The Bank of England has issued a warning that the UK economy could suffer if higher interest rates lead private equity-backed companies to default on their debts.

In its latest financial stability report, the central bank highlighted the significant risk posed by the jump in borrowing costs since late 2021.

Private equity-backed businesses account for around 5% of UK private sector revenues and employ about 10% of the UK private sector workforce, which includes over two million employees. The report warns that companies might cut investments or reduce employment after their private equity financiers refinance their debts at higher interest rates.

“The widespread use of leverage within private equity firms and their portfolio companies makes them particularly exposed to tighter financing conditions,” stated the Bank of England in its biannual report.

Recent years have seen several prominent British companies acquired by private equity firms, including Morrisons, which was bought by Clayton, Dubilier & Rice for £7 billion in 2021, and Hargreaves Lansdown, currently in talks with CVC Capital Partners for a potential £5.4 billion deal.

The report also noted that 25% of all debt maturing in risky credit markets over the next five years originates from private equity-backed companies. The central bank urged private equity firms to disclose more information about the size and quality of their assets.

The Bank of England’s investigation into the sector concluded that losses on loans could impact the UK banking system, which has increased lending to private equity firms. This could result in higher borrowing costs for businesses if private equity-backed companies fail to repay their debts, potentially damaging the real economy.

Such a scenario might “reduce investor confidence,” the Bank warned, further increasing financial pressure on businesses and leading to higher borrowing costs.

Interest rates have risen to 5.25%, a 16-year high, from a record low of 0.1%. The private equity industry has expanded significantly during this period of low borrowing costs, growing from $2 trillion in assets in 2013 to $8 trillion today.

Michael Moore, CEO of the British Private Equity and Venture Capital Association, acknowledged the Bank’s concerns but emphasized the industry’s long-term stability and resilience. He noted that many of the Bank’s issues are already being addressed by new regulatory activities from the Financial Conduct Authority.

Meanwhile, the Labour Party has pledged to eliminate a tax rule that allows private equity executives to limit their tax bills if it wins the general election on July 4. Currently, private equity executives benefit from “carried interest” being taxed at the capital gains tax rate of 28%, rather than the combined income tax and national insurance rate of 47%. Labour plans to tax carried interest at the higher rate, addressing a tax break estimated to be worth £4 billion under the current system.