On 22 April 2024, the Bank of England (BoE) published a speech by Nathanael Benjamin, its Executive Director of Financial Stability Strategy and Risk, on the private equity market and its growth in size, complexity and interconnectedness, as well as its role in financing companies. The speech outlines recent developments and asks questions about the impact of the dynamics within the sector on safe and sustainable growth.

The speech is structured around four questions:

  1. How does the growth of private equity contribute to market-based finance?
  2. What makes up the private equity ecosystem?
  3. Why is the BoE focussing on this now?
  4. Why does the BoE worry about this issue?

How does the growth of private equity contribute to market-based finance?

As a result of the significant growth in market-based financing over the last decade, half of the funding for UK businesses now comes directly from financial markets and non-bank financial institutions. As such, Mr Benjamin highlights that the private equity sector plays a crucial role in funding UK businesses, with around £250 billion actively invested in UK companies via private equity. He also notes that the growth in private markets is contributing to greater competition within the financial sector. However, he warns that while the prominence of the sector both within the financial system and for the real economy is significant, with that comes a responsibility for the sector to ensure that its growth happens safely and sustainably.

What makes up the private equity ecosystem?

Mr Benjamin outlines five key ‘players’ in the private equity ecosystem, each with a different role to play:

  • Financial ‘sponsors’, who manage the private equity funds and typically make money through management fees and carried interest.
  • ‘Limited partners’: the investors into the private equity funds.
  • Banks, which provide and facilitate ‘downstream’ lending to companies owned by private equity funds and ‘midstream’ lending to the private equity funds themselves, as well as having ‘upstream’ exposures where there is recourse to the limited partners.
  • Private credit funds, which participate by lending substantially and directly to companies owned by private equity funds, thereby competing with banks, while also receiving credit from banks.
  • Companies themselves, which are owned by private equity (as well as financed by other mechanisms such as leveraged loans or bond issuance).

He notes that this ecosystem is becoming increasingly complex and interconnected, and that it therefore requires careful navigation and underscores the importance of efforts to understand these linkages more thoroughly.

Why is the BoE focusing on this now?

The speech then turns to the dynamics that the BoE has been observing between these players. Mr Benjamin highlights two primary areas of challenge for the sector: the difficulties that the highly-leveraged companies backed by private equity face in the higher interest rate environment, and the consequences of a lack of exit opportunities for private equity fund investments. He also noted that the sector faces an additional challenge: the drying up of traditional exit routes for private equity funds’ investments via the capital markets, leading to difficulties in achieving the return of capital sought by limited partners.

Why is it concerned?

The dynamics set out are causing the BoE concerns related to the financial system as a whole. Mr Benjamin warns that these developments are set against a backdrop of opacity and are resulting in growing interconnectedness. In terms of opacity, he states that there is a lack of transparency about the degree and kinds of leverage entering the system. In addition, private asset valuations are more opaque than public markets because assets are not ‘marked-to-market’ and there are material risks attached to this; for example, it could increase the chance of an abrupt re-assessment of risks or sharp and correlated falls in value, particularly if further shocks materialise. In relation to interconnectedness, Mr Benjamin reiterates that the environment is becoming more complex and interconnected; for example, banks find themselves exposed to various parts of the private equity ecosystem, pension funds and insurance companies invest in private equity sponsors (and conversely they are sometimes owned by private equity, most significantly at a global level), and there are also significant interlinkages between private credit markets, leveraged lending, and private equity activity. This intricate web of connections adds to the notable lack of transparency, making it difficult to assess financial stability risks.

The speech then discusses the impact of such vulnerabilities on the provision of vital services, including:

  • The impact on systemic institutions.
  • The impact on interlinked markets.
  • The impact on the real economy and employment via the provision of finance, in vital services.

Mr Benjamin concludes by considering the role of the BoE and the Financial Policy Committee in dealing with this. He states that these developments could pose risks to financial stability through several transmission channels – systemic institutions, systemic markets and through the provision of funding. He emphasises the importance of assessing how a disruption to the provision of finance can impact corporates that receive financing from private equity, as well as monitoring the impact on systemic institutions and markets, given their role in underpinning a stable financial system. Mr Benjamin confirms that the BoE will continue to examine the impact of the dynamics in the private equity sector on UK corporates and the rest of the financial system, how this might play out in times of stress, and other related questions, through a combined lens of its primary and secondary objectives of financial stability and sustainable growth.

A further assessment of these risks will be set out in the BoE’s June 2024 Financial Stability Report.