(Bloomberg) -- The Bank of England warned that more private equity-backed firms are “struggling” as higher interest rates put pressure on the opaque industry that has swollen to $8 trillion globally. 

In its twice-yearly Financial Stability Report, the BOE also rebuked lenders and others in the private equity market for poor risk management practices, in an escalation of the UK’s bid to tame risks in the sector.

“Improved transparency over valuation practices and overall levels of leverage would help to reduce vulnerabilities in the sector,” the BOE said on Thursday. “Risk management practices in some parts of the sector also need to improve, including among lenders to the sector such as banks.”

The BOE and other UK regulators have long been concerned about risks in the private equity market, which now finances around 10% of the UK’s private-sector jobs.

The Financial Conduct Authority is carrying out a review of valuation and governance practices, while the BOE in April ordered some banks to stress test their exposure to private equity giants and their portfolio companies. 

In a one-off deep dive into private equity vulnerabilities, the BOE cited high leverage as a key risk and noted that global defaults on leveraged loans are already at around 7%, up from around 2% in early 2022 but comfortably below the 12% peak during the 2008-2009 financial crisis. 

“In a higher-rate environment, higher financing costs create an increased drag on the performance of indebted PE companies, which makes it challenging for PE sponsors to exit their investments,” the BOE said. 

That leads private equity firms into more “unconventional approaches”, such as borrowing against their funds’ net asset value, and restructuring ownership of their companies. 

“Layers of leverage exposure lenders to risk at the portfolio company level, at the fund level and at end-investor level,” the BOE said. 

The BOE said that UK private equity funds were also vulnerable to shocks from overseas since most of their funding comes from global investors, and said that international policy work on private equity risk management was key. 

In its financial stability review, the BOE also noted that hedge funds were increasing their use of leverage, particularly for bond trades.

The BOE is attempting to capture the interconnectedness of stresses on banks, hedge funds, private equity and other market players through its first System Wide Exploratory Scenario, the initial results of which it announced on Thursday.

The central bank said non-banks reported “significant” liquidity needs from margin calls during a hypothetical shock worse than that caused by the 2022 mini-budget or the coronavirus pandemic.

Participants started the scenario with greater resilience than at the start of recent market shocks and expected their liquidity needs could mostly be met by pledging assets. However their responses indicated that terms in the sterling repo market would tighten with selling pressure in sterling corporate bonds, the BOE said.

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