The popularity of private equity continues to grow, but with such recognition comes greater scrutiny. The asset class has gained the attention of the Bank of England’s Financial Policy Committee (FPC), which focuses on maintaining financial stability.
The committee’s review of private equity has concluded that the industry poses a risk to the UK’s financial stability.
Two aspects have been identified: there is a concern about the value of assets controlled by private equity companies and the amount of money lent against them, raising the risk of a dangerous chain reaction should values suddenly drop.
In minutes from its March quarterly meeting, the FPC said: “The private equity sector, which is closely related to private credit and leveraged lending, plays an important role in channelling finance to the UK real economy. Finance for riski er corporates could be vulnerable to a significant deterioration in investor risk sentiment.
“More recently, higher interest rates have made it more difficult for private equity funds to raise investment, contributing to downward pressure on asset valuations.”
The FPC then added: “The extent of transparency around asset valuations, overall levels of leverage, and the complexity and interconnectedness of the sector make assessing financial stability risks difficult and mean that risks need to be managed carefully by those in the sector and by their counterparties.”
Risk assessment
The FPC is now set to publish a further assessment of these risks in its June 2024 Financial Stability Report. But private equity trade body the British Private Equity and Venture Capital Association (BVCA) cautioned against viewing the industry’s use of private equity as dangerous.
Michael Moore, chief executive of the BVCA, said: “The private Equity (PE) model of active ownership focuses on delivering long-term growth. Where leverage is used, it is part of a capital structure appropriate to the business using it. Lenders are sophisticated commercial parties incentivised to ensure that the arrangements promote the company’s growth prospects.
“As we saw during the global financial crisis, the PE model is tried and tested. Private capital has been an important part of the UK economy for over 40 years, showing its resilience through different economic cycles.”
Bank officials also signalled that investors may be too optimistic about the economic recovery and interest-rate cuts. And Moore added: “They said: ‘asset prices are stretched’. The risk of a sharp correction in a broad range of asset prices has increased. Investors in financial markets expect the economy to continue to recover and inflation to fall. They are putting less weight on risks that might cause weaker growth or interest rates to stay higher than expected.
“That means there is a greater risk of a sharp fall in asset prices, making it more costly and difficult for UK households and businesses to borrow.”
It comes after years of private equity activity including takeovers and borrowing by the asset class, powered by cheap credit before interest rates began to rise in 2021.
It resulted in some of Britain’s biggest companies being backed by the industry. Banks are tightly regulated following the financial crisis, limiting their ability to make risky bets, but borrowing by PE is not directly controlled or monitored to the same degree.
This enabled private equity to take advantage of interest rates as low as 0.1%. The industry has boomed as a result. The FPC’s case does not stop with obscure minutes.
Its executive director for financial stability and risk, Nathanael Benjamin, put this case further during a speech in April. “Shining a light on the current dynamics in the private equity market is crucial at this juncture, given the important role the sector plays for the real economy,” he said.
Benjamin also mentioned how global assets under management in the private equity sector have rapidly increased to some £6.3trn in 2023 from around $1.6trn 10 years earlier.
“Developments in that market have the potential to disrupt the supply of funding to real economy companies in a stress. And to cause systemic institutions – such as banks – to experience significant and correlated losses on their exposures linked to private equity,” he added.
Benjamin said that the Bank is looking at the sector given how rates have risen, hitting highly leveraged companies backed by PE along with the lack of exit for private equity fund investments, putting pressure on valuations sold in secondary markets.
It does mean that the sector is under a serious spotlight.
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