The Bank of England warned that the private equity industry poses a threat to financial stability, as it launched a review of this $8 trillion ($6.3 trillion) sector.
Officials are worried about the value assets such as commercial properties and businesses that private equity firms control.
Uncertainty also exists about how much money was lent on them. This could lead to a dangerous cascade of events if the value suddenly drops.
This comes after many years of private equity takeovers, and borrowing fueled by ultra-cheap credits before interest rates begin to rise in December 2020.
The industry has backed some of Britain’s largest companies, including supermarkets Asda, Morrisons and Cobham, as well as the Legoland operator Merlin and the defence company Cobham.
The Financial Policy Committee, a part within the Bank that is responsible for monitoring UK financial stability is conducting a market review to better understand risks.
In the aftermath of the financial crash, banks have been heavily regulated, which has limited their ability to take on risky bets. However, private equity borrowing is not controlled or monitored in the same way.
Private equity could take advantage of rates as low a 0.1pc to go on a shopping spree.
As a result of this, the industry has boomed. Investors have raised record amounts of money to buy companies.
These funds only make up a fraction of the total price that a private equity company pays. The rest comes from the markets, where bonds and loans are raised.
The debt can make private equity companies vulnerable to higher interest rates and increase their level of indebtedness.
In an attempt to control inflation, the Bank raised the rate to 5.25pc over the last two years. This has led to an increase in default rates.
The FPC stated in its minutes of the March quarter meeting that: “The private equity industry, which is closely linked to private credit and leveraged loans, plays an essential role in directing finance towards the UK’s real economy.
“Finances for riskier corporations could be especially vulnerable to a significant decline in investor sentiment.
The recent increase in interest rates has made it harder for private equity funds and other investors to raise capital, which is contributing to the downward pressure on asset values.
The private equity trade association BVCA warned against viewing debt in the industry as dangerous.
Michael Moore, CEO of the BVCA said: “The active ownership model of private equity focuses on delivering growth over the long term.
“When leverage is used in a business, it’s part of the capital structure that is appropriate for that particular company.” Lenders, who are sophisticated commercial parties, are motivated to make sure that the arrangements are beneficial for the company’s future growth.
The PE model has been tried and tested, as we have seen during the global financial crises. Since over 40 years private capital has played a significant role in the UK’s economy, demonstrating its resilience during different economic cycles.
Bank officials have also warned that investors could be overly optimistic about economic recovery and rate reductions.
They said: “Asset Prices are stretched. The risk of a sudden correction has increased in many asset classes.
Investors on financial markets are expecting the economy to continue its recovery and for inflation to decline. Investors are less concerned about risks such as a weaker economy or higher interest rates than expected.
This means that there is an increased risk of a sharp drop in asset prices. This could make borrowing more expensive and difficult for UK businesses and households.
Catherine Mann, who voted last week to keep borrowing costs at 5,25pc, said that investors were “complacent”, about the prospect of lower interest rates.
Ms Mann expressed concern that expectations of a “substantial ease” had gone to far.