Rising Rates, Rising Risk: How The Fed’s Rate Hike Could Increase Litigation Risk For Private Equity Firms

The Federal Reserve recently raised its benchmark rate by a quarter point, its first increase in more than three years. The Wall Street Journal’s verdict is that rising rates will make private equity’s bad year a lot worse. Maybe. Maybe not. One thing the rate hike is likely to do, however, is increase the risk of litigation for private equity firms.

While a single 25-basis-point move by itself is not likely to break a portfolio, 16 of the 18 officials who submitted projections expect another increase, and four of them see two more as possible. In times like these, litigation often follows. That litigation tracks a predictable sequence: disputes with limited partners come first, then conflicts with and between lenders, then counterparty claims, and finally, estate fiduciaries.

Private equity firms should be building their defenses now.

Stressed PE markets tend to breed litigation—be aware of the common pressure points

The industry entered this hike already strained. Per PitchBook, middle-market exits totaled just USD24.7B in the second quarter and median U.S. existing hold times have drifted up to roughly 4.2 years. Distributions to paid-in capital also remain below historical averages and Bain recently counted a backlog of roughly 32,000 unsold portfolio companies.

The stress has largely been deferred to this point through payment-in-kind (PIK) toggles, amend-and-extends, net asset value (NAV)-based credit facilities, and out-of-court restructurings. These deferral strategies largely assume the cost of capital will fall before the runway ends. The Fed’s latest decision—and future rate increases on the horizon—may challenge that assumption.

Each additional hike raises portfolio-company interest expense and likely weakens the financial statements buyers will scrutinize. Funds with strong NAV lenders, well-structured hedges, and diversified portfolios face a different risk profile, but the industry as a whole is moving closer to the point where deferral stops working and someone has to absorb the loss.

Here are five pressure points for private equity firms to evaluate before any litigation starts:

Continuation vehicles are now hindsight targets from both directions.

Continuation vehicles (CVs) have been the industry’s pressure valve. General partner (GP)-led secondaries, led by CVs, reached USD106B in 2025, up from USD71B in 2024 per Evercore. They are also among the most conflicted transactions a sponsor executes because the GP is simultaneously seller, buyer, and valuation authority. Accordingly, limited partner advisory committee (LPAC) consent thresholds, independent valuation support, and conflict-waiver mechanics matter more now than ever.

Regulators have also noticed. The SEC’s enforcement division is reportedly examining CV conflicts, valuation methods, and whether investor disclosures are adequate, and state attorneys general with large public pension LP exposure are an emerging enforcement consideration. Private plaintiffs are also active: in late 2025, an Abu Dhabi sovereign wealth fund sued a U.S. PE sponsor over a proposed CV transaction in the Delaware Court of Chancery.

Rising rates sharpen this exposure. A wider gap between buyer and seller expectations makes any CV price more contestable after the fact, and the attack can come from either side. If the asset outperforms, exiting LPs will say it was sold too cheaply. If it deteriorates, rolling and new investors will say they overpaid. Deal features that looked routine at signing may draw scrutiny.

Your marks are evidence.

Higher rates mean higher discount rates and higher discount rates mean the marks in your quarterly reports may be aging poorly. In litigation, every valuation memo, LPAC presentation, and fundraising deck is a potential exhibit. The questions plaintiffs will ask are simple: What did the sponsor know about value, and when did the investors learn it?

That litigation has already started, and it is likely to increase. The first quarter of 2026 brought several class actions against business development companies (BDCs) alleging false or misleading statements, including understated credit risk (per Kroll Bond Rating Agency). Sponsors should expect plaintiffs to use quarterly reports, investor presentations, and valuation memos as the primary evidence in these cases.

The fight moves inside the capital structure.

For sponsors that rely on private credit, the old assumption was that a small, cohesive lender group would negotiate rather than litigate. That assumption may be eroding. Non-pro-rata exchanges, uptier transactions, and drop-down financings invite claims that favored lenders extracted value at minority holders’ expense.

As of early 2026, 6.4% of private credit loans carried “bad PIK” (i.e. PIK added by amendment after origination)—nearly triple 2021 levels. Every additional hike pushes more borrowers from cash-pay to PIK and more lender groups toward the transactions and lawsuits that follow.

Signed deals and earnouts.

Deals signed before the Fed’s recent rate increase were priced against a different rate outlook. Some buyers will try to renegotiate and a few will try to walk. Changes in interest rates generally fall within the general-economic-conditions carve-outs of material adverse effect (MAE) definitions, and since Akorn v. Fresenius, Delaware’s MAE standard has been difficult to meet. 2018 WL 4719347 (Del. Ch. Oct. 1, 2018). But, the analysis is always fact-specific, and idiosyncratic rate sensitivity in a particular sector may not fit neatly within a general-conditions carve-out.

Buyers are therefore more likely to test financing conditions, interim operating covenants, and closing deliverables. Earnouts tied to earnings before interest, taxes, depreciation, and amortization (EBITDA) targets that assumed cheaper capital will produce a steady stream of accounting and good-faith disputes.

The retail channel raises the stakes.

The push to open 401(k) plans to private markets also gives this rate cycle a new class of plaintiffs. On January 16, 2026, the Supreme Court agreed to hear Anderson v. Intel. Docket No. 25-498 (October Term 2025/2026). That case will decide whether plaintiffs challenging underperforming plan investments must plead a “meaningful benchmark” as a comparator. If the Court lowers the pleading bar, rate-driven underperformance in products with private equity exposure cases will likely see a meaningful uptick.

What to do before the next hike

Market indications are that the latest hike won’t be the last rate hike in the near term. Another hike will only increase litigation risk. Here are steps to consider taking before the next rate hike and before any litigation begins:

• Treat every CV as a future litigation exhibit. Run a real market check, obtain independent valuation support, give the LPAC time and complete information, and make sure existing LPs and incoming buyers see the same data. If your firm has not engaged an independent valuation advisor for each CV in the last 12 months, start there.

• Paper your marks contemporaneously. When rates move, document that valuation assumptions were revisited and why they changed or held. Every quarter-end should produce a written record showing the inputs used, the discount-rate adjustment, and the rationale. These should be prepared before, not after, an LP inquiry.

• Audit your credit documents. Review sacred-rights provisions, pro-rata sharing clauses, and anti-LME protections across the portfolio before a lender group tests them. Assign a lawyer to each credit facility with instructions to flag any provision that could permit a non-pro-rata exchange or uptier without unanimous consent.

• Run and retain a solvency analysis before any distribution. A dividend or fee that looks routine today will be judged against the balance sheet two to four years from now. Engage an independent financial advisor to prepare the analysis.

• Stress-test pending deals. For anything signed but not closed, revisit financing conditions, interim covenants, and earnout mechanics against a scenario where rates are 50 to 75 basis points higher at closing. If the deal economics do not survive that stress test, the negotiation needs to happen now.

• Read your insurance tower now. Directors and officers (D&O) and fund errors and omissions (E&O) markets have tightened considerably, and coverage that was available two years ago may no longer be. Confirm how current policies respond to LP claims, regulatory investigations, and insured-versus-insured exclusions, and begin the renewal conversation early enough to fill any gaps before notice becomes urgent.

Additional tip: Consider the Texas dimension

The Texas Business Court now offers a credible alternative to Delaware’s Court of Chancery for governance and transaction disputes. Its judges must have at least 10 years of complex business litigation or transaction-law experience, appeals go to the new Fifteenth Court of Appeals in Austin, and the court has jurisdiction over corporate governance disputes, derivative proceedings, securities claims, and large commercial contract disputes.

Texas’s 2025 Texas Business Organizations Code (TBOC) amendments include provisions that may help: They codify the business judgment rule, permit exclusive forum-selection clauses designating the Business Court, and allow prospective jury trial waivers. For sponsors, that statutory framework is more protective of board decisions than Delaware’s current regime. For PE-backed portfolio companies headquartered in Texas, litigating where the business operates, where witnesses reside, and where documents are located offers practical advantages. The Texas Business Court is certainly worth consideration.

The firms that come through this cycle intact will be the ones that built a defensible record before the lawsuits were filed.