The City watchdog sounded the alarm yesterday over what it called the "excessive" levels of debt being used to finance private equity deals.
According to the Financial Services Authority's figures, in the first half of 2006 £11.2bn was raised by private equity fund managers compared with £10.4bn raised through flotations on the London Stock Exchange.
Some 13 banks which responded to an FSA survey also reported a combined exposure to private equity deals of €67.9bn (£45.5bn) compared with €58bn at June 2005.
With the size of deals and the level of debt used to finance them increasing rapidly, the FSA's warning that a major failure was "all but inevitable" is probably stating the obvious.
But what concerns the regulator is its belief that the ramifications of this failure - or a cluster of smaller failures - could lead to an almighty mess and even threaten the stability of Britain's financial markets. That is because it is not just the levels of debt used to back deals that has increased sharply, but the way it is being divvied up between finance houses has changed radically.
Until recently, if a major deal went bad the creditors would be brought together in a club to sort out the wreckage. Negotiations are often painful - the saga of Le Meridien Hotels that was put into the hands of its lenders in 2003 went on for months.
However, a rescue bid usually emerges after heads have been banged together for long enough.
The FSA's fear is that these sort of talks may no longer be possible, particularly in the bigger deals that involve ever larger numbers of banks putting up finance.
Those banks now often seek to reduce their risk by laying it off with others, through the use of various instruments such as credit derivatives.
The watchdog described this "risk transfer" as "opaque, complex and time consuming" and warned that it could "create confusion which could ... in an extreme scenario, undermine an otherwise viable restructuring".
In other words, in today's blockbuster deals nobody is sure any more who holds how much debt. Stricken companies, which might otherwise be revived, could be left in limbo for months and even years while the lenders fight it out, with the potential of legal battles over the arcane wording used in some derivative contracts lasting for years.
The FSA also raised concerns about potential market abuse arising from private equity deals. Hector Sants, managing director of the regulator's wholesale business unit, said this was because a large number of organisations and people tend to become involved in private equity deals.
Because of the number of insiders involved in deals, it makes it that much easier for information to leak out and be used by the unscrupulous.
When Mr Sants tackled hedge funds and started publishing similar discussion papers, it subsequently became clear that several investigations were being conducted.
When asked whether the same was happening with private equity companies, Mr Sants gave an opaque response: "You should not read anything into this either way. We don't comment on individual situations."
However, this non-answer will do nothing to damp down speculation that the regulator is seeking a scalp.
The regulator also voiced fears that the sheer number of private deals was damaging Britain's stock market, and potentially its economy. It noted that the UK equity market shrank by £46.9bn in the first half of 2006 - while some of that was due to falling share prices, private equity deals were also responsible for taking companies off the market.
There is little that the FSA can do about this.
But what is clear is that after tabling all these concerns and raising the spectre of potentially dire consequences if, when, a big deal goes belly up, the FSA appears to be unsure about how to act on those issues it can influence.
Mr Sants said the FSA's 94-page tome was designed to initiate "discussion". There will be a four-month consultation period on "whether we have correctly identified the risks" and "which of the potential risk- mitigation actions merit further analysis".
Big private equity firms will be brought under Sants' umbrella alongside hedge funds. There will be increased monitoring of debt levels, and visits to private equity companies, while "key messages" will be put out into the market in the meantime.
Mr Sants was at pains to stress that "private equity is an important part of the financial markets". Regulation will be "proportionate".
But all this has provoked some decidedly mixed views in the venture capital industry, which is beginning to grow concerned about what the regulator might do next.
Jon Moulton, managing partner of Alchemy Partners, said: "They clearly think they ought to be doing something, but they don't seem to know quite what it is.
"We have the most heavily regulated private equity industry in the world. In the US, it is unregulated and there is no evidence of casualties. The danger is that they could regulate us out of existence very quickly and this is one of the few growth industries in the UK at the moment."
He said he found some of the statements in the report's executive summary "ominous", particularly when it talked about areas that go beyond its remit.
John Cole, private equity partner at Ernst & Young, called the FSA's paper "a sensible and even-handed approach".
"As our report on exits across Western Europe revealed last week, private equity companies are consistently out-performing public companies in terms of creating value," he said.
But he added: "Any threat of a heavy-handed and over-regulatory approach from the authorities in either London or Brussels would not be helpful to an important contributor to the strength of European Capital Markets and to the stability of the businesses that private equity companies own or the jobs that they provide."
Peter Linthwaite, chief executive of the British Venture Capital Association, said: "We welcome the fact that the FSA has no current concerns in the way our business is conducted. It is reassuring to find that the FSA sates that the industry is already appropriately regulated. Together, the industry and the FSA need to ensure that regulation remains appropriate and never becomes an obstacle to the good conduct of our business."Reuse content