In basic terms, the federal funds rate refers to the target rate that commercial banks borrow and lend their cash reserves overnight. The federal funds rate influences short-term treasury interest rates and indirectly affects everything from home and automobile loans to credit card rates.
This month the Federal Open Market Committee increased the federal funds rate by 25 basis points (.25 of a percent) from .25% to .50% and it is expected by the end of 2022 the federal funds rate will be close to 3.0%.
If treasury yields follow suit (all indications are that they will) then the risk-free rate of return will increase as the federal funds rate increases. This is important since the risk-free rate is a component of an investor’s overall discount rate.
So, how does this impact private company valuations? All things being equal and in simplified terms, a 20% discount rate can translate to a 5x EBITDA multiple and if the discount rate increases by 3% due to the increase in the federal funds rate, a 5x multiple turns into a 4.3x multiple and has the effect of decreasing valuations.
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