I’ve frequently spoken and written about leverage-on-leverage contagion risks from the private equity and credit markets with feedback loops to real estate. Some of the articles are here.

As interest rates slumped in the decade leading up to 2022, this space increasingly attracted yield-starved capital from institutions and individuals alike.

Our capital management firm was inundated with endless solicitations from the space. However, each time, due diligence led us to conclude that what was presented as sophistication and innovation was more boondoggle and Ponzi-like.

Then, the 2022-23 normalization of interest rates began to illuminate the darkness in private debt and equity products, and redemption requests started to be frozen. Funds in the space have been devising ways to extend and pretend, paper over losses and avoid mark-to-market pricing. Still, liquidity and insolvency problems are compounding under the surface.

This week, newly appointed Bank of England Financial Policy Committee member Nathanaël Benjamin delivered a lucid and insightful speech outlining why developments in Private Equity (PE) pose broader financial stability risks for public markets, banks, the economy and employment. It’s very well articulated and 13 pages worth a read. See Not-So-Private Questions. Here’s a taste:

The strong growth and attractive returns of the private equity asset class over the last ten years has occurred during a period of low interest rates. However, since the start of 2022 interest rates have increased substantially. And markets are not expecting for the foreseeable future a return to the low levels seen in the recent past. So, the sector is now facing challenges.

These challenges fall into two categories. Firstly, the difficulties that the highly leveraged companies backed by private equity face in the higher interest rate environment. And secondly the consequences of a lack of exit opportunities for private equity fund investments. Private equity is particularly vulnerable to this, given its extensive use of leverage, and the illiquid nature of its investments.

…So it seems some people have been stuck. And this has catalysed the development of new types of leverage. Private equity “secondaries” funds have been established to purchase the increased supply of limited partner interests. These funds, in turn, often require leverage to meet return targets. In addition, for some time sponsors have been creating “continuation funds” to restructure and spin off the ownership of selected sponsored companies, thereby providing an exit opportunity on their investments. New investors in continuation funds in turn may look for leverage against their capital commitments. And we have also seen additional forms of leverage being sought in the form of secured financing against portfolios of existing limited partner interests in private equity funds.

We are also observing a trend towards private equity funds themselves seeking leverage, backed by the entire net assets of the fund. This is a way for sponsors to generate additional liquidity, in some cases reflecting pressure to finance dividend pay-outs to investors, to repay portfolio companies’ debt, or to purchase new fund assets.

These loans are in the form of net asset value financing (“NAV financing”). While NAV financing has been present for many years, 17Capital – a financier of private equity investors – projected a seven-fold increase in NAV financing from $100 billion to $700 billion by 2030. As the providers of NAV facilities have recourse to the assets of the private equity fund, and these assets are leveraged themselves, this has been termed
“leverage on leverage”. You can see why.”