Fed Rate Hikes Could Cause Bankruptcies To Bloom In Private Equity Portfolios

The Federal Reserve approved the first interest rate hike in the U.S. since 2018 this month, and several more increases seem likely in the months to come. Fed Chair Jerome Powell and his colleagues believe a bit of monetary tightening will remedy the worst inflation to wrack the American economy in four decades. 

That policy shift could be bad news for some investors who indulged in a yearlong private equity party during 2021. Backed by rock-bottom interest rates and a booming stock market, the industry spent more money and bought more companies than ever before. But the economy is now in a different place. If interest rates rise as expected, the hangover from last year could include an increase in bankruptcies and other signs of distress. 

“The deals that have been done over the last 18 months—and there was a lot, I mean it was a total bonanza—I am telling you, they are highly leveraged,” says Markus Lahrkamp, a managing director in the private equity performance improvement group at advisory firm Alvarez & Marsal. “I’ve not heard any buyer’s remorse yet, but I don’t think we’re that far away from when this is going to start.” 

After years of being essentially free, debt is starting to get more expensive.

“As rates rise, the days of access to inexpensive capital are certainly waning,” says Glenn Mincey, KPMG’s global and U.S. private equity leader.

The ultimate outcome will depend on how the U.S. economy responds to rising rates. If the economy is as strong as Powell seems to believe, the impact might be minimal. But if signs of a contraction or recession emerge, trouble could mount. Some companies might miss sales targets and struggle to make hefty debt payments. Others will find it more difficult to raise new debt. Rising rates will put particular pressure on companies that are already operating at close to break-even margins. 

Just 79 companies with private equity backing filed for bankruptcy last year, according to PitchBook data, the lowest annual total since the global financial crisis and a 64% decline compared with 2019. There have only been 18 PE-backed bankruptcies so far in 2022. But before long, that total may begin to climb. 

“The first wave of real distress is probably going to hit us kind of mid-year,” Lahrkamp predicts. “For the first ones, they might have too much leverage, they were not prepared, the companies were not operationally sound. And then from there, it will probably trigger into more and more.”