Private capital sector too complacent about risks, says global regulatory body

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Private equity and private debt executives are too laid back about the mounting risks in their industry, the chair of the top organisation representing securities regulators warned on Thursday, as it published new research on vulnerabilities in the $13tn market. 

The International Organization of Securities Commissions (Iosco) said private finance — which includes private equity, venture capital and debt funds — could be tested in ways that “uncover hidden risks” over the coming years. Higher interest rates, it said, threatened defaults that could put pressure on opaque valuations in a corner of the market subject to far less regulatory scrutiny than the banking sector. 

“There is a degree of nervousness out there but also, frankly speaking, a little too much confidence that all will be fine,” Iosco chair Jean-Paul Servais told the Financial Times of the discussions the regulator had with market participants as part of the research. 

While it is possible that managers of private finance funds handle their positions prudently, the scale of leverage in the sector means “there is vulnerability,” said Servais, who described private finance as “systemically important”.

“When you combine that kind of vulnerability with a lack of transparency, and a changing macro-financial environment, you have a cause for concern,” he added.

Iosco’s report and warnings come amid mounting alarm among global policymakers including the US Securities & Exchange Commission about the migration of risks from the traditional financial sector, such as banks, to other areas like hedge funds and private finance.

Pointing to an 18 per cent increase in private finance assets since 2017 to $12.8tn in mid 2022, Iosco said rising interest rates created challenges for corners of the private finance market that “have relied on continuing access to cheap and secure sources of debt funding” to support them.

“Potential questions therefore arise in terms of these sectors’ ability to navigate this transition to the ‘new normal’,” Iosco said. It pointed to the rapid raise in global interest rates since early last year, which could lead to private finance being “tested in the medium to long term” and could prompt it to “respond in ways that uncover hidden risks”.

Iosco said higher rates were “highly likely” to trigger “a reduction” in available funding for private capital, leaving their portfolio companies short of cash.

“Market participants noted that these risks were especially stark over the medium term,” Iosco said, adding that even though private capital firms had “a significant amount of dry powder . . . defaults [in their portfolio companies] are nonetheless expected over the medium to long term”.

Valuation issues could arise if there were firesales or portfolio companies were forced to raise money from public markets, it said, because private assets tend to be valued based on internal models that adjust more slowly to changing financial conditions than public markets.

These valuations issues were further complicated by conflicts of interest, such as when a portfolio manager had a debt fund and equity fund with exposure to the same underlying company, Iosco said.

The fallout from higher defaults, firesales and plummeting valuations could be wide ranging.

“Private finance is an integral part of the financial system and its scale shows that it is now systemically important,” Servais said. “Our report shows the importance of opening our eyes to the potential impact of a sudden change of market sentiment in this less transparent sector.”