental interest cost, says Craig Warnimont, chief investment officer at Venture Visionary Partners, who typically does not add private equity to client portfolios.

“The decision to add or subtract from your allocation comes down to if you believe there is a good supply of innovative growing companies owned by or available to PE firms and how much they have to pay to buy them,” Warnimont said.

Todd Stankiewicz, president and CIO at Sykon Capital, says the current yield curve environment is more of a concern than the actual interest rates for private equity, “as the potential risk-reward is unattractive due to potential recessionary pressures.

“While the increased cost of capital makes it more difficult to generate excess return in capital-intensive businesses, the current shape of the yield curve and potential for recessionary stress actually calls into question another aspect of performance measurement within private equity, which is vintage year effects,” Stankiewicz said. “Historically, fund vintages from immediately prior to a recession tend to underperform even those vintages launched during the recessionary period.”

For the record, PE funds last year returned the lowest amount of cash to their investors since the financial crisis 15 years ago, according to a Raymond James Financial study released in February. Distributions to so-called limited partners totaled 11.2 percent of funds’ net asset value, the lowest since 2009 and well below the 25 percent median figure across the last 25 years, according to the investment bank.

DON’T PULL THE PLUG

Rich Powers, head of private equity product at Vanguard, says higher rates may indeed hurt some PE players who are overly reliant on cheap financing. Nevertheless, he says the market data suggest that more of the value creation comes from the operational and management playbooks that private equity firms are putting in place.

“Regardless of the rate environment you find yourselves in, whether it’s cuts or raises, sticking to a program of private equity investing is appropriate, much like market timing in public markets is a bad decision,” Powers said.

To be clear, Vanguard’s PE products are for qualified purchasers with $5 million or more in investible assets, a class of investors that should be able to ride out any storm.

Christopher Davis, partner at Hudson Value Partners, also said he won’t back off from his PE allocations because of higher interest rates. He is continuing to commit capital across vintage years, calling it “key to a diversified private markets allocation.

“Higher rates reinforce our preference for secondary funds within PE,” Davis said. “With a shorter J-curve, less blind pool risk, diversification across time, and the ability to potentially acquire stakes at a discount to NAV, we believe secondaries are how investors with a value mindset can access PE. The impact of higher rates, longer paths to harvest, and changing multiples can all be accounted for in the price paid by a competent secondaries fund manager.”

He adds that levered companies – public or private – must all contend with higher costs of capital. Or in other words, like a muddy infield in an MLB game, it’s the same playing conditions for all the players, not just one team.

Matthew Rubin, chief investment officer at Cary Street Partners, isn’t pulling the plug on PE either, even though he believes rates can remain higher for longer. In his view, the next phase of return in the markets is going to be driven by underlying company fundamentals as demonstrated by corporate earnings.

“It is now more than ever where manager selection in the private market segment is critical in selecting managers who have the experience and demonstrated ability to identify opportunities to drive this value and result in outsized returns,” Rubin said.

To Stephen Kolano, CIO at Integrated Partners, it’s a matter of which PE strategy the advisor chooses when weighing the decision whether to fish or cut bait. And similar to the selection of fine wines, it’s a matter of vintage.

“There are certain strategies within the private equity universe that rely more on leverage than others and as a result are more impacted by higher costs of capital,” he said. “Maybe more important though is when those deals were underwritten and the timing of when debt matures and may need to be refinanced.”

Kolano says he’s not changing his overall allocation to private equity, but he is “considering the environment” when making PE investment selections.

“Secondaries are becoming an interesting area to look at, as are distressed debt strategies, as there may be opportunities to add attractively valued assets that are being sold from distressed sellers or those in need of liquidity,” he said.