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Defaults on loans to risky borrowers, a lifeline for companies owned by private equity, have leapt 250 per cent, the Bank of England said as it warned that the sector was “facing challenges in the higher rate environment”.
Global defaults on leveraged loans jumped 5 percentage points, from about 2 per cent in early 2022 to about 7 per cent, the BoE said on Thursday in its twice-yearly Financial Stability Report. About 73 per cent of these types of loans are extended to companies backed by private equity, according to the central bank. There is still some way to go before defaults on leveraged loans reach the peak of 12 per cent hit during the financial crisis, it added.
The BoE is concerned that risks in private equity — which now supports companies employing 10 per cent of workers in the UK’s private sector, or about 2mn people — could spill over to the rest of the economy.
“The global banking system has significant exposure to PE activity. Such exposures could lead to credit losses for banks,” said the report, which details what the BoE considers to be the main risks to the UK economy. “The potential impact of losses on these exposures could in part reflect weaknesses in banks’ risk management practices.”
The central bank and its supervisors within the Prudential Regulation Authority are already pressing banks to better understand and manage their risk when it comes to private equity. The BoE on Thursday repeated calls for lenders to bolster their transparency around valuation practices and overall levels of leverage.
The warning comes as the UK heads for a general election on July 4. The Labour party, which is widely predicted to win by a majority, has the private equity industry in its sights. It wants to increase taxes on carried interest, the performance fees that fund managers receive from asset sales.
Assets managed by private equity groups have quadrupled over the past decade to $8tn, helped by record-low interest rates that drove investor funds into the industry and made buying up businesses cheap. As a result, buyout groups have become increasingly integrated with various parts of the economy and a lucrative source of fees for banks.
“Vulnerabilities from high leverage, opacity around valuations, variable risk management practices and strong interconnections with riskier credit markets mean the sector has the potential to generate losses for banks and institutional investors,” the report said.
Higher interest rates and a slow dealmaking and initial public offering market have made it more difficult for private equity funds to sell or list companies. At the same time, growing demand from investors to return capital has forced firms to turn to “unconventional approaches”, such as net asset value financing and dividend recapitalisations, to free up cash, adding more leverage to the underlying assets.
“The PE market has multiple financing structures, and layers of leverage, much of which are provided by banks. Layers of leverage expose lenders to risks at the portfolio company level, at the fund level, and at end-investor level,” the report said.
The BoE acknowledged that private equity groups have played a “significant role” in providing funding to UK companies and said businesses owned by buyout groups account for approximately 5 per cent of UK private-sector revenues.
It also highlighted that hedge fund leverage has hit a four-year high, particularly for fixed-income relative-value strategies, which it says makes them vulnerable if repo markets tighten or other firms are forced to quickly unwind positions.
