Private equity firms have become an integral part of the global economy, owning everything from family homes to supermarkets and cosmetics companies — even hospitals.
Assets controlled by groups such as Blackstone, Apollo Global Management and Carlyle Group have quadrupled since 2012, to about $8tn.
As the size of the private equity industry has grown, so too has the debt it uses to buy companies, enabled by a decade of ultra-low interest rates.
At the centre of this sprawling web of debt are some of the global financial system’s most critical institutions: banks. They now have multiple connections with the industry — including lending to buyout-owned companies, the funds that acquire them, the firms that manage them and the investors that back them.
As higher interest rates put pressure on borrowers, regulators are asking an important question: could the private equity industry pose a risk to the wider financial system?
To understand the answer, you first need to peel back private equity’s layers of leverage.
A private equity firm will launch a fund with partners investing some of their own money. This group of executives, known as general partners, are responsible for managing the fund.
The fund will also raise cash from outside investors, called limited partners.
General partners and limited partners can borrow money to finance their commitments to the fund, using their existing stakes in other funds as collateral.
A general partner typically receives a fee for managing the fund as well as a share of the profits from successful investments.
Meanwhile, money from limited partners is used as security for a subscription line from the bank — short-term financing used to acquire companies before cash from limited partners is tapped. This type of borrowing reached $900bn in 2023.
While the subscription line helps fund part of the deal, it is primarily supported by debt financing from banks. The outstanding debt sits on the acquired company’s balance sheet and is paid off using cash generated by the business.
Banks will usually attempt to sell on this type of debt to other buyers, but if demand wanes they can end up holding on to it and incur losses.
Private equity funds repeat this process of acquiring businesses multiple times, eventually building a portfolio of companies owned by the fund.
This buyout model, where private equity funds use investor cash and significant amounts of debt to acquire businesses, has been used to buy companies such as casino group Caesars Entertainment and pharmacy chain Alliance Boots.
It is perhaps the most well-known and common use of leverage in the industry, but it is also just the beginning — as the private equity business has evolved over four decades, its leverage structures have become fiendishly complex.
Because the buyout model is heavily dependent on an active market for selling and listing companies — two of the main avenues through which a fund can exit an investment — a near three-year slowdown in such deals has made it difficult to return cash to investors.
This freeze has led to the growth of specialist funds that buy up private equity stakes. These are often launched by private equity firms, including French group Ardian and Wall Street rival Blackstone. The investors in these so-called secondaries funds can be the same as for the private equity funds themselves.
Meanwhile, investment firms such as Dyal Capital and Goldman Sachs-linked Petershill have raised billions of dollars to buy shares in private equity groups from general partners, which in effect gives them a share of their revenues and profits.
Limited partners have also increased the pressure on private equity firms to return capital, and threatened to withhold investments in future funds if they do not.
This has forced private equity firms to get more creative about how they free up cash, which has led to a rise in complex financing arrangements such as dividend recapitalisations and net asset value lending.
Specialist secondaries groups can buy stakes in private equity funds from limited partners. These deals typically give buyers access at a discount — and limited partners much-needed liquidity.
To finance the purchase of these stakes, secondaries funds raise money from limited partners and combine it with their own cash and debt from banks.
Individual companies can take out more debt, either for business purposes or — in a controversial move known as a dividend recapitalisation — to boost returns for investors.
This form of debt has topped $30bn so far this year, according to data from PitchBook, which is almost equivalent to the total issued in the boom year of 2021.
The fund can also borrow money from banks by using its stakes in portfolio companies as underlying collateral.
Known as net asset value financing, the money can bail out a struggling business or fund a payout to investors.
Net asset value loans have raised concerns because the fund’s stake in the company acts as underlying collateral — but the company is already leveraged, hence the term “leverage on leverage”.
If things go wrong, net asset value loans can spread risk usually limited to one company across the whole fund. Net asset value lending was estimated to be worth $100bn last year.
Complicating matters further, specialist players known as general partner stakes funds can buy a share in a private equity firm from its executives.
These funds can also borrow money from banks secured by management fees and carried interest income — a share of the overall profits of a private equity fund.
But it is not just banks that service the private equity industry. Private credit funds have been on the rise in recent years, with assets topping $1.7tn.
They compete with banks to meet private equity’s funding needs, lending to individual funds as well as their portfolio companies.
Private credit funds also use subscription lines from banks to finance their lending activities.
There is little transparency or liquidity in the private credit market, which has made regulators nervous that an economic shock could leave banks exposed.
This is an abridged version of the sprawling private equity network, with multiple layers of debt, in which banks have become increasingly intertwined.
Much of this lending is ultimately underpinned by the financial health of a fund’s portfolio companies. Yet every transaction ends up adding more leverage to heavily indebted businesses, which can make them more vulnerable in a downturn.
The only people with a birds-eye view of the total borrowing across a firm, its funds and their portfolio companies are the general partners.
“There should not be a pocket of the market that touches on so much of the economy in such a sizeable way, where we can say, oh there’s leverage, and then very few of us can explain what that leverage means and why it might — or might not — be risky”, said Victoria Ivashina, a professor at Harvard Business School specialising in private capital.
Different types of lending are led by different teams within a bank, and often different banks altogether. The lack of oversight has regulators worried about whether lenders can really know just how exposed they are.
The Bank of England official responsible for financial stability strategy and risk, Nathanaël Benjamin, cautioned in April that there were “natural questions about the risks of these financing arrangements, and the growth in kinds and quantity of leverage, or ‘leverage on leverage’, throughout the ecosystem”.
In its Financial Stability Review in May, the European Central Bank said that although private markets had a relatively low risk profile overall, they had an “opaqueness and uncertain resilience” that was a source of concern.
The debt that ties private equity in with the banks, insurance companies and other groups dubbed “non-bank financial institutions” means that any stress in the industry could ripple across the wider financial system.
“The opacity, complexity, and interconnectedness of the sector have made assessing its developments difficult, but it also means that it is all the more important,” Benjamin added. “These developments could pose risks to financial stability.”
Additional reporting by Alexandra Heal.
Comment guidelines
This article is missing the context of how big the industry is as a whole and whether the total level of leverage is problematic e.g. debt/ EV or what the debt coverage ratio is.
Arden 7 and 8.