The Bank of England has warned that the private equity industry faces challenges in a higher interest rate environment

Last week, the Bank of England warned in its semi-annual Financial Stability Report that defaults on loans to high-risk borrowers -- the lifeblood of private equity-owned companies -- had jumped 250 per cent. The central bank said the private equity industry faces challenges in a higher interest rate environment.

The global default rate on leveraged loans has jumped 5 percentage points from about 2 percent at the beginning of 2022 to about 7 percent, the report noted. About 73 percent of such loans were made to private equity-backed companies.

The Bank of England is concerned that risks from private equity could spread to other parts of the economy, as private equity-backed companies employ up to 10 per cent of the UK's private sector workforce, or around two million people.

The global banking system is heavily exposed to private equity activity, which can lead to credit losses. The boe is concerned that losses from these exposures could reflect deficiencies in banks' risk management practices.

The Financial Stability Report sets out the main risks to the UK economy. The Bank of England and its Prudential Regulation Authority watchdog have urged banks to better assess and manage the risks of private equity investments. The boe repeated its call for banks to be more transparent about their valuation practices and overall levels of leverage.

The boe's concerns are not unreasonable. The private equity industry has grown rapidly over the past decade, tripling its assets under management to $8 trillion. That has been helped by record low interest rates, which have driven investor money into the sector and made it cheap to buy companies.

However, with interest rates rising and markets slowing, the private equity industry has come under increasing pressure. Higher interest rates and a slowing market for mergers and initial public offerings have made it harder for private equity funds to sell or take companies public. At the same time, investors are increasingly demanding capital returns, forcing private equity firms to turn to "unconventional methods" such as net asset value financing and dividend recapitalization to free up cash, which further increases the leverage of underlying assets.

The boe said the private equity market has multiple funding structures, as well as multiple layers of leverage, much of which is provided by banks. Multiple layers of leverage expose banks to risk at the portfolio company level, at the fund level and at the end investor level.

The Bank of England acknowledged the "significant role" private equity groups play in funding UK companies, saying buy-out group-owned companies accounted for about 5 per cent of total UK private sector revenues.

However, the boe also pointed out that there are some risks in the private equity industry, such as vulnerabilities from high leverage, opaque valuations, variable risk management practices, and strong links to riskier credit markets. These risks could lead to losses for banks and institutional investors.

The Bank of England's warning sparked concern and concern in the markets. Investors and analysts say the risks in the private equity industry cannot be ignored, and that banks and other financial institutions need to strengthen risk management to cope with possible losses.

The boe's warning is a reminder that the private equity industry, while playing an important role in providing capital to companies, also carries some risks. Investors and financial institutions need to remain vigilant and strengthen risk management to ensure the stability and sustainable development of the market.