City lawyers have welcomed the Financial Services Authority's (FSA) first discussion paper into private equity, which announced that the 14 largest UK-based funds would face increased scrutiny given that a future default of a private equity-backed company was "inevitable".
Excessive leverage available to borrowers, potential for conflicts of interest because of the many tranches of debt in one deal, insider trading and unclear ownership of economic risk are all areas of concern for the FSA, which has asked for responses to its study.
Ashurst finance partner Mark Vickers said: "There's been such an explosion in debt instruments that the actual risk doesn't sit with the lender of record. The regulator is looking at the integrity of the sector because it's concerned about a domino effect."
The risks are all the more real given the predominance of private equity, which raised £11bn in the first half of 2006, compared with the £10bn raised in IPOs on the London Stock Exchange during the same period.
Corporate partner Laurie McFadden at Freshfields Bruckhaus Deringer said of the findings: "There were no great revelations. There are potential issues that they raise, but the outcome really depends on the state of the economy."
Determining the level of regulation for the private equity sector was the study's main aim and the FSA's conclusion was that increased regulation would damage competitiveness and drive funds to less-scrutinised jurisdictions.
It does, however, call for more openness and disclosure at the largest funds and banks.
"Private equity is a hugely important source of income," said Vickers. "The regulator is quite rightly asking if we're shoring up problems for the future. I think it gives a well-considered and researched commentary on the conspicuous features of the market."
The FSA is not alone in its concerns and its study follows US probes into anticompetitive behaviour among private equity funds.
This increasing transatlantic convergence is a boon to firms such as Bingham McCutchen, which have set up financial regulatory teams in the past year to help clients through investigations in both the UK and the US.