Sunday, June 10, 2007

More On Interest Rates

This is from a Barron's interview with Shawn Kravetz, Founder and president, Esplanade Capital (subscription required).

Meaning we expect a slowdown, as opposed to a collapse. A lot of my concern boils down more broadly to rates. If interest rates remain in this ballpark, lots and lots of things will squeak by. But if we see a rate spike, the real-estate market will face even more risk, and that will have a substantial impact on consumption. People's discretionary income will fall dramatically as the cost of keeping a roof over their head rises. Lastly -- and this is very important -- the discount rate that we as investors use, and particularly what private-equity firms use to calculate their beloved terminal value -- the present value of future cash flows -- will go up, and the terminal value will fall. The private-equity put that has been so valuable of late across industries will start to wither. And the leverage that private-equity firms and hedge funds use to support some of these valuations will also go away. A lot hinges on what happens with rates, and we don't see any immediate spike in rates. But that's the one thing that most concerns us.

This is a very important point. Private equity is very important to the stock market right now. When a private equity firm is looking at an acquisition, they perform an analysis that calculates what all of the expected future cash flows are worth in today's dollars. One of the variables in this calculation is interest rates.

I don't know what the break-even point of rates is, and it probably varies from deal to deal. However, as rates increase expect the number of deals to drop.