Rate-Mageddon or: How i learned to stop worrying and welcome higher interest rates

INSIGHT

Rate-maggedon or: How I Learned to Stop Worrying and Welcome Higher Interest Rates Given the strength of the November Jobs Report –nonfarm payrolls surged by 211,000 – and as emerging markets have begun to stabilize, it is near certain the Federal Open Market Committee (FOMC) will raise rates when they meet next week.

According to the CME Group’s FedWatch Tool, the ‘Implied Probability’ of a 50-basis point increase is now above 83%.

New Normal There is no denying that interest rates have remained at or near historic lows for some time. Following peak rates in the early- to mid-1980’s rates ‘normalized’ in the late 1980’s and in a recent report Bryon Ehrhart, CEO of Aon Benfield Americas, and Chairman of Aon Securities, Inc. noted ‘we have seen more than 30-years of [interest rate] decline.’ This includes a prolonged period of record low interest rates - nearly half of the 51-year average with the Effective Funds Rate averaging less than 20% the long-term average.

New Normal?

20%

For Rate Increase: William H. Gross, Pimco co-founder ‘If only to prove that they can begin the journey to ‘normalization’.

They should, but their September meeting language must be so careful, that ‘one and done’ represents an increasing possibility – at least for the next six months. The Fed is beginning to recognize that six years of zero bound interest rates have negative influences on the real economy.’

Janus Capital Investor Outlook, 2 September 2015

While the cause of near zero interest rates may vary from market to market, the effect has been clear, fund managers pushed the envelope in search of higher returns – in some cases to make good on obligations they made more than a decade ago.

Effective Rate Since 1954

16%

12%

x̄ (since 1954), 5.00%

8%

4%

0%

Does the prolonged period of low, interest rates signal a new normal?

The short answer is yes. 375 Park expects rates in developed markets to remain below the 20year average for the next two to three years at a minimum.

x̄ (since 1995), 2.73%

This has led to an explosion of private equity activity, and assets under management (AUM) are at historic levels. Looking forward to 2020, 375 Park expects that total AUM will continue to grow as asset value accelerates.

However, 375 Park analysis indicates higher interest rates have the potential to slow growth in ‘dry powder’ levels as marginal performers are forced to compete against increasing returns in other categories. In light of slowing growth in ‘dry powder levels’ mid-market will need to refine their competitive advantage to successfully close funding.

SOURCE: FEDERAL RESERVE ECONOMIC DATA (FRED)

The U.S. is not alone; since 2009, the Bank of England has left rates at 0.5%, while the Bank of Japan has kept rates at or near zero since 2010, and the European Central Bank lowered rates to 0.5% in September 2014.

This document has been prepared by 375 Park Associates for advertising and general information only. 375 Park Associates makes no guarantees, representations or warranties of any kind, expressed or implied, regarding the information, including, but not limited to, warranties of content, accuracy and reliability. Any interested parties should undertake their own inquiries as to the accuracy of the information. 375 Park Associates excludes unequivocally all inferred or implied terms, conditions and warranties arising out of this document and excludes all liability for loss and damages arising therefrom. This publication is the copyrighted property of 375 Park Associates. ©2015. All rights reserved.

On Uncertainty: Reuben L. Sushman, Managing Director | 375 Park Associates ‘Uncertainty has made it more difficult for midmarket firms to measure the impact of various structured products by themselves.’

YOUR GROWTH PARTNER© Hong Kong +852 2251 8329 | New York +1 (212) 763-0159 www.375parkllc.com

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INSIGHT

Rate-maggedon or: How I Learned to Stop Worrying and Welcome Higher Interest Rates Billions

Growth in Dry Powder will Slow $5,000 Unrealized Portfolio Value

Forecast

Dry Powder

$4,000

$3,000

$2,000

$1,000

$-

SOURCE: 2015 PREQIN GLOBAL PRIVATE EQUITY & VENTURE CAPITAL REPORT, 375 PARK ANALYSIS

What Does A Rate Increase Mean for MidMarket Firms?

Increased competition in the private money markets will force mid-market firms to explore a structured approach through a combination of debt and equity offerings.

This will require the expertise to implement an effective capital management program.

The true impact of a rate increase depends on the maturity of a company’s debt profile.

For example, if a company were to refinance as much as 50% of their debt profile in the next six months, a 50-basis point increase in Federal Reserve’s Effective Funds Rate would equate to an additional 1% in interest payments per year.

Depending on the terms, this could increase to nearly 5% in additional interest payments per year if the Federal Reserve ‘normalizes’ rates from current levels to the 3% range by 2017.

Most mid-market firms, especially those under $100 million in revenue, lack the resources to manage their debt profiles and according to 375 Park Managing Director, Reuben L. Sushman, ‘uncertainty has made it more difficult for mid-market firms to This document has been prepared by 375 Park Associates for advertising and general information only. 375 Park Associates makes no guarantees, representations or warranties of any kind, expressed or implied, regarding the information, including, but not limited to, warranties of content, accuracy and reliability. Any interested parties should undertake their own inquiries as to the accuracy of the information. 375 Park Associates excludes unequivocally all inferred or implied terms, conditions and warranties arising out of this document and excludes all liability for loss and damages arising therefrom. This publication is the copyrighted property of 375 Park Associates. ©2015. All rights reserved.

measure the impact of various structured products by themselves.’ This uncertainty has also made it more difficult for lenders to underwrite mid-market debt.

Industry analysts report October marked the fifth straight monthly decline in mid-market loan levels - reaching their lowest levels since February 2009.

While a clear rate direction will help midmarket firms more accurately forecast their cost of capital, it will also strengthen the U.S. dollar. On the plus side, a stronger dollar will allow those mid-market firms with healthy balance sheets to target strategic acquisitions internationally and sellers will benefit from higher valuations as foreign investors seek to expand their holdings in the U.S. However, a stronger dollar will drive up the cost of U.S. exports while diminishing the value of foreign earnings.

To remain competitive, mid-market firms will need to hone their value propositions, including ramping up operational excellence activities, and capital management mechanisms including foreign exchange.

Insight

Given the Fed’s reticence to raise rates in October 375 Park believes a minimum 25 basis point rate hike is a near certainty next week. This will signal the beginning of a rate normalization cycle that could incrementally add 200 basis points to the Fed’s Effective Fund Rate by 2017.

Assuming this is correct, the Fed would move rates much closer the historical average rate for the internet era of 2.73%.

Whilst rate normalization would force midmarket firms to mitigate the impact of a stronger dollar, clear policy direction will allow mid-market firms with effective capital management mechanisms to gain a tangible advantage over their peers.

YOUR GROWTH PARTNER© Hong Kong +852 2251 8329 | New York +1 (212) 763-0159 www.375parkllc.com

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