Bank of England warns of systemic risk from private equity

Private equity-owned companies unable to repay pre-crisis leveraged loans could lead to widespread defaults, according to the Bank of England - although it also said the industry could play a role in restructuring companies in difficulty.

There is a significant ‘hump’ of debt maturities relating to pre-crisis leveraged buyouts that could pose a risk to UK financial stability, the Bank of England warned on Thursday.  

In a report, David Gregory, of the Bank’s Markets, Sectors and Interlinkages Division, warned that private equity-owned businesses in the UK are servicing £160 billion (€185 billion; $239 billion) of debt, £32 billion of which will need to be refinanced by 2015. That could spark widespread insolvencies and defaults, with follow-on implications for the banks that issued that debt. 

“There is a need to remain alert to any return to the debt levels used on acquisitions in the run-up to 2007-2008 crisis,” Gregory warned. The Financial Policy Committee, which will be formally established within the Bank of England to protect the stability of the financial system in the UK, “will continue to monitor potential risks to financial stability from private equity sponsored activity”, he said. 

There is a need to remain alert to any return to the debt levels used on acquisitions in the run up to the 2007-2008 crisis.

David Gregory

The British Private Equity & Venture Capital Association quickly responded to the warning on Thursday, maintaining the Bank was missing the point about leverage levels. 

“What matters is a sustained ability to service that debt, whilst at the same time driving investment and creating jobs. Any ownership model will have its failures but research clearly shows that private equity-owned businesses are less likely than others to become insolvent and are better at financing themselves appropriately for the long-term interests of their investors,” said BVCA chief executive Mark Florman. “Private equity is emphatically part of the solution, not part of the problem.”

The Bank did point out that there may be an “important role for buyout funds to play in promoting economic recovery” by taking over struggling companies and restructuring them.  Activity in the UK buyout market is, however, subdued, the report found. “In contrast with the US, where many investors report that the buyout market is showing new signs of activity, the market in the UK remains less active than before 2008,” Gregory said. 

Private equity-owned businesses represent about 5 percent of the corporate sector by total assets but account for 8 percent of the total corporate debt, according to PEI sister publication Private Debt Investor, which reported on the bulletin earlier Thursday. Private equity-owned companies were therefore on average more highly-levered than other corporates. 

The report found a significant factor in the dramatic increase in the quantity of buyout debt was the ‘originate to distribute’ model. Banks originating leveraged loans became less focused on the inherent risks of the transaction and more focused on collecting arrangement fees. 

Private equity is emphatically part of the solution, not part of the problem.

Mark Florman

“The growing importance of larger deals coincided with a loosening in credit conditions on lending used to fund acquisitions by private equity companies. Banks started to relax both the price and non-price terms and conditions of these loans in order to compete for business,” it said. 

The Bank of England did argue leverage can have a positive impact on a company. Greater leverage means regular and higher interest payments, reducing ‘free’ cash flow. Lower free cash flow can help to exert discipline on company management by removing resources that could otherwise be used to invest in negative net present value projects, the report suggested.

Bank of England is far from alone in raising warnings about private equity and systemic risk. Regulations in Europe and the US that would restrict or more strictly monitor private equity activity have been launched to combat so-called systemic risk. For example, the US Dodd-Frank Act’s Volcker rule severely limits banks’ ability to house or run private equity operations, in part because of concerns about the risks posed by private equity on banks’ balance sheets. 

Magda Ali contributed to this report.