The Financial Services Authority (FSA) welcomes the Committee's interim Report into private equity, published on 30 July 2007, and the support which the Committee has given to our work in this area. In this Memorandum we respond to those recommendations in the Report which are directed to the FSA and provide further information on our continuing work on issues of particular interest to the Committee.

Highly leveraged deals

We welcome the Committee's support for our proposal to conduct a twice early survey of banks' exposures to leveraged buyouts.[1] In preparing this survey, we will specifically consider the potential for monitoring the incidence of covenant-lite loans. [2]

Systemic risk

The Committee makes three further recommendations with respect to the systemic implications of the leveraged loan market:

• We urge the FSA to investigate the operation of due diligence in highly-leveraged firms.[3]
• We recommend that the FSA examine incentive structures relating to debt.[4]
• We recommend that the FSA continue to work towards obtaining assurance that the banking system has the appropriate incentive structures and monitoring mechanisms in place to handle such risks (i.e. exposure to leveraged buyouts). [5]

On the first point: our mandate covers firms which conduct regulated activities within the UK, but does not extend to private equity-owned firms unless they themselves carry out regulated activities. Rather, we regulate the private equity firms and investment banks that arrange, structure and execute the takeover (and subsequent sale) of such firms. As we have outlined in our previous submissions to the Committee, regulated firms are subject to ongoing requirements and monitoring in terms of due diligence and risk management systems and controls.

We understand the Committee's second and third points to relate to the robustness of systems and controls through which the banking sector manages entry and exposure to private equity business. In line with our risk-based approach, we focus our supervisory attention on the areas which we believe represent the highest risk to our statutory objectives. When considering the leveraged loan market, our attention is appropriately weighted towards the FSA-regulated banks which form the transmission mechanism for economic risk to be dispersed throughout the marketplace. Our concern is to check that those banks have in place, and operate, effective controls and risk management practices at each stage of their involvement in private equity business—including loan origination, risk transfer and ongoing risk management of exposures.

We will continue to work with domestic and overseas regulatory bodies to identify and address risks to financial stability presented by developments in market practice in the private equity sector.

Effective supervision of the private equity market remains a priority for the FSA. We will keep the Committee informed as our work in this area progresses.

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