Worth the risk?

The UK’s Financial Services Authority has outlined the possible threats to financial stability posed by private equity.

Today the Financial Services Authority, the UK regulator, published a discussion paper on the risks posed by the private equity industry to financial market stability.

Explaining why the FSA undertook the review, Hector Sants, FSA wholesale markets and institutions managing director, said: “We believe private equity can significantly enhance capital market efficiency by widening the availability of capital, increasing the effectiveness of company valuations, identifying
companies with growth potential and facilitating their transformation.”

Too much regulation can be detrimental to capital market efficiency, but too little regulation can damage market confidence: “So we are asking industry and policy makers to engage with us in ensuring that the UK maintains an appropriate approach to regulating the private equity industry.”

First the FSA is looking for a response on whether it has correctly identified and quantified the risks the industry poses to financial stability. It has identified the following threats as high risk:

Market abuse: The significant flow of price sensitive information in relation to private equity transactions creates considerable potential for market abuse. This flow is increasing as the complexity of the transactions grows and more parties become involved. The involvement of participants in both public and private markets and the development of related products traded in different markets, eg Credit Default Swaps on leveraged loans, increases the potential for abuse.

Conflicts of interest: Material conflicts arise in private equity fund management between the responsibilities the fund manager has to itself – including its owners/staff; the investors in the separate funds/share classes it manages and the companies owned by the funds. Advisers and leveraged finance providers also face significant conflicts, particularly where they take on multiple roles in relation to an individual transaction, between their proprietary and advisory activities and between their different clients.

The FSA has declared the following as medium high risk:

Excessive leverage: The amount of credit that lenders are willing to extend on private equity transactions has risen substantially. This lending may not, in some circumstances, be entirely prudent. Given current leverage levels and recent developments in the economic/credit cycle, the default of a large private equity backed company or a cluster of smaller private equity backed companies seems inevitable. This has negative implications for lenders, purchasers of the debt, orderly markets and conceivably, in extreme circumstances, financial stability and elements of the UK economy.

Unclear ownership of economic risk: The duration and potential impact of any credit event may be exacerbated by operational issues which make it difficult to identify who ultimately owns the economic risk associated with a leveraged buy out and how these owners will react in a crisis. These operational issues arise out of the extensive use of opaque, complex and time consuming risk transfer practices such as assignment and sub-participation, together with the increased use of credit derivatives.

The entrance of new types of market participant with business models that may not favour the survival of distressed companies adds further complexities. These factors may create confusion which could damage the timeliness and effectiveness of work-outs following credit events, such as defaults or covenant breaches, and could, in an extreme scenario, undermine an otherwise viable restructuring.

Finally medium low risk threats include:

Market access constraints: UK retail investors currently only have limited access to the private market via venture capital trusts and a small number of private equity investment trusts. Indirect access is also limited as few UK pension or insurance vehicles have committed significant capital to private equity. This is partly because of the need for frequent re-negotiation of limited partnership agreements and the substantial delays before committed capital is drawn down. These factors enhance the perceived complexity and reduce the internal rate of return associated with private equity investing.

Market opacity: Although transparency to existing investors is extensive, transparency to the wider market is limited and is subject to significant variation in methodology and format. This makes relative performance assessment and comparison complex, which may deter investment by various professional investors who may not be comfortable interpreting the information. It could also lead to ill-informed investment decisions by such investors.