As the Fed Party Ends, Private Equity Prepares for the Hangover

The tightening macroeconomic environment poses challenges for an asset class that thrives on borrowed money.

Illustration by II

Illustration by II

Private equity survived and even thrived during the Covid-19 pandemic. But the asset class will face headwinds as interest rates rise.

Already there are signs of depressed returns. In the third quarter of 2021, returns — measured by the standard internal rate of return, or IRR — dropped to 6.8 percent, the lowest since the beginning of 2020. “Factors including soaring inflation, higher interest rates, slowing quantitative easing, and the prospect of quantitative tightening are swiftly changing the liquidity paradigm,” according to a report from PitchBook based on preliminary data for the fourth quarter. Returns dropped across all fund sizes and regions, but PitchBook did observe more resilience from funds in Europe and those under $500 million.

On Wednesday, the Federal Reserve announced that it planned to start the process of withdrawing the money it put into the economy at the start of the pandemic. At its two-day policy meeting, the Fed announced that it will cut $95 billion a month from its holdings starting in September.

“The tighter policy environment [is] putting downward pressure on risk assets and causing PE returns to normalize after several standout quarters driven by ultra-loose fiscal and monetary policies,” the report said. “Due to the bulk of sponsor returns coming from multiple expansion, the rising interest rate environment is likely causing multiples to flatten and returns to reduce.”

However, the authors of the report noted that, despite the drop in PE returns, the asset class experienced stronger performance than the public market. In the third quarter of 2021, PE returns outperformed the returns of both the S&P 500 and the STOXX Europe 600, the report said.

The asset class’s relative success was reflected in outsized commitments from some of the country’s largest public pension funds. In fact, as Institutional Investor previously reported, the country’s largest public pension plan, the California Public Employees’ Retirement System, allocated the highest percentage of capital to the private markets of any public pension plan in the U.S. In November 2021, the $489 billion pension announced that it would increase its private equity portfolio from 8 percent to 13 percent of total assets.


While PE returns slowed in the third quarter of 2021, the PitchBook report said that overall returns are still above the asset class’s five-year quarterly average. Meanwhile, in the fourth quarter of 2021, PitchBook said that preliminary data shows that private equity’s returns continued to moderate. “With the bulk of PE returns coming from RVPI marks, the inflationary and rising interest rate environment means discount rates are moving north, resulting in lower asset valuations,” the authors wrote.

Nevertheless, PitchBook authors reminded investors that “returns across PE are not monolithic” and the gap between the performance of the best and worst managers will continue into 2022.