What is the impact of higher interest rates on PE expected returns?

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The evolution of institutional private equity can usefully be understood as four broad phases.

The first phase was characterised by a relatively small and specialised industry. Competition for transactions was limited, operational improvements were substantial and skilled managers could acquire businesses at attractive prices.

The second phase saw the institutionalisation of private equity. Fund sizes increased, large institutional investors entered the market, and leverage became more widely available. Competition intensified, but the buyout model continued to benefit from favourable financing conditions and economic environment.

The third phase, which broadly spans the 2010s, was unusually favourable. Interest rates declined steadily, debt financing became exceptionally inexpensive and valuation multiples gradually expanded. Buyout managers therefore benefited simultaneously from operational improvements, cheap leverage and a supportive exit environment. These three forces reinforced one another and contributed materially to the strong returns observed during this period (public equity also did very well).

The fourth phase began with the sharp increase in interest rates from 2022 onwards. It should not be interpreted as the collapse of private equity. Many companies remain valuable and many managers will continue to perform well. The economic environment has nevertheless changed fundamentally. Financing costs have increased, valuation multiples have stopped expanding, exits have become more difficult, fund lives have lengthened, distributions remain weak and an increasing proportion of reported performance depends on unrealised NAV rather than realised cash.

This change can be illustrated using a bottom-up approach to estimating expected buyout returns.

Rather than extrapolating historical fund performance, I developed a framework that derives expected returns directly from the economics of a representative leveraged buyout. This methodology was adopted as the basis for BlackRock’s long-term expected return estimates for the asset class. The framework is presented in full in Chapter 8 of The Science of Valuation in Private Markets (Phalippou, 2026).

The key result is remarkably simple. The expected gross equity multiple of a leveraged buyout can be written as
MOIC = c + s * EY_0,

where (EY_0) is the entry earnings yield, or equivalently the inverse of the entry EBITDA multiple. The intercept (c) captures the effect of leverage and financing costs, while the slope (s) captures the contribution of operating growth, exit valuation, taxation and reinvestment through buy-and-build acquisitions. The complete derivation is provided in Chapter 8 of my book.

Table 1 applies this framework to a representative buyout under four different market environments. All scenarios assume identical leverage, operating characteristics and investment policy. Only financing costs, operating growth and exit multiples differ.

The comparison highlights several important points.

First, under conditions broadly representative of the 2010 decade, modest operating growth combined with inexpensive debt and moderate multiple expansion was sufficient to generate gross annual returns in excess of 20%.

Second, exactly the same company can generate materially lower returns simply because debt becomes more expensive and valuation multiples no longer expand. Nothing in the underlying operations has deteriorated. The difference arises entirely from changes in capital market conditions.

Third, gross buyout returns are not the returns received by the limited partner. A significant proportion of committed capital never reaches the underlying portfolio companies because it is absorbed by management fees, organisational expenses and other fund costs. As an illustration, Table 1 assumes that only 85% of committed capital is ultimately invested. Carried interest is then calculated on the profits generated after fees. Under these assumptions, a gross return of approximately 23% per annum is reduced to approximately 16% for the limited partner, while a gross return of approximately 13% falls to approximately 7%. The difference illustrates the economic significance of the fee structure rather than the precise outcome of any individual fund.

Finally, the calibration illustrates why the current environment represents a structural rather than temporary change. During the previous decade, relatively modest operating improvements could produce attractive buyout returns because cheap leverage and expanding valuation multiples contributed materially to performance. Today, a much larger proportion of the expected return must come from genuine organic growth in operating earnings. That is a considerably more demanding assumption for the asset class as a whole.

Historical returns earned during the previous regime therefore cannot simply be extrapolated. They reflected a combination of operating performance and exceptionally favourable capital market conditions that no longer prevail.

References

Phalippou, L. (2026). The Science of Valuation in Private Markets: How to Think about Price When You Buy to Sell. Independently published.

BlackRock Investment Institute. (2019). The core role of private markets in modern portfolios. BII In Depth, March 2019.