Watchdog monitors PE market

The rising number of private equity buyouts has prompted UK watchdogs to keep
a closer eye on credit markets. The Financial Services Authority (FSA) found
that 13 banks had backed 67.9bn euros (£49bn) worth of deals – up 17% on last
year. It warned that such deals might not always be prudent and could provide an
opportunity for market abuse.

The FSA has also launched a discussion on the private equity market “seeking
feedback from the industry and public policy makers”. Its comments follow a
review of the private equity market, which was launched in March.

Focus on PE
In its discussion paper, the FSA gives six reasons why it has focused on private
equity:
• The growth in capital flowing into private equity funds has risen
dramatically. In the first half of 2006, UK-based private equity fund managers
raised £11.2bn of capital as compared to £10.4bn of funds raised via initial
public offerings (IPOs) on the London Stock Exchange’s public equity market in
the first half of 2006 – a rise of 64% compared to the same period in 2005;

• Leveraged finance provision to private equity transactions has increased. The
FSA says that system-wide exposures are now substantially greater as banks are
increasingly distributing debt to non-banks, such as hedge funds;
• The reach of private equity has also risen through the increased availability
of debt finance and the willingness of equity firms to band together to
co-operate on a single transaction. This has enabled larger transactions to take
place;
• The development of secondary markets within the private equity sector through
secondary MBOs may be reducing capital flows to public markets;
• Public to private transactions, widespread share buy-backs/payment of special
dividends and reduced capital flows from the private market have contributed to
a decline in the market capitalisation of the UK equity market, which has not
grown since 2004 Q4; and
• The FSA says that market participants have expressed concerns about a
perceived lack of understanding with respect to the nature of private equity
business models and their inherent risk.

Key risks
The FSA has also identified seven key risks:
• Market abuse (high risk) – the significant flow of price sensitive information
in relation to private equity transactions creates potential for market abuse.
This flow is increasing as the complexity of the transactions grows;
• Conflicts of interest (high risk) – material conflicts arise in private equity
fund management between the responsibilities the fund manager has to itself,
investors and the companies owned by the funds;
• Excessive leverage (medium-high risk) – the amount of credit that lenders are
willing to extend on private equity transactions has risen substantially, which
may not be entirely prudent. The FSA says that the default of a large private
equity-backed company, or a cluster of smaller private equity-backed companies
is inevitable;
• Unclear ownership of economic risk (medium-high risk) – it is difficult to
identify who ultimately owns the economic risk associated with a leveraged
buyout and how these owners will react in a crisis;
• Markets access constraints (medium-low risk) – UK retail investors only have
limited access to the private market via potentially high-risk 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 capital
to private equity;
• Market opacity (medium-low risk) – although transparency to existing investors
is extensive, transparency to the wider market is limited. This makes relative
performance assessment and comparison complex, which may deter investment by
professional investors who may not be comfortable interpreting the information.
It could also lead to ill-informed investment decisions by such investors; and

• Reduction in overall capital market efficiency (low risk) – the inflows of
capital into private equity funds, combined with the debt market’s appetite for
leveraged finance products, is fuelling an expansion of the private equity
market. This is resulting in an increasing proportion of companies with growth
potential being taken private and fewer private companies going public because
of the development of the secondary private equity market.

The FSA has applied measures to mitigate and reduce the risks inherent in the
private equity sector. These include establishing an alternative investments
centre of expertise and undertaking proactive market surveillance, targeting the
credit markets.

Additional measures
The regulator has also outlined a number of potential additional measures:
• Requesting one additional data point from private equity firms to identify the
higher impact firms and, therefore, target supervisory resources more
effectively;
• Regularly surveying leveraged lending and distribution;
• Engaging in a targeted fact-finding exercise with trade associations and
experienced market practitioners to understand the issues and risks;
• Undertaking targeted thematic reviews responding to identified risks, such as
the significant conflicts of interest arising in private equity structures; and

• Removing provisions in the Listing Regime, which were perceived to create a
barrier to the listing of private equity funds.

The British Venture Capital Association has welcomed the review, but says
that the FSA’s concerns are concentrated on a few large deals, rather than how
the industry conducts itself as a whole.