Are private equity investments riskier in the current interest rate environment?

Private equity has spent much of the past decade operating in an unusually favorable financing environment. Cheap debt supported aggressive dealmaking, rising valuations helped managers exit investments, and abundant investor capital allowed firms to raise ever-larger funds.

Higher interest rates challenge each part of that model.

The immediate problem is straightforward: debt becomes more expensive. But for wealth advisors, the more important issue is what happens when higher financing costs collide with elevated purchase prices, slower exits, refinancing needs and an increasingly crowded private-equity market.

The result can be a much longer investment cycle—and potentially a much longer wait for investors to receive their capital back.

That matters because private equity is not simply another allocation on a portfolio statement. It is a long-duration commitment whose liquidity, valuation and return profile are deeply influenced by the availability and cost of credit.

The Private-Equity Model Is Highly Sensitive To Rates

Private-equity firms generally raise capital from pensions, insurers, endowments, family offices and wealthy individuals, then combine that equity with debt to acquire companies.

The companies themselves typically carry much of the borrowing used to finance an acquisition.

That leverage is central to the private-equity model. If the acquired company grows earnings, pays down debt and can eventually be sold at an attractive valuation, equity investors can earn a substantial return.

Higher interest rates complicate all three parts of that equation.

First, companies with floating-rate debt face higher interest expenses. More cash goes toward servicing debt rather than investing in operations, making acquisitions or distributing capital.

Second, refinancing becomes more expensive. A company that borrowed when rates were considerably lower may discover that refinancing its debt materially increases its annual interest burden.

Third, prospective buyers face the same financing problem. If the cost of borrowing rises, buyers generally have less capacity to pay high prices for acquisitions.

That creates an uncomfortable mismatch for private-equity managers: sellers may want yesterday’s valuations while buyers are financing today’s interest rates.

The Exit Problem May Be More Important Than The Financing Problem

It is tempting to view higher rates primarily as a debt-service issue. For private equity, however, the exit market may be just as important.

A private-equity fund ultimately needs to monetize investments. Historically, that has often meant selling portfolio companies to strategic buyers, selling to another financial sponsor or taking a company public.

When rates rise, buyers typically reassess what they can afford.

A company that appeared reasonably priced when financing was inexpensive can look considerably less attractive when the buyer has to finance the acquisition at a higher interest rate. Even if the company’s operating performance has not changed, the economics of the transaction can.

This helps explain why private-equity managers have accumulated so-called “zombie funds”—older funds whose investments have remained unsold well beyond the timetable investors originally expected.

The reported value of these stuck assets has reached approximately $349 billion.

For advisors, the important distinction is between reported valuation and realizable liquidity.

A portfolio company can continue to be carried at an apparently reasonable valuation while remaining difficult to sell at that valuation. Until a transaction occurs, investors do not have the same certainty about the price or timing of the eventual realization that they would have with a publicly traded security.

That distinction deserves more attention in client portfolio reviews.

The $349 Billion Logjam Can Become A Fundraising Problem

The consequences extend beyond existing investments.

Private-equity managers depend on successful realizations to demonstrate performance and return capital to limited partners. Those distributions help investors commit capital to subsequent funds.

If exits slow, investors receive less cash.

That can create a feedback loop.

Fewer distributions can make limited partners more cautious about committing to new funds. Lower fundraising can constrain private-equity managers. Meanwhile, managers may have to spend more time managing older portfolios rather than deploying capital into new opportunities.

The industry’s economics can also become more complicated because management fees are typically tied to assets under management or committed capital. A prolonged fundraising slowdown can therefore affect the revenue model of private-equity firms themselves.

For wealth advisors, this is an important reminder that private-equity exposure should not be evaluated solely by looking at the underlying companies.

The health of the fund manager, fundraising environment and exit pipeline matters too.

Private Credit Adds Another Layer Of Complexity

The relationship between private equity and interest rates becomes even more important because many large alternative-asset managers now operate substantial private-credit businesses.

Private credit initially benefited from the higher-rate environment because floating-rate loans generated higher yields.

But the same characteristic that makes private credit attractive in a rising-rate environment can create stress for borrowers.

Companies owned by private-equity sponsors may simultaneously face higher interest costs on their acquisition debt while depending on private-credit lenders for additional financing or refinancing.

If earnings weaken, leverage becomes more difficult to manage.

That does not mean every private-credit portfolio is heading toward widespread distress. Credit quality, covenant structures, industry exposure, sponsor support and collateral all matter.

But it does mean advisors should resist treating private credit as a simple extension of traditional fixed income.

The underlying borrower economics deserve examination.

AI Is Creating A Second Risk Channel

Interest rates are not the only pressure facing private equity.

Some managers have substantial exposure to software companies whose business models could be disrupted by artificial intelligence.

That creates an unusual convergence of risks.

A private-equity sponsor may own a highly leveraged software company purchased at a valuation that assumed durable recurring revenue and strong future growth. If AI changes the economics of the software market, the company’s growth assumptions may need to be revised at precisely the moment when higher borrowing costs are reducing financial flexibility.

The issue for advisors is not whether AI will ultimately create more winners than losers.

It is whether a particular portfolio company can maintain its expected cash flow, competitive position and debt-servicing capacity during a period of technological disruption.

That is a much more useful diligence question.

What Advisors Should Ask About Private-Equity Allocations

For advisors, the current environment argues for moving beyond the question, “What is the fund’s reported return?”

A more useful review starts with liquidity.

When is the capital realistically expected to come back?

Fund documents may specify a nominal investment period and fund life, but those dates should not be treated as guarantees of liquidity. Advisors should examine the age of the fund, the percentage of unrealized investments and the manager’s recent realization activity.

Next comes leverage.

How much debt sits beneath the portfolio companies, and when does it mature?

The relevant information includes floating-rate exposure, hedging arrangements, interest coverage, maturity schedules and refinancing requirements.

Then comes valuation.

What assumptions support the current carrying values?

Advisors should understand whether valuations depend primarily on higher earnings, comparable-company multiples, transaction multiples or other assumptions. A stable reported NAV does not necessarily mean economic risk has remained stable.

Finally, examine the manager.

Is the sponsor generating actual realizations, or primarily extending holding periods?

A manager with strong operating results but few realizations presents a different liquidity profile from one consistently returning capital to investors.

Portfolio Construction Needs A Liquidity Budget

Private equity can play a legitimate role in a diversified portfolio, but its illiquidity should be explicitly budgeted.

This becomes particularly important for high-net-worth clients who may have multiple private-market commitments across several vintage years.

One fund may appear manageable in isolation. Ten funds can create a very different liquidity profile.

Advisors should therefore aggregate private-equity, private-credit, venture-capital, real estate and other illiquid commitments when assessing the client’s overall liquidity exposure.

The key question is not simply how much the client has allocated to alternatives.

It is how much capital could be unavailable precisely when public markets are under pressure and the client may want to deploy cash elsewhere.

That distinction becomes especially important for clients approaching retirement, making large capital purchases or relying on portfolio distributions.

Prepare Clients For Time, Not Just Volatility

Public-market investors are accustomed to thinking about risk through price volatility.

Private-equity investors experience a different form of risk: time.

A stock can fall 20% and remain liquid. A private-equity investment can maintain a relatively stable reported valuation while remaining inaccessible for years longer than expected.

That makes communication critical.

Advisors should set expectations around the possibility of delayed exits, refinancing challenges and distributions that arrive later than originally anticipated.

The conversation should also distinguish between a delayed realization and a permanent impairment. They are not the same thing.

At the same time, a delayed exit should not automatically be interpreted as evidence of superior long-term value. Time itself has an economic cost, particularly when investors could have deployed the capital elsewhere.

The Strategic Question For Advisors

The higher-rate environment does not make private equity irrelevant. It changes the conditions under which private equity must be evaluated.

The era of easy financing allowed leverage and valuation expansion to do substantial work for private equity returns. A more expensive cost of capital puts greater emphasis on the fundamentals of the underlying businesses: organic earnings growth, cash generation, competitive advantages and sensible capital structures.

That shift can ultimately separate stronger investments from deals whose economics depended heavily on cheap debt and rising valuations.

For advisors, the practical response is not to make a blanket judgment about private equity.

It is to become more granular.

Review the vintage. Examine the leverage. Understand the refinancing calendar. Track realizations rather than relying exclusively on reported NAV. Assess manager fundraising and distribution activity. Stress-test liquidity across the client’s entire private-market portfolio. And identify which portfolio companies face additional structural risks from technological change.

Private equity was built around the idea that patient capital can create value.

Higher interest rates are testing how much of that value comes from the businesses themselves—and how much depended on favorable financing conditions.

For wealth advisors, that is ultimately the more important question.