Will the Fed Ease into QE3? (And, what’s it mean for PE?)

It’s tough to tune into an economics debate on TV these days without seeing a split screen and pundits on each side of it arguing the merits and metrics of a third round of quantitative easing. QE3 might come as early as this summer and—depending on which side of the screen you listen to—is necessary to save the U.S. economy from getting sucked into the European Union’s fiscal downdraft, or is yet another wrongheaded call to punt the proverbial can only further into the future. Aside from the debate around QE3—every day, we seem closer to needing it. It is the timing of its implementation that will drastically impact private equity firms’ investment strategies and capacity to achieve attractive lending terms. However, PE pros have no tea leaves to definitively read, less than a month away from the expected conclusion of QE2.

While, in recent months, Federal Reserve Chairman Ben Bernanke has done what he could to scuttle immediate expectations of another round of quantitative easing, he now faces a confluence of challenges. Home prices and home sales are down. Unemployment continues to hover over the U.S.’s recovery and manufacturing recently has plummeted. Treasury yields have fallen and, increasingly, experts and investors believe the Fed will not be able to raise interest rates in the next nine months. Any substantial and sustained downturn could land the American economy not too far from where it stood just over two years ago. And QE2—at an expected $600 billion, a fraction of the first round of quantitative easing, which totaled $1.7 trillion—is expected to conclude before Independence Day. Pundits seem to fear a U.S. economy without any lifeline.

In spite of this, one QE3 implementation scenario posed to peHUB doesn’t involve a near-term solution. Bob Snape, managing director with BDO Capital Advisors, suggested the Federal Reserve may wait until the beginning of 2012 to resume buying billions in Treasury bonds. If this is the case, Snape said, industries like energy, healthcare and tech (all already practically pecked to death by a litany of PE investors) should expect to fare well through the rest of ’11. Others, he suggested, probably shouldn’t.

But is that what PE buyers might want? Undoubtedly, the end of QE2 with no encore act would drive equities markets down. After all, financial sponsors can barely keep their mitts off listed consumer companies, eyeing and buying restaurants and retailers alike. That dry powder would mean much more in a market where strategics were scared off if financial sponsors can still lure sellers back to the bargaining table. But would it be worth the trade-off for what private equity firms would lose, in terms of their ability to amass debt for deals? For the KKRs, Blackstones and Carlyles of the world, they can probably afford a break between QE programs–the middle market, likely, would suffer more.

Another option is to simply extend QE2 until September, play wait-and-see and hope for greener pastures. Regardless of markets’ gag reflex in September upon the conclusion of QE2 with no immediate backup, the Federal Reserve (and jittery investors) would only have a three-month wait until the 2012 quantitative easing.

Given the aggregate reactions of homes, equities and hiring to the prospect of the QE2’s conclusion later this month, it is safe to say the Federal Reserve will have to act once again to buoy the American economy. It’s just a matter of when. Without more encouragement from poor economic indicators, it is unlikely the Federal Reserve will decide to plunge right into QE3 on the heels of QE2’s conclusion. But private equity firms looking to deploy capital should prepare to do so sooner, rather than later, as QE3’s arrival in 2012 might still come just in time for the Fed to raise interest rates.