Private equity crash could trigger next wave of financial crisis, Bank warns

The Bank of England warned on Thursday that the next phase of the UK’s six-year financial and economic crisis may be triggered by the collapse of debt-laden companies bought by private equity firms in the boom years before the crash.

In its latest quarterly bulletin, Threadneedle Street said the need over the next year to refinance firms subject to heavily leveraged buyouts posed a systemic threat, reports The Guardian.

The Bank added that it would use its new role as the watchdog of the City to monitor private equity deals in future “episodes of exuberance” to prevent a repeat of the debt-driven takeover boom in the run-up to the banking crisis.

“In the mid-2000s, there was a dramatic increase in acquisitions of UK companies by private equity funds,” the Bank said.

“Many of these buyouts, especially the larger ones, were highly leveraged and the increased indebtedness of such companies poses a risk to the stability of the financial system – a risk that is compounded by the need for companies to refinance debt maturing over the next few years in an environment of much tighter credit conditions.”

Noting that there had been a surge of private equity deals in the first six years of the last decade, the Bank said a feature of the investments had been the use of debt. Buyouts were typically financed by money borrowed from banks, with the debt becoming the liability of the purchased company.

There was evidence, it said, that private equity companies had been particular beneficiaries of “forbearance” by commercial banks – the tendency of lenders to go easy on borrowers for fear that they might go bust. But it said a refinancing challenge was looming in 2014, because the peak in debt issuance was in 2007 and the average maturity of leveraged buyout debt is seven years.

Deals became bigger and bigger as the decade wore on, and this trend coincided with a loosening of credit conditions by banks, which made debt finance even more attractive as they vied for business.

The study cited the case of Royal Bank of Scotland, now 83% owned by the taxpayer after being rescued from collapse by the Treasury in October 2008. An aggressive expansion into leveraged finance was an important factor in RBS’s credit losses, Threadneedle Street said.

Owners of private equity companies say the buyouts help to make companies more efficient by spurring management to provide regular interest payments on the debt.

But the Bank said there were also potential downsides to private equity, including the risk that the pressure for short-term returns would starve companies of long-term investment.

“A consequence of the increased use of debt financing on buyouts in the mid-2000s was that debt to earnings ratios, in particular on deals in excess of £100m, climbed to persistently high levels.

“One risk to the UK financial system from these debt levels is the heightened fragility of the corporate sector. Specifically, higher debt levels could make companies less likely to undertake long-term investment if that investment is crowded out by the costs of servicing debt.”

In a separate article in the bulletin, the Bank said it would expect to make a profit on the purchase of gilts under the £375bn quantitative easing programme unless the announcement that the scheme was to be reversed triggered a big rise in long-term interest rates.

The Bank has been making money on its gilt purchases since QE began in early 2009 because the price of government bonds has risen.

When the time comes for QE to be reversed, the Bank expects the fall in bond prices to push up yields – a measure of the cost of borrowing – on gilts.

Work by the Bank’s economists has shown that the state would still make a small profit on QE if yields on 10-year gilts rose from 2% to 5% but there would be a £5bn loss if they increased to 6%.