This month, the Reserve Bank of Australia decided to keep interest rates on hold following some signs that inflation is easing – but is it? A raft of Government spending measures will soon hit the economy, add to this, the price of oil has rallied from its June low which place upward pressure on a range of prices for every day items.
In our view, the RBA would have been better served increasing interest rates again this month in a bid to avoid having to raise them even more in the near future. But the media, and now the Federal Government are placing so much pressure on the RBA to make popular decisions, the RBA effectively have their hands tied. The RBA’s best tool to combat inflation is interest rates, but if the Government just keeps handing out cash to combat the effects of higher interest rates, what do we expect to happen?
Investing in a high interest rate environment
We constantly speak to companies that are raising capital, and after a decade of low interest rates, we’re having difficult conversations with these companies trying to explain why valuations are so much lower in higher interest rate environments.
High interest rates provide cashed up investors with a significantly higher risk free investment returns. While interest rates were at their lows, investors turned to capital markets to generate a higher returns, and could access cheap funding to leverage their investments. This amount of cash flowing into capital markets resulted in company valuations artificially inflated. Fast Forward to today, following multiple, rapid interest rate rises, and investors are able to invest in secure, tier one companies offering high yield products with the added benefit of liquidity. Here are some of the ways high interest rates are impacting capital markets:
Cost of Capital
High interest rates generally mean that borrowing money becomes more expensive. This directly impacts investors cost of capital, especially venture capital and private equity firms that often rely on external funding sources to finance their investments. Higher borrowing costs can lead to reduced capital available for investments, making venture capital and private equity firms more cautious and selective in their investment decisions.
Valuations
High interest rates can lead to a decrease in the valuation of companies that are raising capital. As the cost of capital rises, investors expect higher returns to compensate for the increased risk. This can result in lower valuations for companies seeking funding, which might lead to companies receiving less funding for a greater equity stake.
Exit Environment
High interest rates can affect the overall health of the stock market and corporate borrowing, making IPOs less attractive or difficult to achieve. Additionally, potential acquirers may be less inclined to purchase startups when borrowing costs are high, which can limit potential exit opportunities for unlisted investments.
Investor Behaviour
Higher interest rates can alter investor behaviour and preferences. When interest rates are high, investors may seek safer, low-risk investment options such as bonds or other fixed-income assets, rather than taking on the higher risk associated with early stage investments. This shift in investor sentiment can reduce the amount of capital flowing into the capital markets.
Startup Growth
Startups often rely on debt financing to support their growth before they can become profitable. High interest rates can make it more expensive for startups to borrow money for expansion or operations, potentially hampering their growth prospects. This, in turn, may impact the attractiveness of early-stage companies to investors.
Industry Focus
In periods of high interest rates, investors may shift their focus toward industries that are less sensitive to interest rate fluctuations. Certain sectors, such as technology and biotech, may be more affected by interest rate changes due to their capital-intensive nature and long-term investment horizons.
Overall, high interest rates can create a challenging environment for capital markets, leading to decreased investment activity, lower valuations, and potential shifts in investment strategies. Conversely, in a low-interest-rate environment, capital markets generally experience increased activity, higher valuations, and a greater appetite for risk-taking among investors.
Savvy investors that understand how interest rates affect capital markets, can use higher interest rate to their advantage, invest in companies at lower valuations or enter the private credit markets where companies with strong cashflows look for debt, rather than dilute at lower valuations.
