The Federal Reserve’s sharper-than-expected move to slash its interest rate target by 50 basis points has most private market pros dancing in the streets.
They point to the significantly reduced cost of capital that benefits dealmakers of all stripes. Private credit firms, meanwhile, will be forced to adjust credit lines and loan terms to remain competitive.
While there’s reason for renewed optimism—perhaps no more so than a projected uptick in exit markets—private investors may not want to pop the champagne just yet.
That’s because the Fed’s sudden shift, orchestrated by Chairman Jerome Powell, is primed to take longer to impact opaque alternative assets than public ones.
Trickle-down macroeconomics
Stock indexes notched fresh highs this week on expectations that lighter debt burdens will juice growth. VC- and PE-backed firms, though, don’t have the same creditworthiness as blue-chip companies with abundant free cash flows and easily collateralized stock.
For these companies, the wisdom of tapping suddenly cheaper debt is not so clear-cut, according to Sháka Rasheed, a general partner at Open Opportunity Fund, which invests in underrepresented founders and investors.
Lower rates could also lead to an eventual bump in loan defaults, especially if economic conditions deteriorate. Under more restrictive rates, private credit funds and other lenders could afford to be selective. Now, there’s a temptation to issue loans to companies that may lack the same quality.
The safer play may be to hit pause and see how the macroeconomic environment plays out. That’s especially true for startups, which may find that a new era of lower rates, given time, will make more risk capital available to fund their growth.
But, Rasheed cautioned, it could turn out that large US LPs lean into stocks over illiquid equities on the belief that cheaper capital will more quickly benefit the stock market.
“The actual effect, when it comes down to private markets and secondary risk profiles, ends up having a little bit of a delayed and bigger effect,” Rasheed said. “The actual impact on capital flows won’t show up until months down the road.”
More Fed rate cuts to come
Dealmakers expect additional rate reductions before year-end. The Fed pointed to cooling inflation and softening employment figures to justify its decision to cut by half a point.
PitchBook lead analyst Zane Carmean said that the Fed’s tightening strategy has “had a substantial impact on private market dealmaking,” especially the anemic exit environment for PE and VC. One result has been historically low distributions to LPs, which have pumped the brakes on cutting checks to newer vintages.
GPs are thus feeling pressure to strike deals, and further rate cuts could finally close the gap between buyers and sellers.
That impact will likely be felt soonest in smaller M&A and PE add-on deals. But the Fed’s recent move likely won’t move the needle on deals that define the market, like jumbo tech IPOs or debt-heavy buyouts. For larger deals to pick back up, further easing is needed.
The path forward is far from certain. The Fed is searching for the “neutral rate,” which even Powell admits is unknown. There’s still a chance that expectations for a soft landing get upended.
Likewise, it’s hard to guess the impact of the current easing cycle on private markets. The closest historical precedent is the late 1990s, which is a poor analogy for many reasons—PE and VC were still cottage industries by today’s standards, for starters.
As PitchBook lead private equity analyst Tim Clarke put it:
“There really is no precedent for this.”
Featured image by Jenna O’Malley/PitchBook News
