UK Regulators
Increasing Focus on
Private Equity Leverage
October 2024
As the Private Equity (PE) industry has grown rapidly over the past decade, banks have become increasingly exposed to complex and inter-connected leverage structures employed by PE firms. In the UK, the financial services regulators (the Bank of England (BoE), the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)) are each considering the implications of this exposure. This greater regulatory scrutiny may lead to a tighter credit environment which PE firms will need to consider how to navigate.
Background
For large periods of PE’s expansion1, the sector has benefitted from a low interest environment that gave it easy access to cheap debt. As these benign economic conditions have receded, however, PE firms have faced a number of headwinds over recent years that have forced them to seek new ways of securing returns to their investors2. This has led to the growth of complex and interconnected leverage structures, as PE firms have increasingly used funding from banks in more creative ways. By contrast to the more traditional PE lending arrangements, these new structures involve banks having exposure across the structure – from direct lending to portfolio companies, to loans secured against those portfolio companies to the funds themselves and further financing to limited partners holding interests in those funds3. But against the backdrop of higher interest rates, regulators are concerned that these funding structures may have exposed banks to risks they do not fully understand.
The Regulators’ Views
1. The BoE
The BoE has focused on the potential macro-economic impact of these funding structures. In June of this year, the BoE’s Financial Policy Committee (FPC) explored the vulnerabilities that these structures might create for the UK financial system. The essence of the risk identified by the FPC lies in the type of credit funding PE relies on – over two thirds of PE-backed companies’ market based credit is from higher risk funding (such as high yield bonds, leveraged syndicated loans, and private credit lending), compared to a quarter for all firms in the UK4. This riskier financing creates vulnerability to market shocks and, as the FPC noted, the risk is potentially further amplified by PE-backed companies being highly concentrated in a small number of sectors (such as finance, insurance, and information and communications)5, creating the possibility that sector specific stress in one of these areas will disproportionately affect the wider PE industry. The BoE also believes that a downturn for PE firms could negatively affect banks and lead to a spillover effect of tightening credit conditions more generally6. The BoE has therefore welcomed further regulatory work examining these vulnerabilities7.
2. PRA
With these risks in mind, the PRA has focused on the ability of the entities it supervises to adequately account for their exposure to PE. In a thematic review of banks’ risk management practices in relation to PE, the PRA found some significant gaps in their approaches to and understanding of the risks8. As a result, the PRA has asked lenders to carry out a gap analysis of their current practices against the PRA’s expectations and to respond to the regulator with the results and, if applicable, a detailed remediation plan by 30 August9. Additionally, the PRA is reported to have asked certain individual firms to provide it with more detail on their exposures.
3. FCA
The FCA is responsible for regulating the activities of PE firms themselves. In light of concerns over transparency, its attention has focused on the techniques that the PE industry uses for valuing private assets. In March 2024, the FCA set out its supervisory strategy for asset management and alternatives, and among the different priorities outlined, it mentioned that it would be conducting a multi-firm review that examines the valuation processes used for private assets10. The FCA noted that a higher interest rate and tighter credit environment had put pressure on asset prices and that it was vital that private asset valuations were “robust and reliable in all market conditions”11. According to the Alternative Investment Management Association (AIMA), an industry association in the PE sector, the FCA began its multi-firm review in July of this year12.
The Regulators’ Views
1. The BoE
The BoE has focused on the potential macro-economic impact of these funding structures. In June of this year, the BoE’s Financial Policy Committee (FPC) explored the vulnerabilities that these structures might create for the UK financial system. The essence of the risk identified by the FPC lies in the type of credit funding PE relies on – over two thirds of PE-backed companies’ market based credit is from higher risk funding (such as high yield bonds, leveraged syndicated loans, and private credit lending), compared to a quarter for all firms in the UK4. This riskier financing creates vulnerability to market shocks and, as the FPC noted, the risk is potentially further amplified by PE-backed companies being highly concentrated in a small number of sectors (such as finance, insurance, and information and communications)5, creating the possibility that sector specific stress in one of these areas will disproportionately affect the wider PE industry. The BoE also believes that a downturn for PE firms could negatively affect banks and lead to a spillover effect of tightening credit conditions more generally6. The BoE has therefore welcomed further regulatory work examining these vulnerabilities7.
2. PRA
With these risks in mind, the PRA has focused on the ability of the entities it supervises to adequately account for their exposure to PE. In a thematic review of banks’ risk management practices in relation to PE, the PRA found some significant gaps in their approaches to and understanding of the risks8. As a result, the PRA has asked lenders to carry out a gap analysis of their current practices against the PRA’s expectations and to respond to the regulator with the results and, if applicable, a detailed remediation plan by 30 August9. Additionally, the PRA is reported to have asked certain individual firms to provide it with more detail on their exposures.
3. FCA
The FCA is responsible for regulating the activities of PE firms themselves. In light of concerns over transparency, its attention has focused on the techniques that the PE industry uses for valuing private assets. In March 2024, the FCA set out its supervisory strategy for asset management and alternatives, and among the different priorities outlined, it mentioned that it would be conducting a multi-firm review that examines the valuation processes used for private assets10. The FCA noted that a higher interest rate and tighter credit environment had put pressure on asset prices and that it was vital that private asset valuations were “robust and reliable in all market conditions”11. According to the Alternative Investment Management Association (AIMA), an industry association in the PE sector, the FCA began its multi-firm review in July of this year12.
Future Implications
The focus of all three regulators on leverage in PE suggests that it is an area of concern which could see future regulatory development. That being said, the actions taken so far indicate that regulators are still at a review stage and the direction of travel is far from clear. The FCA’s CEO, Nikil Rathi, recently cautioned against rushing to regulate the PE sector stating that he was “not convinced” that PE presented a systemic risk and that the regulators should not “go into overkill regulatory mode”13.
Future Implications
The focus of all three regulators on leverage in PE suggests that it is an area of concern which could see future regulatory development. That being said, the actions taken so far indicate that regulators are still at a review stage and the direction of travel is far from clear. The FCA’s CEO, Nikil Rathi, recently cautioned against rushing to regulate the PE sector stating that he was “not convinced” that PE presented a systemic risk and that the regulators should not “go into overkill regulatory mode”13.
Nonetheless, the increasing regulatory focus on leverage in the PE sector suggests that PE firms may face tighter credit conditions moving forwards. This could potentially manifest itself in two ways. Firstly, through a general reduction in banks’ exposure to PE and PE-backed companies, as some banks may seek to “de-risk” in response to the PRA’s focus on risk management. And secondly, through a reduction in direct lending specifically at the fund level, as private asset valuation techniques become subject to requirements for more transparency, potentially resulting in financing secured on a fund’s assets becoming trickier to obtain.
These tougher lending scenarios could present challenges to PE firms, but also opportunities, especially for other non-bank market participants to support funding or liquidity requirements of the PE industry.
This article was prepared with contributions from Cleary associates Noah D’Aeth and Andreas Wildner.
Nonetheless, the increasing regulatory focus on leverage in the PE sector suggests that PE firms may face tighter credit conditions moving forwards. This could potentially manifest itself in two ways. Firstly, through a general reduction in banks’ exposure to PE and PE-backed companies, as some banks may seek to “de-risk” in response to the PRA’s focus on risk management. And secondly, through a reduction in direct lending specifically at the fund level, as private asset valuation techniques become subject to requirements for more transparency, potentially resulting in financing secured on a fund’s assets becoming trickier to obtain.
These tougher lending scenarios could present challenges to PE firms, but also opportunities, especially for other non-bank market participants to support funding or liquidity requirements of the PE industry.
This article was prepared with contributions from Cleary associates Noah D’Aeth and Andreas Wildner.
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