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Interest Rate Cuts - How They Affect The Private Equity Markets

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An overlooked benefit of The Federal Reserve Board cutting interest rates by 75 basis points last week and an expected additional 50 points is the palatable benefit it has and will have for equity investments:

  • As money market, bond, and other debt instrument yields decrease there is a natural movement of capital to equity
  • A companies' cost of capital decreases, the required return on that capital is less, thus spurring investment
  • For companies with leveraged balance sheets, operating cash flow increases as debt service costs decrease
  • A declining interest rate environment generally tends to move equity earning multiples, and thus prices, upward -- in lower interest rate environments investors are willing to pay more for the same expected stream of future incomes
  • In today's economy, the cuts effects on equity values are almost self-fulfilling. The markets assume that in a lower interest rate environment equity values will increase because they have usually done so historically. Psychology is often as important as fundamentals in influencing market movements, and nothing has proven to be more beneficial psychologically than declining interest rates.

 

Further to this point, the noise of the chattering classes often drowns out the remarkable resiliency of American capital system. In America, there is an enormous institutional commitment to maintaining stability and fluidity to economic markets. Rarely do things, on a macro level, get out of balance either very badly or very exuberantly (or when there is exuberance, it is usually contained to a particular sector).

It is no accident that the United States is the unrivaled venture capital investment center of the world, and no accident that a significant plurality of most the leading technology companies in the world are American firms. Capital usually feels safe in the United States, and it is safe capital that inve sts in growth investments. Stable monetary policy, which Americans often take for granted, plays a key part in inculcating this sense of safety.

 


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