Last month, the Fed cut rates for the first time since 2020. While those looking to buy a home are probably breathing a sigh of relief, so should PE and VC investors. Let’s talk about it.
Why did the Fed cut rates?
In September, the Fed cut rates by a whopping 0.5%. Interestingly, Governor Bowman voted for a 0.25% rate cut, marking the first time a Fed governor has dissented on a rate change since 2005. But regardless, we got out 0.5%.
Regardless of all the reasons the Fed may throw out there, rates are going down for two reasons. First, Jerome Powell has done what, quite frankly, many of us thought was impossible: he controlled inflation without destroying the economy. By increasing rates, Powell was able to bring inflation down from nearly 10% to the roughly 2.5% that it sits at today.
Second, lower rates are better for the economy. So long as inflation is under control, low rates kickstart investment, drive new jobs, and pour lighter fluid on the stock market.
How Declining Rates Impact Limited Partners
While you may have noticed your savings account interest rate went down last month, there are a few very big benefits to PE and VC investors from declining rates.
- Stronger valuations: Lower interest rates mean future cash flows do not need to be discounted as much, allowing market valuations to surge. This is especially true for tech companies, who are often valued on cash flows that are not expected to happen until far out in the future. This is why tech stocks, in particular, were hit so hard in 2022 when the Fed started increasing interest rates. But going forward, we should expect the opposite to happen, which will help those invested in tech-focused funds.
- Ease of Borrowing: For the last few years, high rates meant the classic model of levering up on debt and buying a company for little cash upfront did not always work. Declining rates mean we will likely start to see more LBOs going forward. Allocating to funds that execute this type of strategy before rates drop lower could be an attractive move. The early bird gets the worm, after all.
- Increased Exit Opportunities: Over the last few years, PE funds have struggled to provide distributions to investors as markets were seized up due to the attractiveness of 5%+ t-bills. Lowering rates will make holding cash less attractive, and more capital will be put to work in the coming years. This means more companies will graduate from Venture to Growth and Growth to Buyout. More companies will file for IPOs. More companies will be taken over in M&A moves. All of this is good for Limited Partners who are expecting to see capital returned to their pocket sooner rather than later.
When the market is changing, it is always the most exciting time to invest. Decreasing rates mean a lot of good things for PE and VC fund investors.