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Defaults on subprime borrowers, a lifeline for private equity-owned companies, jumped 250 percent, the Bank of England said, as it warned the sector “faces challenges in a higher rate environment”.
Global defaults on leveraged loans jumped 5 percentage points, from around 2 percent at the start of 2022 to around 7 percent, the BoE said on Thursday in its twice-yearly financial stability report. According to the central bank, about 73 percent of these types of loans are made to private equity-backed companies. There is still some way to go before leveraged loan defaults hit the peak of 12 percent during the financial crisis, he added.
The BoE fears that risks in private equity – which now backs companies employing 10 per cent of UK private sector workers, or about 2 million people – could spill over into 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 sees as the main risks to the UK economy. “The potential impact of losses on these exposures could partly reflect deficiencies in banks’ risk management practices.”
The central bank and its supervisors at the Office for Prudential Regulation are already urging banks to better understand and manage their private equity risks. The BoE on Thursday repeatedly called on lenders to step up their transparency about pricing practices and overall leverage levels.
The warning comes as the UK heads to a general election on July 4. The Labor Party, widely tipped to win a majority, has the private equity industry in its sights. He wants to raise taxes on carried interest, the performance fees that fund managers receive from asset sales.
Assets under management by private equity groups have quadrupled to $8 trillion over the past decade, helped by record low interest rates that have drawn investment funds into the industry and made it cheaper to buy businesses. As a result, redemption groups are increasingly integrated into various parts of the economy and are a lucrative source of fees for banks.
“Vulnerabilities from high leverage, opacity around valuations, volatile risk management practices and strong linkages 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 slow closings of deals and initial public offerings have made it difficult for private equity funds to sell or list companies. At the same time, growing investor demand for capital returns has forced firms to turn to “unconventional approaches” such as net asset value financing and dividend recapitalizations to free up cash and add more leverage to underlying assets.
“The securities market has several funding structures and layers of leverage, most of which are provided by banks. Layers of leverage expose lenders to portfolio company, fund and end-investor level risks,” the report said.
The BoE acknowledged that private equity groups played a “significant role” in providing funding to UK companies, saying businesses owned by buyout groups accounted for around 5 per cent of UK private sector income.
She also pointed out that hedge fund leverage has hit a four-year high, particularly for relative-value fixed-income strategies, which she said makes them vulnerable if repo markets tighten or other firms are forced to quickly exit positions.