PE firms face crisis as rising interest rates threaten acquired companies
Private equity funds, once seen as the cream of Wall Street, are facing a crisis as rising interest rates put their acquired companies at risk of collapse under the burden of increased debt.
Names like KKR & Co, Platinum Equity, and Clayton Dubilier & Rice have been caught off guard by the rapid increase in interest rates, which have more than doubled in some cases. Many private equity funds failed to anticipate central banks raising rates and neglected to hedge against the risk, leaving companies with a total debt of $3 trillion exposed to rising interest costs.
Hedge fund Man Group estimates that in Europe, 70% of all loans in private equity were unhedged in January, even after the European Central Bank had already started raising rates. Over the past decade, hedging against interest rate risk was cheap, and few firms took it seriously. Now, these companies are facing severe difficulties as a result.
The exact extent of the interest burden is uncertain, as private equity funds are not providing detailed information. However, an analysis by Bank of America revealed that almost three-quarters of all loans made during the buyout boom in the US were not protected against interest rate hikes as of August 2022.
The consequences of rising rates could be disastrous for hundreds, if not thousands, of companies. This not only affects investors facing substantial losses and employees whose jobs are at risk, but also poses a threat to the global economy, which could derail if bankruptcies accumulate.
The situation highlights how even the brightest minds on Wall Street, including bank executives, traders, and economists, were largely blind to rapidly rising inflation and failed to anticipate the aggressive measures central banks would take to control it.
Private equity funds are now grappling with high debt burdens that they imposed on their acquired companies, in addition to challenges such as wage inflation, high energy costs, and disrupted supply chains. Companies owned by private equity, such as Aventiv Technologies, are struggling to turn a profit while negotiating refinancing deals and coping with soaring interest costs.
The interest burden on mid-sized companies acquired by private equity in North America rose to 43% of earnings before interest, taxes, depreciation, and amortization (EBITDA) last year. This is six times higher than the interest burden for mid-sized companies in the S&P 500 index, and it becomes increasingly burdensome as interest rates continue to rise. In the US, the average interest rate on large loans reached 10% in June 2023, compared to 3.9% at the end of 2021 before the Federal Reserve’s aggressive interest rate policy began.
Experts warn that the consequences of rising interest rates could lead to the collapse of hundreds of companies unable to meet their debt obligations. Private equity-owned firms that did not hedge against interest rate risk are now facing a dire situation.
The lack of a unified risk hedging approach among private equity funds and their acquired companies has left many unnecessarily vulnerable. Some companies, like Wm Morrisons, a well-known UK supermarket chain acquired by CD&R, did not hedge a significant portion of their debt against interest rate increases, leaving them exposed to higher interest costs.
Credit rating agency KBRA predicts that out of the 2,000 mid-sized US companies it analyzed, around 300 are likely to default on their debt obligations due to the inability to generate enough earnings to cover the rising interest costs.
While some companies have managed to secure hedges and mitigate risks, many others are facing dire consequences. This crisis exposes a hidden risk that has long been overlooked, and its impact could reverberate throughout the global economy if bankruptcies pile up.