(Bloomberg) -- The Bank of England is probing how private equity giants and their portfolio companies are dealing with the impact of higher interest rates on their debt burdens as it seeks to understand the risks the sector could pose to the UK economy.

The central bank’s Financial Policy Committee has seen private equity sponsored companies turn to “amend and extend” agreements, where companies push back payment dates rather than try to refinance the debt at a higher rate. These deals and others like it may increase the risk of “larger than expected credit losses being incurred in the future,” the committee warned. 

The committee will continue to evaluate these risks and others tied to the private equity industry ahead of a fresh analysis in June.

“The sector had faced challenges,” the committee said in minutes based on its meeting on March 13. “Fundraising appeared to have become more difficult; traditional exit routes (such as initial public offerings) had slowed; default rates on leveraged loans, which were often used to finance private equity sponsored activity, had increased, and there was evidence that valuations in some sectors had come under pressure.”

Read more: It’s the Return of Extend and Pretend

The committee’s warnings comes amid a rise in the use of payment-in-kind features in debt financings, a facility that allows borrowers to push back cash outlays by paying interest with more debt. One of the junior creditors to Stonegate Pub Co., the UK’s largest pub operator which is owned by private equity firm TDR Capital, provided a payment-in-kind facility to one of the firm’s holding entities, Bloomberg reported in February.

The moves do come with the risk that borrowers won’t be able to generate enough profits to make their interest payments when they finally come due. But those layering PIK debt onto buyouts see it as a temporary solution until interest rates moderate.

The central bank has previously said its examining the potential for systemic risk in the $1.7 trillion private credit market and it’s warned that the next blow up in financial markets may be triggered by corporate credit after a massive build-up in private debt over the past decade.

Commercial Real Estate

Separately, the committee also warned that risks to the global real estate sector are creating a danger to financial stability. 

Commercial real estate prices could fall further and spark losses for lenders, the Financial Policy Committee said on Wednesday. Significant downside risks remain in Chinese property, creating contagion risks for global financial markets via lenders to property developers.

Of particular concern is how much of commercial real estate debt is held outside the banking sector, where officials have less visibility. 

“Global risks have continued to increase and remain material,” the committee said in the minutes. That’s even as global asset valuations have continued to rise, increasing the “risk of a sharp correction in a broad range of asset prices,” the central bank said.

The coronavirus pandemic ushered in a new era of remote work, cutting into office occupancies. Rising interest rates have also eroded the value of buildings around the world, fueling concern that commercial-property landlords may fall behind on their mortgage payments.

In response, lenders around the world have been setting aside additional provisions for loans they’ve extended to property owners. The European Central Bank last month signaled to banks that they may face higher capital requirements if they have an insufficient handle on risks they face from their exposure to commercial property. 

The overall default rate on UK commercial real estate debt reached 4% in the first half of 2023, according to an October survey by Bayes Business School. That’s up from 3% at the end of 2022 even as the amount of outstanding debt held steady. 

Households Improving

Officials also warned on Wednesday that they’re seeing more UK mortgage borrowers seek longer-term loans, which ease affordability constraints for many consumers. Just under half of mortgages in the last quarter were 30 years or longer, the committee found.

“Longer mortgage terms meant a higher risk of debt being pushed into old age,” the BOE said, noting 40% of new borrowers last quarter would be past the current state pension age at the end of their deals. 

Longer mortgages also allows homebuyers to borrow more, increasing leverage and reducing the financial resilience of borrowers in the face of future shocks, the committee warned.

Still, the outlook for UK households had improved “somewhat,” boosted by strong income growth and a more benign profile for interest rates, the BOE said.

The BOE said it was maintaining its countercyclical capital buffer for banks at 2%.

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