What has been unusual about this interest rate hike cycle is the rapidity and aggressiveness of the increases. Our portfolio saw some margin squeezes last year, however the companies’ pricing adjustments have caught up and their cost containment has yielded results. As a result, in general the margin situation has improved over the last six months.

The rate increase has not been a major issue. It is common practice in our industry to use hedging tools such as interest rate swaps. At Advent, we have that in place for approximately 60% of the assets. There are other derivative tools at our disposal too. The unhedged assets are often those with low levels of debt and/or those that are close to exit.

At Advent, we are in the business of selecting high-quality companies to own and to which we add value. An important consideration at selection is whether a given company is sufficiently differentiated to command pricing power. In inflationary times, this type of business can pass on inflationary costs to customers, through price adjustments, or upselling, or cross-selling, all of which are well within the private equity toolkit.

For our portfolio, we have found that appetite towards lending to IT/software businesses and aerospace & defence has remained strong. Healthcare is another sector that has been consistently preferred when it comes to debt financing. High quality companies in all of these sectors have predictable revenue outlook, stable businesses, and rich cashflows, which are all qualities that the lenders favour.

In the last decade, quantitative easing and super low interest rates drove a lot of liquidity to our industry, funding new entrants, and financing many lesser quality investments that may have been completed only because of the excessive liquidity resulting in cheap debt.

There is a wide dispersion of performance in private equity, between different managers and different transactions. I think some of the lesser quality deals completed in the last decade would really struggle under the pressure of increased inflation and a higher burden of debt. In contrast, higher quality businesses are able to go through a more challenging period and come out stronger and even grow in scale through industry consolidation or a decrease in competitive intensity as some firms fall out of the market. The current environment will prove to be the acid test of the quality of different private equity managers. Selectivity, expertise and a risk management mindset make all the difference.

The era of zero-interest rates is likely to be squarely behind us. The reduction in excess liquidity instils selection and pricing discipline and reduces competition, all good things for our industry.

The key to alpha generation in private equity lies in asset selection and value creation through active ownership during the holding period. Yes, the base rate will be higher than in the last decade, but the capital supply/demand dynamics for deal entry will become better, since the market will be less crowded, in other words less noisy. Because of these two factors, I don’t believe that private equity outperformance during the next decade should diminish compared with the prior level, just because of the rate increases.

In the last decade, the overall financing environment was buoyant because of the abundant supply of money.

When the COVID-19 pandemic hit in early 2020, the global credit market froze for a short period of time. Central banks reacted promptly and flooded the market with liquidity, which gave a boost to the already abundant liquidity available.

As inflationary fears seeped into the market at the beginning of 2022, the credit market cooled somewhat. Then the Russian invasion of Ukraine in February last year compounded the inflationary fears because of the impact on energy supply. The central banks started an aggressive set of interest rate increases. The credit market found it difficult to price deals with increased macro and geopolitical uncertainties, and as a result the borrowing cost base and borrowing margins accelerated quite a lot last year.

More recently, the sentiment has improved as the end point of the rate increase is closer. Also banks wrote off their losses at the end of last year, and have been more active this year compared with the majority of 2022 and private credit players have increased activity as volatility subsided. Consequently, the credit spread has narrowed quite a bit. It is currently only about 50-75 basis points higher than during the pre- rate hike period. You may have seen the headlines recently about some very large financings completed, which suggests renewed strength on the financing front.

In the traditional bank syndicated market (the vast majority of the lending market), covenant-lite remains the standard while that market’s accessibility responds to the market volatility. For example, it was closed for a month here and a month there during the height of volatility through Q2-Q4 last year. In the private credit lending market (the minority component of the lending market), there was an increased use of financial covenants (leverage covenants) during June to December last year, and more recently covenant-lite has made a comeback

My personal estimate is interest rates will probably peak in Q3 and be held at those levels until at Q2 2024, after which time the rates are expected to come down. However, you will not see a cascade of money coming into the market upon stabilisation of inflation and interest rates.

The inflation target could well be higher than the 2% level going forward. My take is that steady state inflation is likely to be around 3% in the USA and probably slightly lower at 2.5% for Europe.

Interest rates will come down from current levels but it is unlikely for base rates to go back down to the ultra-low levels of the past decade as I don’t believe that quantitative easing will come back for some time.

At Advent, we focus closely on the dynamics of the debt markets and how our portfolio companies might be impacted. We want to make sure that we are putting in place the appropriate capital structures in our companies so that they are well-equipped for both favourable and more difficult macroeconomic times.