UK Finance Regulator Warns Banks about Private Equity Lending

Alarm bells appear to have been ringing recently at the Bank of England’s banking watchdog arm, the Prudential Regulation Authority (PRA). The area of concern the PRA have is that it appears that banks have few or no risk policies in place to efficiently monitor their aggregate financial exposure to the UK’s burgeoning private equity (PE) industry.

UK private equity assets have grown from £2 trillion to £8 trillion in the past decade and PE owned businesses now employ nearly 2.2 million people with a further 1.3 million indirectly involved in the sector. This growth has come about largely as a consequence of the low interest rate environment that existed between 2009 and 2022 creating extremely attractive opportunities for PE sponsors to raise capital for acquisition purposes. As the PE sector has grown in recent years so has the array of ‘non traditional’ forms of financing options being offered by banks directly or indirectly via the private credit markets.

In order to understand the PRA’s current concerns regarding the growth of PE in the UK it is necessary to re-examine the root causes that led to the 2007-08 financial crisis. Prior to the financial crisis many unregulated non-bank financial institutions (shadow banks) which included hedge funds, private equity funds, structured investment vehicles and large investment banks were excessively exposed to the subprime US mortgage market. In addition many of these institutions were responsible for the creation of the complex mortgage securitization products that led to the wider ‘credit crunch’ scenario developing.

When the US subprime mortgage market began to collapse the opacity and interconnectedness of those debt securitization products led credit markets to freeze lending due to the uncertainties in assessing counterparty risk resulting in the subsequent global financial crisis. The PRA and other global bank regulators now fear that the $12 trillion global private equity market which is also known for its opacity and complex financial structures has become a potential systemic threat to future financial stability.

The PRA have recently completed a thematic review of UK regulated banks and have concluded that most banks have serious risk management deficiencies in respect of their lending to the private equity sector. Regulated banks provide finance at each stage of PE investment process. They provide ‘downstream’ lending to companies that are owned by private equity firms, ‘midstream’ lending to the private equity funds themselves and ‘upstream’ lending to the PE funds limited partners (investors). The thematic review of private equity regulated bank lending found that in most cases banks were not in a position to readily calculate their overall risk exposure to PE funds given the numerous funding conduits they may be exposed to.

The current evolution of the PE industry and the growing complexity and inter-connectedness of funding options available to it has led to a growing lack of transparency about the source and degree of leverage entering the system. According to Nat Benjamin, a member of the Bank of England’s Financial Policy Committee in a speech given at Bloomberg on 22 April 2024, PE vehicle sponsors are now using novel financing arrangements such as Net Asset Value Financing to further increase leverage to provide liquidity to pay dividends to investors or repay debt – essentially leveraging already leveraged assets.

The PRA are aware that the private equity industry is now of sufficient size that any failure in the sector could pose risks to the UK’s wider financial stability by impacting systemic institutions, systemic markets and wider funding channels. Although the PRA recognise that insurers and pension funds have some exposure to private equity risks they are more concerned that any deterioration in the UK’s macro-outlook could have serious consequences for the regulated banking sector who appear to not be managing their PE counterparty risk and credit exposures sufficiently - as detailed in the PRA’s ‘Dear Chief Risk Officer’ letter sent to all banks on 23 April 2024.

The PRA's initial findings from their thematic review of private equity bank lending indicate that the current risk criteria used by the banks may well be inappropriate given the prevailing macro-economic conditions which have changed significantly in the past two years with multiple increases in the bank base rate together with a deteriorating global geopolitical backdrop. It seems likely that the next steps in the PRA's review will be to set up a consultation process with the banks with the aim of re-evaluating and stress testing their PE sector risk models to ensure capital adequacy requirements are maintained.