Fed Policy to potentially disrupt valuation curve in the PE market

The direction of the US Fed’s interest rate policy holds significant importance in the context of how capital flows into emerging markets. The moot question is how much of an impact it will have on cross-country flows. The other significant issue that could tilt sentiment heavily on the risk side is the perception people hold about where inflation could move. All this will have significant bearing on the movement of asset prices and valuations in the private equity market.  

Rate hikes to come with a gap 

One of the key takeaways in the latest policy meet is that the US Fed has given sufficient time for the markets to digest the expected interest rates hike in 2023. In its last policy announcement, the US Fed kept interest rates at zero, but has projected two hikes by the end of 2023. As the rate hikes are still sometime away, global flows are not expected to be affected, in the near term at least. This should help keep the current asset-price inflation, quite healthy.  

The US Fed has pledged to continue asset purchases at $120 billion monthly pace. Indeed, the Fed expects to maintain this stance until ‘substantial further progress’ had been made on employment and inflation. This is a sufficiently good premise to consider that flows into emerging markets could continue for now. This has also kept global market sentiments firm.  

The minutes of the US Fed show that policymakers are optimistic that the US recovery is upbeat with economic activity and employment showing signs of strength. The US Fed acknowledged that the higher inflation readings “reflect transitory factors.” Some of the factors that are driving inflation higher, which is currently at a 29-year high in the US, is due to supply disruptions and labour shortages. Hence, the Fed believes that this could keep inflation projections elevated as higher prices could persist for now. Though the markets reacted to Fed’s likely tapering from 2023, 10-year bond yields have softened 1.37% from 1.73% at the time of Fed policy announcements. 

Inflation risks still high 

That said, sustained higher inflation cannot be eliminated.  To an extent, how the public sees inflation playing out can also influence how central banks across the world deal with the situation. This largely depends on how corporations view inflation affecting their businesses. In fact, if corporates believe that inflation is transitory, then it is quite possible that major effects of inflation will not be seen until 2023 onwards. Note that in such a situation, corporates may not bake inflation clauses into contracts as a result, inflation spikes will be smoother.  

However, if corporates suspect that inflation may not be as transitory as the US Fed believes it to be, then there is a risk of inflation spiking earlier than anticipated. This could see some global central banks potentially raising rates even earlier to contain inflation.  

Faster economic recovery signals ‘taper’ on the cards

The other factor to remain watchful for in the coming quarters is how the broad economic recovery indicators such as employment shape up. In fact, this will determine how soon the US Fed decides to ‘taper’ its asset purchase program. Given the labour shortages and higher inflation expectations, there will be significant pressure to announce slower asset purchases as early as December.  

Given this backdrop, the pressure on the private equity market could be seen much earlier. Once interest rates are raised, capital flows could take a U-turn from riskier assets such as emerging markets to markets considered as ‘safe havens’. This will certainly have an impact on the amount of capital flowing out from countries like India.   

Valuations puffed, hence caution warranted  

Nevertheless, equity valuations are expected to remain elevated for a few years at least. With dry powder from earlier capital raises is quite high, equity investors are still paying an exorbitant price for private equity deals for now.  

But suffice it to say that once rates are raised, it may become a tad difficult to raise capital Note that it will potentially mean that the era of ‘cheap money’ will come to an end. These issues are also likely to mean that investors are likely to increasingly focus on the deal pricing in the coming years.  

That would make the private equity market see a contraction in deal valuations – at least in the runaway asset prices seen in recent times. Eventually, over the next few years, we may also see profitable exits becoming harder for firms, particularly for those who have invested at these frothy valuations.  

That said, we expect to continue to focus on the bi-modal strategy for the foreseeable future as valuations continue to remain elevated. We see the need to be cautious in many of the opportunities as prices have remain elevated. In any case, there is no need to be aggressive as there are many deals in the early-stage market that is available at comparatively reasonable valuations.  

Our stance is that once the interest rates increase/ or inflation goes beyond what is manageable, we would expect any corrective action to have a direct implication on both private and public company valuations. 

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