Why Private Equity Needs Better Risk Management Now
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Regulators in the EU and UK are increasingly scrutinizing banks and their risk management practices, raising important questions about how well banks understand their exposure to private equity funds and the robustness of their risk management frameworks.

Banks currently maintain various relationships with the private equity sector, including providing loans to funds that make acquisitions and the management firms that oversee them, as well as to companies owned by funds and investors who finance these activities. Financial sponsors therefore need to prepare for more scrutiny at all levels of their banking relationships as banks try get a better understanding of how lending aggregates across individual exposures.

Beyond regulatory pressures, it is prudent for financial sponsors to reassess their risk management approaches to mitigate vulnerabilities and ensure long-term resilience. By strategically investing in risk management, they can significantly reduce the likelihood of costly risk events and protect the performance of their funds.

Regulatory scrutiny on private equity exposure intensifies

This year, UK regulators, including the Financial Conduct Authority (FCA), Prudential Regulation Authority (PRA), and the Bank of England (BOE), have underscored the need for improved risk management practices within the private equity sector. The FCA's review of valuation practices for private assets, the PRA's request for disclosure information from banks, and the BOE's focus on opaque valuation and risk management practices in its Financial Stability report all signal a heightened regulatory focus on the sector.

The European Central Bank (ECB) has recently identified the rapid growth of non-banking financial intermediaries (NBFIs) as a significant threat to Eurozone financial stability. By late last year, NBFIs held €42.9 trillion in assets in the EU, surpassing the €38 trillion held by regulated banks. In the US, bank loans to non-depository financial institutions have risen at a 13% CAGR from 2015 to 2024, increasing from 4% to over 9% of total loans.

Consequences of inadequate risk management in private equity

Irrespective of regulatory expectations, inadequate risk management in private equity can lead to several issues:

Cybersecurity risks in private equity: A risk event, such as a cyberattack, could result in financial loss and reputational damage. For example, in 2022, hackers fraudulently accessed bank accounts totalling $1.3 billion at three British private equity firms, resulting in nearly $700,000 permanently lost to the attackers.

Avoidable costs from poor investment choices: Unnecessary costs can arise from potentially avoidable events due to management setting the wrong investment priorities.

Lower valuations due to insufficient risk management: If future investors perceive that risk management is insufficiently mature, this may potentially impact valuation due to the risk of regulatory sanctions, future losses, or remediation cost.

Four risk management priorities for private equity firms

In private equity firms, risk management is typically integrated within the deal and operational teams rather than being centralized as is standard in financial institutions.
To strengthen their risk management practices, private equity firms should prioritize a systematic review of key risk areas, including: 

1. Establish centralized risk management frameworks

These frameworks can be effectively applied across their funds and portfolio companies. For example, firms can centrally invest in a cyber risk management framework that can be implemented across portfolio companies and integrated into new deal due diligence processes. There is also an increasing trend towards centralized coordination of insurance, even though portfolio companies bear the costs.

2. Develop comprehensive crisis management strategies

Enhance the capability to respond rapidly to crises, such as the COVID-19 pandemic, by deploying dedicated teams to assist the portfolio companies most impacted.

3. Implement proactive macroeconomic risk management strategies

Actively address macroeconomic risks by implementing hedging strategies to mitigate interest rate exposure, particularly when inflation forecasts suggest potential increases.

4. Conduct strategic risk assessment for informed investment decisions

When evaluating potential acquisitions or investments, as well as conducting due diligence on target assets, ensure that adequate time and resources are allocated to assess the risk profile and risk management capabilities of the firms under consideration. Furthermore, firms can develop a clear strategy for exiting businesses under unfavourable conditions and avoid reinvesting when perceived risks are considered excessively high.
By focusing on these areas, private equity firms can enhance their overall risk management effectiveness and resilience.

Embracing change for a resilient future for private equity

The increasing regulatory scrutiny on banks and their relationships with private equity serves as a critical call to action for the sector to adopt robust risk management practices. To enhance transparency and disclosure to banks, private equity firms must streamline their processes to respond effectively to data requests.
Leaders in risk management will not only secure funding but also significantly reduce the likelihood of costly risk events, thereby protecting both financial performance and reputation. This proactive approach empowers private equity firms to drive growth and innovation with greater confidence and security in an evolving landscape.