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Defaults on loans to risky borrowers, a lifeline for private equity-owned firms, have risen by 250 percent, according to the Bank of England, which warned that the sector “faces challenges in the higher interest rate environment.”
Global defaults on leveraged loans rose by 5 percentage points, from around 2 percent at the start of 2022 to around 7 percent, the BoE said on Thursday in its half-yearly Financial Stability Report. According to the central bank, about 73 percent of these types of loans are made to companies backed by private equity. There is still some way to go before defaults on leveraged loans reach the 12 percent peak reached during the financial crisis, it added.
The BoE is concerned that risks in private equity – which now backs companies employing 10 percent of the UK private sector workforce, or around 2 million people – could spill over to the rest of the economy.
“The global banking system is significantly exposed to PE activity. Such exposures could lead to credit losses for banks,” said the report, which details what the BoE considers to be the key 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 regulators within the Prudential Regulation Authority are already pushing banks to better understand and manage their private equity risks. The BoE on Thursday reiterated a call for lenders to increase their transparency around valuation practices and overall levels of debt.
The warning comes as Britain heads towards a general election on July 4. The Labor Party, widely predicted to win with a majority, has the private equity industry in its sights. It wants to increase taxes on carried interest, the performance fees fund managers receive from asset sales.
Assets managed by private equity groups have quadrupled to $8 trillion over the past decade, thanks in part to record-low interest rates that have driven investor funds into the sector and made buying companies cheap. As a result, buyout groups have become increasingly integrated with different parts of the economy and provide a lucrative source of fees for banks.
“Vulnerabilities due to high leverage, opaqueness around valuations, variable risk management practices and strong connections to 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 sluggish market for dealmaking and initial public offerings have made it harder for private equity funds to sell or list companies. At the same time, growing demand from investors to return capital has forced companies to turn to “unconventional approaches,” such as net asset value financing and dividend recapitalization, 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 is provided by banks. Layers of leverage expose lenders to risks at the portfolio company level, at the fund level and at the end-investor level,” the report said.
The BoE acknowledged that private equity groups have played an “important role” in providing finance to British companies and said companies owned by buyout groups account for around 5 percent of the UK’s private sector revenues.
It also highlighted that hedge fund leverage has reached a four-year high, particularly for fixed income relative value strategies, which the report said makes them vulnerable if repo markets tighten or other firms are forced to rapidly unwind their positions.