If you are diversifying your portfolio and considering branching out into private investments, it’s important to understand how they perform in various market conditions. Interest rates are currently having a key impact on real estate, private investments, and the public market.
Private investing means purchasing shares in privately held companies, either at the individual level or through private investment pools. Returns depend on company performance, which often depends on the skills and experience of company managers and the given market the company targets. Although this type of investment comes with reduced liquidity, often private placements will earn higher rates of return. This is referred to as the "liquidity premium." Understanding your risk and liquidity profile is essential for choosing the right mix of asset classes for you. If that includes private investments, you need to know how they are impacted by interest rates.
The Fed uses interest rates as a way to influence economic activity, inflation, and labor markets. When there are concerns about inflation, increasing interest rates can help slow the economy by restricting the amount of money that businesses borrow, slowing down hiring, and reducing consumer spending. Conversely, when the economy stagnates, the Fed may cut interest rates as a way to incentivize investment and stimulate economic growth.
Rising interest rates can impact all types of investments in various ways. When interest rates go up, bond prices go down. When interest rates are high, it may be a good time to buy bonds, but it decreases the value of the bonds already in your portfolio. Rising interest rates can also impact stock prices, although less directly. Growth stocks often go down because higher rates slow down business growth as businesses are less willing to take on more expensive debt. The real estate market typically responds quickly to changes in interest rates. As rates go up, the market cools, and as rates go down, there is a lot more activity. This is largely due to the fact that most real estate is bought and sold using significant amounts of debt, which generally makes real estate very sensitive to interest rates.
Private investments—such as real estate syndications, private equity, venture capital, private debt, and life insurance settlements—behave similarly to the stock market. Both private equity firms and the businesses they manage are more reluctant to take on debt that is more expensive, which can lead to slower growth and lower returns. Company valuations also decrease with rising interest rates, making it more difficult to exit private investments. Private placements that use debt are also subject to risk in a rising rate environment, so be mindful of how much leverage your investment has and make sure it matches your risk profile.
However, rising interest rates also create unique opportunities for private investments to pick up distressed assets or to make timely investments at attractive entry points. For example, private equity managers thrive on purchasing businesses, improving them, and then selling them at a profit. When interest rates go up, competition for deals goes down, allowing some private equity firms to grow their portfolios if they can ride out this phase on the market. Be aware that lower competition can sometimes lead to more fierce bidding and higher purchase prices.
Private lending, or loans secured by real estate, can often charge a premium for making a non-bank loan when interest rates are high, as demand for capital goes up and banks likely curtail their lending desks. When diversifying your portfolio to include private investments, keep all of these factors in mind: risk level, liquidity, market impact, and portfolio balance.
Interest rate risk sensitivity and broader macroeconomic conditions were more impactful than most investors realized this past year. Evaluate what opportunities arise when interest rates go up. Where are investment returns likely a good value and what are your goals as an investor? Do you want passive income and stability? It might be worth exploring more fixed-income opportunities, either in traditional or private placements.