PE’s Black Friday

Every holiday season, consumers are subjected to a barrage of advertisements promising that everything from tricycles to luxury SUVs are—now, and for a limited time only—being offered at a discount that will never again be available.

Private equity firms ought to look at the Federal Reserve’s second round of quantitative easing the same way. However, they must be sure not to leave the lot behind the wheel of a lemon.

QE2, as it has been dubbed, will have the Fed purchasing billions of dollars in Treasury bonds over most of 2011—substantially less than the first round of quantitative easing that had the Federal Reserve gobbling up $1.7 trillion in debt from 2008 until early 2010. However, there is no set cap on what the Fed will buy. So the Fed may buy more than $600 billion in Treasuries over a longer timeframe, extending into 2012.

The Fed hopes to encourage lending to corporate borrowers to stimulate American job growth, all without spurring inflation or higher interest rates. However, these outcomes could be short-lived. Many economists believe that by holding short-term interest rates down, the Fed could inadvertently cause inflation, which in turn would push investors to demand higher interest rates. This could create a brief window of opportunity for PE firms willing to invest immediately.

Indeed, in the last six weeks since the program launched, long-term interest rates have risen. Economists reacted by encouraging investors to buy assets like homes and companies while long-term rates still linger near historic lows.

“When you have more, and cheaper, financing, you will see more deals done,” says Jeff Werbalowsky, co-chief executive of Houlihan Lokey.

This proved to be the case throughout 2010. Still, leveraged lending markets have been a lot less kind to financial sponsors over the last year than generally thought. LBO firms have been required to inject substantially more equity into deals following the end of the recession.

“Overall leverage is still lower than historic averages,” says Watts Hamrick, managing partner with Pamlico Capital, the North Carolina-based private equity firm. “But that is offset somewhat by historically low interest rates.”

Indeed, low interest rates have been one of the few saving graces in the leveraged lending market. If those go higher, PE firms may find themselves in the same quandary they did in late 2008.

“I think we have hit the top tick of the bond market,” Werbalowsky says. “If you can lock in financing, now is the time to do it.”

Jonathan Marino is the new editor of peHub.com and the daily Wire. The opinions expressed here are his own.