Banking sector exposure to private equity

Introduction

The growth over the past ten years within the private equity (‘PE’) sector has been a topic of increasing focus from regulators in recent months, with asset growth from $3 trillion to $8 trillion over the period. The Bank for International Settlements (BIS), for example, recently proposed updated standards for counterparty credit risk management, which has a strong focus on managing exposures to non-bank financial intermediaries (NBFIs), whilst the EBA also commented on EU/EEA banks’ interconnectedness with NBFIs.

In April 2024, the PRA published its findings from a thematic review of the adequacy of banks’ risk management practices for PE-related financing activities. The PRA expects banks to review these findings and perform a gap analysis assessment against their current internal practices. The findings and remediation plans from this assessment must be shared with both the Board Risk Committee and the PRA by 30th August 2024.

In summary, these expectations span across four themes:

• Holistic approach to risk management - Identification of all transactions and exposures relating to the PE sector, with data aggregation capabilities sufficient to enable monitoring at sponsor and PE fund level;
• Credit and counterparty risk interlinkages - Credit due diligence procedures and management information capable of identifying overlapping credit exposures, collateral pledges, and financial claims across PE-related exposures and activities;
• Stress Testing - Stress testing capabilities that consider scenarios giving rise to heightened defaults and loss correlations, both at an individual sponsor level and across the PE sector. This should incorporate all PE-related financing activities, including derivatives exposures; and
• Board level reporting - Board management information ('MI’) reporting ensures that Boards are appropriately informed regarding aggregate exposures linked to the PE sector, in addition to its materiality within the context of the institution’s overall strategy.

We consider several elements across the four key areas that should be prioritised and how firms can enhance their broader risk management capabilities for PE-related financing activities.
 

Types of activities and exposures to the private equity ecosystem

As a result of the growth of the PE sector, the activities and types of services that banks provide to PE clients have widened. Exposures to the PE ecosystem now span several different business lines within banking groups and cover a wide range of products, for example secured loans and credit lines, syndicated leveraged loans, and derivatives.

A single banking group can therefore have multiple exposures within different business lines that are directly or indirectly linked to the same sponsor, limited partner, PE fund, or portfolio company.

The figure below shows some of the different services provided by banks to different levels of the PE ecosystem.

Figure 1. Banks’ exposures to different levels of the private equity ecosystem

Main challenges and risks for banks

Due to the complexity of banks’ service offering to PE clients, as well as the interlinkages between different levels of the PE ecosystem, having an overarching view of all exposures to the PE industry (and specific counterparties) is of vital importance to banking groups offering these services. At the same time, the complexity and potential silos between different business lines creates unique challenges for banks to develop that holistic view.

Although the PRA review has focussed only on the independent credit and counterparty credit risk management (‘CCRM’) processes, from a 2nd Line of Defence perspective, the variety of PE exposures also encompass other risk stripes, including market and liquidity risk. Some examples of issues posed by PE exposures across the different risk stripes include:

• Credit Risk: Client due diligence and onboarding; collateral management and monitoring; identification of connected counterparties and large exposures limits; credit concentration risk; step-in risk; watchlist process and default management procedures
• Counterparty Credit Risk: Collateral management and monitoring; wrong-way risk assessment
• Market Risk: Pipeline risk in syndicated leveraged loans to portfolio companies
• Liquidity Risk: Monetisation of illiquid holdings in portfolio companies; margin financing for derivatives exposures at portfolio companies

As a consequence of the wide range of risks posed by PE exposures, banks will face challenges across all stages of their risk management process, including risk identification, measurement, monitoring, and governance.

The table below depicts some of the key risks, challenges, and leading practice observed across the four different areas:
 

Figure 2. Key risks, challenges, and best practices observed for banks’ risk management of private equity exposures

How can Deloitte support

Deloitte is well placed to support banks both in identifying and remediating gaps in their risk management of PE-related exposures, with a wide range of technical and regulatory expertise available on the challenges identified above. To find out more, please contact the authors listed below.
 

Further reading:

Private equity financing − speech by Rebecca Jackson | Bank of England
Not-so-private questions − speech by Nathanaël Benjamin | Bank of England
https://www.bankingsupervision.europa.eu/press/interviews/date/2024/html/ssm.in240710~8a289e1673.en.html
Guidance on leveraged transactions (europa.eu)