Reserve Bank taking stock of private equity’s economic risk

As financial regulators globally begin to sound the alarm on risks posed by private equity, the Reserve Bank of New Zealand says risks at home are limited – but it is watching.
Both the European Central Bank and the Bank of England have, in recent months, highlighted possible risks posed to financial stability by the rise of private equity, and particularly their lending practices.
In a financial stability review released this May, the European Central Bank said that though private markets are currently small relative to traditional financing, continued strong growth, financial innovation and opaqueness in private markets could contribute to financial stability risks.
“Adverse economic shocks could result in rising defaults, valuation corrections and losses for private funds and their investors.”
The European Central Bank said this risk carried through to traditional banks, and that lending exposure to private equity, as well as increased competition, could incentivise sub-optimal practices.
The Reserve Bank’s stability report, released on Tuesday, addressed private equity in a section on developments in finance outside that which it directly regulates.
Following the global financial crisis, banking regulation tightened significantly meaning that, coupled with a trend away from stock market listings, non-bank lending and private equity play an increasingly important part in the financial system.
According to the International Monetary Fund, the private equity industry has about US$8.2 trillion in assets under management globally, and the private credit market grew to about US$2.1t in 2023.
Total domestic bank credit to non-financial sector borrowers was about US$91t last year.
Like the other central banks, the Reserve Bank of New Zealand said there were benefits to private capital – providing finance to startups that might struggle through other channels – but also risks, including a lack of transparency and “complex lending exposures” the sector creates for the banking system.
In a brief phone call while on holiday, New Zealand Private Capital Association’s executive director Colin McKinnon said because of a lack of private capital lending in the country, he would be surprised if the Reserve Bank was concerned about the space at all.
Private equity’s relationship with traditional financing can be more complicated than it appears.The Reserve Bank said banks sometimes lend to private equity funds and the companies in their portfolios, creating multiple layers of lending that could make it hard to monitor the overall risk to the bank.
“In some cases, overseas banks are unable to measure their overall exposure to the private equity sector.”
The Reserve Bank said international private capital funds operating in New Zealand could pull back their supply of financing or be unable to repay bank loans if economic conditions became stressed.
“So far, the resilience of private capital funds to stressed financial conditions has not been tested to a large extent.”
Overall the Reserve Bank said financial stability risks from private capital in New Zealand were limited. “Private equity and private credit markets are at an earlier stage of development than in other countries and the scale of investments is low.”
It said New Zealand’s major banks’ simple way of transacting with the private capital industry prevented the multiple layers of lending or “leverage on leverage” that other financial regulators had highlighted.
Similarly, New Zealand household investment exposure to private capital is limited to institutional and wholesale investors. KiwiSaver funds have also had limited investment into private capital compared with those in Australia.
It might not always be like this though.
“The limited investment so far may partly reflect that the KiwiSaver industry is in an earlier development phase compared to the Australian market,” the Reserve Bank said.
And there’s proof private equity is turning its attention to New Zealand. Last year, multi-trillion-dollar investment firm BlackRock opened an office in Auckland.
Despite this, 2023 was a relatively quiet year for private equity investments.
According to EY’s annual New Zealand Private Capital Monitor report, released alongside the New Zealand Private Capital Association, high interest rates and economic headwinds saw private equity deals drop back to pre-pandemic levels last year.
In a forward to the report (released in May), McKinnon said total private equity investment activity totalled $1.89 billion in 2023, compared with $2.95b in 2022.
While interest rates are falling, a rush of private equity might not happen immediately. “The outlook for the next six months remains neutral as a result of current global macroeconomic factors, with levels of optimism increasing in future years.”
He said private capital was still a significant contributor to the New Zealand capital market eco-system.
“We see private capital continuing to play an important role throughout the coming year, particularly as businesses face continued global geopolitical tensions, inflation pressure and high interest rates.
“This will see many businesses look to equity to both shore up their businesses and provide for more flexible growth”
Global geopolitical tensions were a key theme of yesterday’s financial stability report, saying if the relationship between New Zealand and our key trading partners deteriorates, market access could be restricted, with pronounced impacts on New Zealand’s agriculture, tourism and education sectors, affecting domestic demand and worsening the economic outlook.