(Bloomberg) -- UK regulators are scrutinizing how some of the world’s biggest banks help private equity firms layer on debt, prying into a controversial corner of the $8.2 trillion buyout industry.
The Prudential Regulation Authority has asked banks to provide more information about their offering of net-asset-value loans to buyout funds, according to people with knowledge of the matter. It’s asked some lenders how much capital they have dedicated to the effort and how much leverage they’ve offered to fund managers for these loans, the people said.
A spokesperson for the PRA declined to comment.
NAV loans are a type of debt that allows fund managers to borrow against a pool of companies they own, making them a controversial form of financing because they let private equity managers layer more leverage onto their funds. That’s because the borrowing comes on top of loans taken out by many managers when they first acquire a company.
NAV loans have existed for more than a decade but the recent slump in dealmaking has forced many fund managers to increasingly turn to these facilities as a way to offer liquidity to early investors, especially when the sluggish appetite for transactions takes company asset sales off the table. That’s caused the market for such loans to explode in recent years and it’s now sitting at about $100 billion globally.
A slew of bankers and other industry participants have publicly defended the offering of NAV loans, arguing they’re typically priced appropriately for their risk. They serve as a crucial way for titans of private equity to manage their liquidity even in the midst of a drought in deals, they say.
Still, at least one body representing buyout funds’ investors — the Institutional Limited Partners Association — has argued that private equity firms should alert investors before they borrow against their funds’ assets. The worry for these investors, according to the ILPA, is that any distributions they receive from a NAV-based facility could later be recalled to help pay down the loan, imperiling the limited partner’s ability to invest in other funds or even make payments to its beneficiaries.
The Bank of England has already warned that it believes NAV financing could hinder financial stability in the UK because of how risky it is for banks. In its June financial stability review, it said such “leverage on leverage” could “expose lenders to risks at the portfolio company level, at the fund level, and at end-investor level.”
‘Double Whammy’
With its latest inquiry, the BOE is primarily worried that many private equity funds began buying up assets in the heyday of the post-Covid era, when low interest rates pushed up prices. The funds are now using those assets to secure the NAV loans, but private valuations are notoriously opaque and hard to value.
One note of concern for the PRA is that if the value of these assets in the underlying portfolio has fallen significantly, banks might not know until it’s too late.
“What people fear is leverage on leverage,” Jackie Bowie, a managing partner at the risk management advisory firm Chatham Financial. “You’ve then got leverage at the fund level that you’re relying on secured against an asset value which is deteriorating. So you just end up with a double whammy.”
Bowie said the growth in NAV financing “seems to be huge” with lenders setting up teams to focus solely on originating these types of loans. “We’d recently been asked to provide advice to help clients structure and put in place NAV-based facilities,” she said. “We wouldn’t have been having these conversations two or three years ago.”
Stress Testing
The PRA’s inquiries about NAV financing are part of the central bank’s broader review of private equity financing, according to some of the people familiar with the matter. So far, the regulator has focused that review on areas like how banks manage counterparty credit risk in private equity financing, one of the people said.
The questions come after the watchdog sent a so-called “Dear Chief Risk Officer” letter in April to many of the largest banks across London asking firms to assess their ability to properly manage risks tied to the broader private equity sector. Firms were ordered to provide this analysis to supervisors by the end of August and the central bank is now evaluating those submissions as it considers next steps, one of the people familiar with the matter said.
Rebecca Jackson, a PRA official, said at the time that the regulator wasn’t pleased with banks’ ability to monitor their exposures.
“Very few firms carry out routine, bespoke and comprehensive stress testing for aggregate sponsor related exposures,” she said. “We found that hardly any banks do it well in this context.”
--With assistance from Nicholas Comfort and William Shaw.
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