At 50 basis points, the size of the cut was notable. The last two instances of a cut greater than 25 basis points were the Covid pandemic of 2020[3] and the Global Financial Crisis of 2008.[4] While not signaling a crisis, the move does formalize a shift from fighting inflation to fighting a potential recession caused by an over-cooling labor market.
The cut signals the end of an era. That being the case, what can we expect in the new one? And specifically, what does it mean for investors in private markets?
Scanning the horizon
As we have documented elsewhere[5], a high interest rate environment makes it harder to rely on a ‘rising tide lifts all boats’ investment strategy, fueled by cheap borrowing and ever-expanding multiples.
Investing outside the stock market into private deals, whether as an equity investor or as a private lender, has offered investors an alternative path up to now.
The Federal Reserve’s (the “Fed”) official projections suggest that rates could fall by a further 2% over the next few years.[6] It’s reasonable to ask if this reversal of course takes the sheen off private markets investments. Let’s examine this hypothesis in more detail.
The bear case
If capital becomes more widely available, companies will have more options to fund growth. This means that private markets investors will experience more competition for assets.
Equity investors will likely have to offer higher multiples to compete with other bidders, and hence risk either losing out on deals or overpaying for target companies. Debt investors, meanwhile, will need to settle for lower returns, not only as a result of the lower rate environment but also as traditional lenders re-enter the market offering more attractive rates.
To the extent that the Fed’s move indicates the potential for (though not yet the expectation of) a recession, sticking to traditional investing (i.e., public markets) may represent the most prudent course for the time being.
The counter
While the above arguments are correct to an extent, they represent a limited view of what private markets investing involves.
While it is true that more people can enter the private markets space if the cost of capital continues to decline, successful private markets investing relies on the judgment of the deal team rather than the wider economic market conditions.
For instance, there will be niches where traditional lenders lack confidence or experience, where private lenders can not only offer funding but also more tailored and flexible lending terms. The success of private equity investing, similarly, relies precisely on the ability to see through the hype and invest in firms and sectors less prone to bubbles and eventual collapse if, and when, a recession hits.
Public valuations are, according to various key measures, elevated in historical terms.[7] Lower rates tend to boost or at least buoy valuations, but earnings growth is ultimately required to maintain them through broader economic woes. Private markets, by contrast, can offer investors lower valuations with stronger upside potential.
Conclusion
Investing exists in both ‘smart’ and ‘herd-like’ forms.[8] While the latter requires a certain economic backdrop to success, the ‘smart’ form is able to flourish in almost all conditions.
On top of this, the principle of diversification remains even more relevant in times of greater uncertainty. Even if the outlook for public markets is bright, maintaining exposure to the (much larger) universe of private firms is an essential tool to guard against risk.
It is too soon to draw any firm conclusions about the long-term effects of US monetary policy on valuations, private or public, or how the dynamics of private markets investing will change as a result.
The key task for investors is to retain the ability to discern between ‘smart’ and ‘herd-like’ behavior, and if possible, find a team with the expertise, network, and track record to see them through the coming, yet unknown, environment.