Private Equity Financing – The PRA Demands Action

As part of the ongoing fallout of the collapse of Archegos Capital Management in 2021 the PRA has conducted a thematic review of private equity financing.

The PRA has published its findings in a ‘Dear Chief Risk Officer’ letter, which has been sent to all relevant CRO’s and backed up by a speech by Rebecca Jackson, Executive Director for the PRA’s Authorisations, RegTech, and International Supervision Directorate (ARTIS).

She opened her speech by highlighting how private equity had grown as an asset class from around $2 trillion in 2012 to around $8 trillion in 2023. This has been coupled with a material increase in lending to funds and the arrival of new and complex forms of ‘leverage on leverage’, such as Net Asset Value (NAV) loans secured by fund assets, which provide leverage to funds against already leveraged portfolio companies, and growth in secured financing facilities, for example, backed by Limited Partner interests.

We have also seen the emergence of "private credit funds", which both raise financing from banks and compete directly with them to provide traditional and non-traditional forms of leverage.

All this has happened over a relatively benign decade and the regulator’s concern is that there are growing correlations between the funds, their portfolio companies, the markets in which they operate and broader macro factors such as interest rates and general economic conditions which may develop under certain conditions.

On the back of this it’s not inconceivable to envisage a significant, unforeseen Archegos-style risk correlation developing, resulting in rapidly evaporating liquidity, in the event of a crisis and therefore leaving banks open to severe, unexpected losses. It might also be on a scale to create a systemic risk. So, from this perspective, the PRA conducted its systemic thematic review of private equity financing to investigate how holistically risks in this market are managed.

The PRA found that there were gaps, and often significant gaps, identified in most of the frameworks that they assessed. In short, banks could not holistically identify, measure, manage or monitor the risks emanating from their private equity financing business, despite the emphasis that the PRA has repeatedly placed on holistic risk management since the default of Archegos Capital Management.

The overall risk here is that when banks fail to properly measure and assess their aggregate risks it is difficult to undertake meaningful stress testing, to inform boards of their firm’s overall scale of their combined exposures to the sectors and therefore to define a meaningful risk appetite for those sectors.

To address these risks, banks have to ensure that trade capture and risk management systems assign transactions, exposure and collateral information to the right metadata. When done right this will allow banks to calculate and monitor not only their exposures linked to individual fund managers, funds and companies, but also their overall consolidated direct and indirect exposures to the sector as a whole.

Credit and counterparty risk due diligence procedures and management information processes should also recognise where there are overlapping credit exposures, collateral pledges and financial claims across the full range of private equity exposures. These are important factors to consider when exposures are layered as they are in private equity.

Stress testing should be a routine part of a bank’s toolkit. It should consider the highly idiosyncratic risk profile that private equity-linked financing and hedges can create and the potential for higher than previously observed default and loss correlations during periods of stress.

Lastly, with private equity providing an increasing risk and revenue profile for many banks, it is of the utmost importance that boards are informed of the aggregate sectoral exposure and to take this into account when setting the business strategy and risk appetite for the sector.

In their supporting ‘Dear Chief Risk Officer’ letter the PRA has asked relevant CRO’s to review their current private equity sector practices and assess them against the findings set out in the Annex to their letter and that firms place a high priority on any necessary improvements to their risk management approach in the area.

Relevant CRO’s are requested to share the output of their benchmarking exercise with their Board/Board Risk Committee and provide this analysis, together with their detailed plans to remediate any gaps to their PRA supervision team by 30 August 2024.

FMCR has extensive experience in the field of risk management, modelling and stress testing and if you would like to discuss how we can help investigate shortcomings in your private equity exposures and assist in developing a remediation plan, please contact contact@fmcr.com in the first instance.