The Private Equity Machine

Matteo Matera

Tommaso T. Bartolozzi

Table Of Contents:

What is Private Equity? Why everybody talks about it? Why did it became so dominant

In silence, away from the radar of the public markets, a giant is growing that today manages over 3.7 trillion dollars of “dry powder” (capital committed but not yet invested) globally (Statista, n.d.). This is the world of Private Equity (PE), a financial universe that buys companies, restructures them and resells them with the aim of generating high returns. Born as a niche market in the 80s, today it has become a pillar of contemporary capitalism, with an investment volume that reached $1,750 billion in 2023 alone (Ljungqvist, 2024).

The engine of this industry is the leveraged buyout (LBO), a transaction in which a private equity firm, called a financial sponsor, buys a target company using a large portion of debt to finance the transaction. The goal is to achieve an annualized return on investment (IRR) historically greater than 20% (Rosenbaum & Pearl, 2013).

The ideal profile of an LBO target

In selecting target companies, sponsors of leveraged buyout transactions adopt a highly selective approach, oriented towards maximizing returns and mitigating operational and financial risk. The ideal companies for an LBO are generally characterized by stable and predictable cash flows, capable of sustaining high levels of debt over time without compromising business continuity. Predictability of cash flows is in fact an essential element to ensure the regular servicing of the debt contracted to finance the acquisition, reducing the probability of default and allowing for more accurate financial planning (Kaplan & Strömberg, 2009).

Alongside financial stability, sponsors are looking for companies that hold an established and defensible competitive position within their target market. The presence of barriers to entry, such as economies of scale, patents, strong brands or a distribution network that is difficult to replicate, is a strategic advantage that reduces competitive pressure and allows high operating margins to be maintained even in adverse economic contexts (Acharya et al., 2013). At the same time, low capital intensity (Capex requirements) represents another relevant selection criterion: companies that require limited investments to maintain their production or commercial capacity allow them to allocate a greater share of cash flows to debt service, thus improving the sustainability of the transaction during the entire holding period.

Another crucial element is the quality of the management team. Sponsors tend to favor solid management teams, with a clear strategic vision and demonstrated operational skills, often incentivizing them through management participation or equity rollover mechanisms that allow them to align the interests of management with those of financial investors (Gompers et al., 2016). This alignment incentivizes the achievement of growth and operating efficiency objectives, creating shared value in the medium term.

Finally, opportunities for operational improvement are one of the key levers for post-acquisition value generation. Sponsors are looking for companies that have room for optimization in cost management, in the restructuring of production processes and in the rationalization of the supply chain. The goal is to increase overall efficiency, free up internal resources and expand profit margins, thus maximizing the final returns of the transaction at the time of exit. In summary, the combination of financial stability, competitive strength, low maintenance investments, managerial quality and operational efficiency potential outlines the ideal profile of target companies for LBO transactions, characterized by a low operational risk and the ability to constantly generate adequate financial resources to support the debt burden (Axelson et al., 2013).

Historical evolution and famous takeovers

In the 80s and 90s, the PE gained notoriety thanks to historic takeovers that captured the financial imagination:

RJR Nabisco (1989): The largest leveraged buyout of the time, orchestrated by Kohlberg Kravis Roberts (KKR) for $25 billion. This case showed the world the power of leverage and the effect of private equity funds on corporate governance.
Heinz (2013): Purchased by Berkshire Hathaway and 3G Capital for $23 billion, highlighting the role of PEs even in mature and highly reputable companies.
Dell (2013): Michael Dell and Silver Lake Partners took over the company from the list, leveraging strategic transformation away from public scrutiny.

These examples illustrate how the PE can act as a catalyst for policy change, redefining markets and industrial models.

The PE market tends to follow the trend of the more general M&A market. The 80s were years of great expansion for the LBO market, incentivized by the very favorable debt market. We can see several consequences: an increase in prices paid, an increase in junior debt, increasingly indebted financial structures, a shift to riskier sectors and an increase in the debt default rate. In the historical series, the trend of acquisition multiples is relevant, reaching their highs at the end of the economic cycle and in the vicinity of a crisis, from 2002 to 2007 multiples went from 6.2 to 8.9 times the value of EBITDA and transactions tend to have a debt component that is greater than the equity component. The market is positive about periods of great euphoria and expansion: low interest rates lead to more indebted and riskier transactions. Currently, multiples in the EU average 11 times the value of EBITDA, but following a downward trend compared to the post-COVID years when interest rates were close to zero.

The importance of institutional investors

The entire private equity ecosystem is underpinned by a network of institutional investors known as Limited Partners (LPs), the true providers of capital that power the industry machine. These include pension funds, insurance companies, sovereign wealth funds and university endowments, united by the search for higher returns in a macroeconomic environment characterized, especially in the decade following the 2008 crisis, by persistently low or even negative interest rates (Ang & Sorensen, 2012). The massive entry of these players has led to an unprecedented expansion of the assets managed by private equity funds, helping to transform the sector from a financial niche to a structural component of the global capital system. This flow of resources has allowed sponsors to significantly increase the size of their deals and adopt increasingly complex and diversified strategies, extending the reach of private equity to new markets and manufacturing sectors (Metrick & Yasuda, 2021).

The participation of LPs is not limited to capital injection, but profoundly influences the investment philosophy of the funds. Capital commitments by institutional entities are governed by long-term logics and fiduciary constraints, which push managers to balance the search for yield with risk management and diversification of the overall portfolio. In this sense, private equity has become a functional vehicle for asset liability management strategies, allowing investors such as pension funds to compensate for the reduction in traditional bond yields and to pursue alpha-generation objectives through illiquid instruments with high valuation potential (Harris, Jenkinson & Kaplan, 2014). At the same time, the inflow of capital from LPs has triggered a multiplier effect on the availability of investable funds, prompting operators to create new classes of vehicles, such as private credit, infrastructure or growth equity funds, that respond to different risk profiles and time horizons. This internal diversification has made private equity an increasingly sophisticated and interconnected system, in which the relationship between LPs and General Partners (GPs) is both financial and strategic: the former provide liquidity and define return expectations, while the latter transform this capital into value through the selection of transactions, the active management of investee companies and the implementation of exits. Ultimately, the role of LPs represents the lifeblood of contemporary private equity, not only in terms of financial resources but also in terms of strategic orientation, influencing the overall direction of the industry and its evolution over time (Phalippou, 2020).

The macroeconomic impact

In addition to the growth of the sector itself, the EP directly influences the GDP and employment of the economies where it operates, improving business efficiency and increasing productivity. However, the benefits come with significant risks: the massive use of debt increases the vulnerability of companies to economic shocks, and the concentration of private ownership can have negative effects on market transparency. The impact therefore has both positive and negative aspects. LBOs represent a factor in rationalizing the market by intervening on areas of inefficiency in the production system. The PE market identifies inefficient areas and brings them back to the desired levels of efficiency through the use of leverage and through a governance characterized by strong and centralized ownership. The negative aspects are given by the possible predatory nature of the sponsor, especially when this is represented by a Private Equity fund, the goal could be a faster realization of the result by making use of drastic solutions such as corporate break-ups rather than a slow restructuring of the company. In this regard, for explanatory purposes, it is important to report the data of a study (The economics effects of PE buyouts, working paper 20-046, Harvard Business School) in which we find data in terms of employment and wage levels in the two years following the operation.

in listed companies: 13% reduction in employment, 1.7% reduction in wages
in unlisted companies: 13% increase in employment, 1.7% reduction in wages

The impact is influenced by both endogenous and exogenous variables with respect to the target society. Among the endogenous variables we have the type of company, the legal nature, the market in which it operates. Among the exogenous variables we have the trend of the economic cycle, interest rates and the credit market.

THE DEBT STRUCTURE AND VALUE EXTRACTION

How is an LBO funded? And how do sponsors extract value before they even sell?

The financial structure of an LBO is the heart of the private equity industry. Typically, debt makes up 60-70% of the total capital used for the acquisition, with the remainder being equity provided by the sponsor (Rosenbaum & Pearl, 2013). Leverage allows you to amplify returns, but it also increases your risk exposure in the event of economic shocks.

Capital Layers in a LBO

The debt structure in a leveraged buyout transaction is not uniform, but consists of a series of financial instruments with different characteristics, risk levels and repayment priorities. Each category of debt responds to specific needs for a balance between cost of capital and operational flexibility, reflecting the growing complexity of contemporary structured finance transactions. In the safest and most priority part of the structure is bank debt, generally composed of revolving credit lines and term loans. These are secured instruments on the assets of the target company and therefore less risky for creditors, which is why they offer lower interest rates than other forms of financing. However, these loans are accompanied by a series of contractual clauses, the so-called covenants, which impose strict limits on corporate management, regulating aspects such as the distribution of dividends, the contraction of new debt or the sale of assets. Failure to comply with one of these covenants can lead to technical default and authorize the bank to request immediate repayment of the loan, exposing the company to liquidity risks even in the absence of real economic default (Kaplan & Strömberg, 2009).

At an intermediate level of the structure are high-yield bonds, unsecured debt instruments that offer higher yields to compensate for the higher risk taken on by investors. These securities, commonly placed with institutional investors, have longer maturities and less restrictive clauses than bank loans, thus offering greater management flexibility to the management of the acquired company. However, the higher cost of such bonds reflects the subordinated risk associated with their position in the redemption hierarchy: in the event of default, high-yield bondholders are repaid only after the bank debt has been fully paid off (Axelson et al., 2013).

Finally, in the riskiest part of the structure is the mezzanine debt, a hybrid form of financing that combines elements of debt and equity. This intermediate layer offers lenders a superior return, proportional to the higher risk they take, and may include equity components such as warrants or conversion options that allow investors to access a share of the company’s share capital if the transaction is successful. This makes mezzanine debt a particularly flexible instrument, as it allows investors to be attracted who are willing to take more risk in exchange for a higher potential return. Together, these components, banking, fixed income and hybrid, form a multi-level structure that maximizes leverage while maintaining a balance between cost of capital, operational control and default risk (Gompers, Kaplan & Mukharlyamov, 2016).

The Special Purpose Vehicle

To isolate risk and simplify debt management, sponsors create a Special Purpose Vehicle (SPV). This entity formally acquires the target and incurs the debt, leaving sponsors to limit direct exposure. SPVs are crucial for future debt securitization: loans taken out by the SPV can be aggregated and packaged into complex financial instruments, such as CLOs (Collateralized Loan Obligations).

The SPV also acts as a governance structure: debt and loan clauses are managed directly by the SPV, while the operating company remains focused on the core business. This mechanism allows sponsors to maximize financial efficiency and minimize direct risk on their balance sheets.

Extracting value before selling

In addition to financing the acquisition, the debt allows sponsors to recover capital early through Dividend Recapitalization operations. In this practice, a fund can issue new debt to pay an extraordinary dividend to the fund’s shareholders. Generally this happens after a few years of growth of the acquired company which will have a higher EBITDA than the acquisition value and a better NFP. In addition to corporate factors, the market must present the availability of credit at a favorable interest rate. The fund thus achieves a partial return of capital while maintaining control of the company having not yet exited. In unfavorable markets this can be an advantage for the fund which increases the IRR and waits for better times for the exit having already cashed out. However, the company becomes riskier as leverage and pressure on interest grows. The new debt is also entirely distributed to shareholders and therefore cannot be spent in CAPEX, reducing the company’s ability to expose itself to investments, acquisitions and debts that lead to a return. The risk thus weighs entirely on the company which burdens the new debt without having the benefits.

Dividend recap operations are cyclical, increasing in periods with low rates and liquid credit markets, in the post-pandemic years there was a boom generated by low rates. In the following years, the number of recaps decreased by more than 50% compared to previous years (S&P, 2023).

In 2025, Dividend Recaps have seen an increase especially with low interest rates and easy access to private credit, where specialized funds provide loans directly to companies bypassing traditional banks.

The role of Private Credit

Private Credit is now one of the main funding channels for leveraged buyout (LBO) transactions, taking on an increasingly important role in the contemporary private equity landscape. According to Statista data (n.d.), in 2023 the total volume of assets under management of private credit funds reached about $1,600 billion in the United States and $505 billion in Europe, showing an unprecedented expansion compared to the previous decade. This growth has been fuelled by a combination of factors, including banks’ gradual withdrawal from corporate financing following stricter regulations introduced after the 2008 crisis and the growing demand for flexible capital from private equity funds. Private credit has established itself as a privileged alternative to traditional bank credit thanks to its speed of disbursement and greater contractual flexibility. Private credit funds, in fact, can approve and distribute loans significantly faster than banking institutions, ensuring greater competitiveness in acquisition processes. In addition, the structure of the loan agreements is less constrained by restrictive financial covenants, allowing greater adaptability to the cash flows of the target companies and the return needs of private equity funds. However, this elasticity is accompanied by a lower degree of regulatory transparency, as these funds operate outside the traditional banking perimeter and therefore in a less stringent supervisory environment. This represents, on the one hand, an advantage in terms of operability and attractiveness, but on the other hand it introduces elements of systemic vulnerability that are attracting increasing attention from financial supervisors (Bank for International Settlements [BIS], 2024).A further element of complexity derives from the process of securitizing part of these loans in the form of Collateralized Loan Obligations (CLOs), instruments that allow credit risk to be transferred to institutional investors such as pension funds or insurance companies. This mechanism has helped to create a real parallel credit market, capable of expanding the availability of liquidity but at the same time increasing the level of overall financial leverage of the system and its opacity (Fitch Ratings, 2023). The interconnection between private credit, CLOs and private equity funds has therefore profoundly redefined the structure of financing LBO transactions, favoring the growth of the sector but also introducing new dynamics of risk and interdependence that make the alternative credit market an increasingly central and delicate element of the global financial ecosystem.

THE RETURN OF 2008? EXCESSIVE LEVERAGE, CLO, AND OPACITY

How is debt structured and distributed? And why does this mechanism recall the financial crisis of 2008?

The LBO funding model has evolved significantly since the 2000s, but many elements are reminiscent of the Global Financial Crisis of 2008. The parallelism emerges when one looks at how debt is managed and transferred. A large part of leveraged loans today are aggregated, divided into tranches and resold through Collateralized Loan Obligations (CLOs) (Cera et al., 2024). This mechanism is strikingly similar to Collateralized Debt Obligations (CDOs), subprime mortgage packages at the heart of the financial collapse of fifteen years ago (Iyengar, n.d.).

In the context of leveraged buyouts (LBOs), debt originates through leveraged loans, which are often characterized by less restrictive credit clauses (covenant-lites) and with the possibility of using EBITDA adjustments (“add-backs”) that can inflate the apparent repayment capacity. These loans, after a syndication process, are aggregated into portfolios within SPVs (Special Purpose Vehicles) that issue Collateralized Loan Obligations (CLOs) by dividing the repayment flows into different tranches (senior, mezzanine, equity). Investors buy these tranches, assuming the risks related to the subordinated level.

This mechanism closely resembles the Collateralized Debt Obligations (CDOs) on subprime mortgages that fueled the 2008 crisis: even in that case, high-risk mortgages were packaged, tranched and sold, with limited transparency and fragile protections for end investors. Problems arose when a significant portion of the underlying mortgages deteriorated, causing collapses in subordinated tranche values and widespread systemic stresses.

In the case of current leveraged loans/CLOs, there are positive differences from the past: CLOs have historically performed better and recovered faster than mortgage CDOs, and investors today tend to be less leveraged institutional entities with a greater degree of regulation in structured credit markets.

However, there are important vulnerabilities that hark back to the 2008 model:

Many emerging practices, such as covenant-lite, add-back EBITDA, and less document transparency, reduce investor protections and risk masking underlying credit deterioration.
If credit deteriorates on a large scale, subordinated tranches can default and generate forced sales on more senior tranches, amplifying the downside and propagating systemic shocks similar to the mechanics of forced sales in 2008.
The waterfall structure and intermediary chains make it difficult for the end investor to accurately assess the quality of the underlying asset, expanding opacity and information risk.
As many leveraged floating rate loans are often refinanceable, in an environment of high rates or credit crunch many companies could face refinancing difficulties or incur high debt costs, increasing defaults.
the expansion of the role of non-bank financial intermediaries (NBFIs) in the structured credit market amplifies the risk that market shocks may propagate in less controllable ways, also because these entities may be less subject to regulatory requirements and less resilient in countering sudden withdrawals or losses.

In summary, although the CLO market has more robust characteristics than the 2008 CDOs, the underlying rationale: securitization of risky debt and transfer of risk along complex chains, has structural similarities that deserve attention. In adverse scenarios, aggregate credit stress could replicate, on a modern scale, the dynamics of contagion and amplification already seen in the financial crisis. But what are the reasons for resorting to such a risky financial structure?

Despite the high level of complexity and risk, the adoption of financial structures such as Collateralized Loan Obligations (CLOs) responds to precise economic and market logics. Firstly, these instruments make it possible to expand the financing channels available to private equity funds. Through debt securitization, risk is unpacked and distributed to a wider audience of investors, including those who do not wish to gain direct exposure to the typical activity of funds, but who are interested in holding portfolios with investment grade ratings (ECB, 2024).

This dynamic has the effect of mobilising capital from traditionally more cautious segments of the financial market, such as pension funds, insurance companies and bond managers, which can thus access higher yields than corporate bonds of the same rating, while remaining formally within the regulatory constraints imposed by their investment mandates. In other words, securitization transforms an inherently risky asset, financing highly leveraged companies, into a seemingly safe and liquid instrument, reducing the perception of actual risk (Pozsar, 2023).

From a systemic perspective, CLOs also help increase the liquidity of a market that is inherently illiquid. Private equity and leveraged lending, in fact, are segments characterized by long investment horizons and a high capital tie-up. The possibility of splitting and reselling debt in the form of structured securities makes it possible to reactivate the circulation of capital, generating a multiplier effect that supports the overall growth of the sector. However, this liquidity benefit is accompanied by an increase in financial interconnectedness, which in the presence of negative shocks can amplify the transmission of risk along the entire funding chain (FSB, 2023; IMF, 2024).

The apparent paradox of resorting to such a risky structure can be explained by its dual effect: on the one hand, it reduces barriers to access to capital, allowing funds to expand their operations; on the other, it feeds the liquidity and depth of the structured credit market. It is precisely in this unstable balance between allocative efficiency and systemic fragility that the ambivalent nature of contemporary finance manifests itself, where the search for yield and risk management tend to merge into a single dynamic of financial engineering.

Debt in the belly of the company and the risk of default

One of the most critical structural features of leveraged buyouts is that all debt incurred to finance the acquisition is allocated to the target company’s balance sheet, not to that of the acquiring private equity fund. In other words, the bought company becomes the vehicle of its debt (debt pushdown), with a leverage profile that is often unsustainable in adverse contexts.

This model exposes the company to three main vulnerabilities:

Covenant-lite loans, which reduce or eliminate traditional contractual protections for creditors. The absence of stringent financial covenants (e.g. on the debt/EBITDA ratio or interest coverage) allows management to prolong situations of credit deterioration without timely intervention by lenders.
Variable interest rates, linked to benchmarks such as LIBOR or SOFR, which make the cost of debt highly sensitive to monetary policies. Rising rates in recent years have directly impacted debt serviceability, squeezing operating margins and accelerating liquidity deterioration in many LBO companies.
Dividend recapitalization (dividend recap) transactions, in which the private equity fund induces the target company to take on additional debt to distribute dividends to shareholders. These transactions reduce residual equity, increase net leverage and leave companies more exposed to negative shocks.

Recent data show that companies controlled by private equity funds have almost double bankruptcy rates compared to non-investee companies in moderate recession phases (Galbarz et al., 2024). This difference is due not only to the weight of debt, but also to the lack of financial flexibility of companies structured mainly to generate quick returns for the sponsoring fund.

This excessive leverage amplifies systemic risks: a small macroeconomic shock, such as rising rates, a contraction in demand, or worsening credit conditions, can trigger multiple chained defaults, reducing the value of underlying leveraged loans and transmitting losses along the CLO chain. This creates a financial contagion mechanism in which the liquidity crisis of a few LBO companies can quickly reflect on institutional investors and, potentially, on the credit market as a whole (FSB, 2023; IOSCO, 2024).

Quality and risks of the underlying assets

Similar to the 2008 Collateralized Debt Obligations (CDOs), today’s Collateralized Loan Obligations (CLOs), while structurally similar, are intrinsically dependent on the quality and performance of the underlying assets. However, crucial differences emerge that require in-depth analysis to understand the potential risks and vulnerabilities of the current financial system.

In 2008, the global financial crisis was triggered by the massive issuance of CDOs backed by low-quality subprime mortgages. Such loans, granted to borrowers with low repayment capacity, were frequently characterized by aggressive contractual terms and poor due diligence by financial institutions. The housing bubble, fueled by excessive speculation and lax regulation, led to a wave of mortgage defaults, spreading rapidly through the CDO value chain and causing catastrophic losses for banks and investors. The complexity and opacity of these instruments made it extremely difficult to assess actual risk, contributing to a systemic crisis of confidence.

Currently, the landscape has changed, but new concerns arise in the market for leveraged loans and the CLOs that securitize them. More than 80% of new leveraged loans are covenant-lite, i.e. loans with reduced protections for creditors. Covenants are contractual clauses that impose specific financial or operational conditions on borrowers, whose violation may trigger early repayment or other creditor-protection measures. The reduction or absence of such clauses significantly weakens the position of lenders, limiting their ability to intervene promptly in the event of deterioration in the borrower’s financial health.

This implies that, in the event of an economic crisis or a significant slowdown, the risk of loss is transferred more quickly and directly to CLO investors. Without the possibility of early intervention through covenants, creditors are in a weaker position to negotiate debt restructurings or recover funds before the situation becomes irrecoverable (Buchner & Stucke, 2014). This could lead to an increase in defaults and an accelerated write-down of the assets underlying CLOs, potentially triggering a cascading effect similar to that seen with CDOs in 2008—albeit with different dynamics and sectors involved. The growing interconnectedness between the leveraged loan market and the broader financial system, combined with less transparency and reduced investor protections, raises questions about the resilience of the system in the event of future economic shocks.

Role of rating agencies

As was the case with Collateralized Debt Obligations (CDOs) before the 2008 crisis, the Collateralized Loan Obligations (CLOs) market is also largely based on rating agencies. Senior tranches of CLOs are frequently classified as “AAA”, despite being backed by portfolios of leveraged loans: i.e. loans granted to companies with high debt levels and risk profiles below investment grade (Ljungqvist, 2024).

This high rating has a legitimizing effect on the structured product: it allows pension funds, insurance companies and regulated institutions, which by statute must invest mainly in instruments with high creditworthiness, to access the CLO market. In this way, capital from typically conservative investors is channeled towards complex and potentially risky instruments.

However, the high rating does not equate to zero risk. Rating agencies rely on default and correlation models that assume sufficient diversification between the underlying loans; but in times of systemic stress, correlations increase and losses can affect a large part of the portfolio simultaneously. As the 2008 crisis demonstrated, even apparently safe senior tranches can suffer significant losses when the modeling assumptions do not withstand macroeconomic shocks (Partnoy, 2009; Ljungqvist, 2024).

In addition, a distortion of incentives remains: rating agencies are remunerated by the issuers of CLOs, replicating the conflict of interest already observed in the pre-GFC period. This economic incentive can lead to rating inflation, i.e. overly optimistic assessments aimed at favoring the distribution of the product on the market (Pagano et al., 2023).

Overall, the role of rating agencies in CLOs is a critical link in the chain of trust that underpins risk securitisation. If valuations do not accurately reflect the quality of the underlying loans, the system can accumulate hidden risks that only manifest themselves ex post, when market liquidity evaporates and losses materialise even on the most protected tranches.

Key figures and current market

By 2024, the global Collateralized Loan Obligations (CLO) market has reached an estimated value of approximately $1,200 billion, recording an average annual growth of 10% over the past five years (IMF, 2024). The United States holds the largest share of this market, with over $800 billion of leveraged loans securitized in CLOs, followed by Europe with about €200 billion. European expansion is supported by private credit and the growing role of non-bank funds (FSB, 2023; ECB, 2024).

These data attest to the systemic scope of the phenomenon, which, from a financial niche, has evolved into a pillar of global credit. Currently, debt securitized in structured loans exceeds $1,000 billion. It is estimated that about 12,000 companies worldwide are controlled by private equity funds, employing over 12 million workers in the United States alone and generating annual revenues of more than $3,500 billion. The direct and indirect impact of these enterprises on gross domestic product (GDP) is estimated at around 10% (IMF, 2024; S&P Global, 2024).

These numerical indicators demonstrate the deep interconnectedness of the CLO market with the real economy. A slowdown in redemptions of companies acquired through LBOs could impact not only institutional investors holding debt tranches, but also employment, investment and overall corporate credit stability.

The CLO model, designed to amplify the returns of private equity sponsors through leverage and rapid risk redistribution, is now based on an inherently precarious equilibrium. Critical factors such as high average leverage, the increasing prevalence of covenant-lite loans, opacity in the valuation of underlying assets and the heavy reliance on rating agencies make the system vulnerable to external shocks.

Similar to what happened in the 2008 crisis, even a seemingly circumscribed event — such as a wave of defaults in a cyclical sector, a sudden rise in interest rates or a loss of confidence in the credit market — can quickly spread along the financial intermediation chain, generating contagion effects and widespread market tensions. In an economy where structured credit is now integrated into corporate balance sheets and institutional portfolios, the resilience of the system increasingly depends on the transparency, robustness and regulation of securitization mechanisms (Pozsar, 2023; IMF, 2024).

THE DRIVERS OF EXPANSION AND THE HIDDEN RISKS

What fueled such explosive growth? And what are the warning signs for the financial system and the real economy?

The rise of private markets is not a contingent phenomenon, but the result of a convergence of structural forces that, over two decades, have transformed private equity from a niche market to a pillar of global finance. Three main factors explain this growth: the evolution of the LBO economy, regulatory arbitrage, and the growing demand for capital from businesses.

First, the new LBO economy has made the use of leverage more efficient and profitable. The ultra-low interest rate environment, which lasted for more than a decade after the 2008 crisis, has favored the expansion of debt at low costs and has allowed private equity funds to multiply the return on invested equity. Innovation in structured credit markets, particularly the spread of CLOs, has further expanded funding capacity, creating a self-reinforcing cycle between debt availability and acquisition transactions (IMF, 2024). In this context, leverage has become not only an operational tool, but a real engine of financial growth.

Second, the growth of private equity has been fueled by regulatory arbitrage between the banking market and the private market. After the global financial crisis, the introduction of stricter capital requirements for banks (Basel III and subsequent updates) pushed a significant part of corporate credit out of the traditional banking circuit. Non-bank players — private equity funds, private debt and CLO managers — filled this void by offering capital to businesses that banks could no longer finance as easily. This migration of credit risk has reduced the direct exposure of the banking system, but has increased that of the shadow banking system, which is less regulated and more interconnected (FSB, 2023; Pozsar, 2023).

Finally, the growing demand for capital from companies has found in private equity funds a flexible and adaptable access channel. Many companies, especially medium-sized ones, prefer private capital over public markets to avoid transparency burdens, stock market volatility and short-term shareholder pressure. This trend has coincided with a decline in the number of listed companies, the increase in delistings—especially in the United States—and with the progressive privatization of risk: an increasing share of the real economy now moves outside regulated markets, with less visibility and public oversight (S&P Global, 2024).

However, the very structure that made this expansion possible brings with it increasingly evident warning signs. The rise of covenant-lite debt, the weakening of risk control mechanisms and the increasing interconnectedness between institutional investors and complex credit instruments make the system vulnerable to macroeconomic shocks or crises of confidence. In particular, the high aggregate leverage and concentration of exposures on a few large global players amplify the risk of financial contagion and its transmission to the real economy.

In summary, the explosive growth of private markets reflects an unstable equilibrium: on the one hand, allocative efficiency and financial innovation that have supported the expansion of private capital; on the other, the systemic fragility deriving from the structural dependence on debt and the increasing opacity of the system. As in the run-up to the 2008 crisis, the combination of financial euphoria, high leverage and deregulation can turn the driving force of private equity into a potential vector of global instability (IMF, 2024).

Economics of LBOs

Leverage forms a cornerstone of the Private Equity (PE) business model, acting as a catalyst for amplifying equity returns for sponsors. This tool not only multiplies returns, but also offers significant tax advantages, mainly stemming from the deductibility of interest on debt, which reduce the overall tax burden for PE funds.

To illustrate this, let’s consider a practical example in a $500 million leveraged buyout (LBO) transaction. If the transaction is structured with 70% leverage, this implies that $350 million of the total capital is financed through debt. Assuming an average interest rate of 6%, the annual interest amounts to $21 million. The tax deductibility of this interest makes it possible to reduce the taxable profit of the acquired company, with a consequent decrease in taxes due and an increase in the net return for investors. This tax optimisation mechanism, combined with the amplification of returns, has enabled PE funds to attract capital effectively, even in periods of low interest rates and volatile markets, as highlighted by Rosenbaum & Pearl (2013).

The strategic use of leverage in PE environments allows funds to acquire companies with a relatively small equity ratio. This means that, for the same amount of resources invested, it is possible to control a much larger asset base, with the potential to generate significant returns on invested capital at the time of exit. However, it is crucial to point out that high leverage also introduces a greater degree of risk. An unexpected rise in interest rates or a slowdown in the operating performance of the acquired company can erode profit margins and, in severe cases, compromise the company’s ability to repay debt, leading to restructuring or bankruptcy scenarios.

To mitigate these risks, PE funds adopt several strategies, including the negotiation of protective covenants in debt contracts, the implementation of rigorous operational and management improvement plans in acquired companies, and the diversification of the investment portfolio. The acquired company’s ability to generate robust operating cash flows is crucial to the success of a leveraged transaction, as these flows are the primary source for debt service and ultimately shareholder value creation.

In summary, leverage is not just a financing tool, but an integral and distinctive component of the Private Equity investment strategy. Its proper management—balancing the potential for high returns with the inherent risks—is what distinguishes successful operators in the industry.

Regulatory arbitrage

Since the global financial crisis of 2008, the credit landscape has undergone a profound transformation. Banks, held partly responsible for the crisis due to risky lending practices and poor risk management, have been subjected to a much stricter regulatory regime. At the international level, the Basel III Accord was introduced, raising capital and liquidity requirements and implementing rigorous stress tests to assess banks’ resilience to adverse scenarios. These regulations made it significantly more expensive for banks to hold risky loans, such as those for leveraged buyouts (LBOs) or loans to companies with a lower credit rating. The aim was to strengthen banking stability, but it inevitably limited banks’ ability to provide credit to certain companies and for specific high-risk transactions.

This contraction in credit supply by traditional banks created a market gap, promptly filled by the exponential rise of private credit. Private credit refers to loans provided by non-bank funds and investors, operating outside traditional banking regulations. This market has grown extraordinarily, reaching about $1,600 billion in the United States and $505 billion in Europe. Private credit has become a primary source of financing for LBOs, corporate recapitalizations, and loans to medium-sized companies that struggle to access bank financing due to size or risk profile. Its flexibility and speed have made it an increasingly attractive alternative for companies seeking capital.

This sector, often referred to as shadow banking due to its lower transparency and lighter regulation, offers major advantages in terms of speed and flexibility. Traditional banks—burdened by bureaucracy and strict regulation—cannot match the speed with which private credit funds structure and disburse financing. However, this agility comes with an inherent cost: the industry operates with minimal regulatory oversight, introducing hidden and hard-to-quantify systemic risks. Limited transparency and weaker oversight can lead to underestimation of risk by investors attracted by high yields, and to excessive leverage by companies that may underestimate the long-term impact.

A further layer of risk stems from the current trend toward deregulation. While deregulation may facilitate access to financing—especially for small and medium-sized enterprises (SMEs)—it also pushes an increasing share of companies outside regulated markets, where oversight is stronger, information disclosure is clearer, and protections are greater. This migration to less regulated markets increases the overall risk for the financial system: weaker oversight means fewer controls and more room for risky practices. Financial history offers repeated examples of how periods of excessive deregulation often precede large-scale financial crises. Less oversight creates incentives for over-borrowing, allows companies to conceal true financial conditions, and drastically reduces transparency for investors, heightening the likelihood of systemic shocks spreading across the global economy.

Demand from companies

Companies are attracted to private equity for three main reasons:

Speed: Transactions involving private companies are characterized by a significantly more streamlined procedure than those of public companies. Since they do not require passage through the market surveillance authority and the public meeting of shareholders, the completion time is significantly reduced.

Flexibility and Tailor-Made Structuring: Private equity stands out for its ability to offer highly customized financial solutions, adapting to the specific needs of each company. This manifests itself in the possibility of structuring tailor-made conditions for complex transactions such as debt refinancing, corporate recapitalizations to optimize the capital structure, and dividend recaps, which allow shareholders to monetize part of their investment while maintaining control. This flexibility is a significant advantage over public markets, which are often more rigid and standardised.

Confidentiality and Strategic Discretion: One of the cornerstones of private equity is its inherently confidential nature. Sensitive financial and strategic information of target companies—information that could significantly affect their competitive position and market perception—remains off the radar of public markets. This ensures greater discretion, protecting the company from speculation, external pressure, and the premature disclosure of strategic plans that competitors could exploit. Confidentiality is crucial, especially for companies in highly competitive sectors or undergoing significant transformation.

This phenomenon has made private equity crucial not only for institutional investors, but also for the real economy, supporting the growth and renewal of entire industrial sectors.

Risk Signals and Critical Scenarios

The most obvious risk factor in the private equity sector today is rising interest rates. A large part of the loans that support corporate buy-outs or restructuring operations are indexed to variable rates: therefore, when reference rates rise, the financial costs weigh increasingly on the investee companies. In an extreme scenario, a company facing €10 million per year in interest costs could suddenly find itself having to bear 2–3 times as much, with dramatic consequences for liquidity and solvency.

This risk becomes particularly critical in the context of the so-called “maturity wall”. Many companies are estimated to be refinancing nearly $1 trillion of debt over the next three years, a burden that threatens to crush them if rates remain high and market confidence remains weak. Under these conditions, the ability to access new credit on sustainable terms can be eroded, triggering large-scale defaults and restructuring with systemic consequences on the entire financial supply chain.

To worsen the picture, the growing spread of “covenant-lite” loans, i.e. debt contracts that reduce or eliminate financial control clauses (such as periodic compliance with leverage ratios or interest coverage). In the absence of such constraints, lenders lose room for early intervention: they often only become aware of difficulties when the company is already close to insolvency, making corrective actions difficult to implement in time (Resonanz Capital, 2025). In addition, data indicate that recovery rates on covenant-lite loans after restructuring or bankruptcy are lower on average than those on debt with more restrictive covenants (S&P/IOSCO, 2020).

Another frontier of vulnerability is the Collateralized Loan Obligations (CLO) market. Numerous leveraged loans are packaged inside these complex vehicles, which are then re-securitized in tranches with different risks. The opaque structure of CLOs, the difficulty in correctly valuing the underlying assets and the potential inverse correlation in stress phases make this market a possible detonator of chain crises. Regulators and research groups have highlighted how impairment shocks in underlying loans can quickly propagate to more senior tranches, offloading losses on institutional investors and intermediaries (OFR/FRAC, 2019).

Systemic risk is also fueled by the concentration of capital in the hands of a few sponsors and large institutional funds: if one of these players were to encounter management or operational difficulties, the domino effect on the entire private equity structure could be severe. A crisis at the heart of the network could quickly spread to smaller players, portfolio companies, and their creditors.

In parallel, the trend towards deregulation and the choice to remain private for longer or to delist may lead to a decrease in transparency. While offering greater operational flexibility, these choices reduce visibility into the financial condition of investee companies and may exacerbate aggregate risk related to opaque practices or aggressive decisions not subject to public oversight.

In addition, there is a contractual mechanism that amplifies shocks: when a company breaches a covenant, its investment capacity is significantly reduced. Empirical studies show that after the violation of maintenance covenants, capital investment decreases by an average of 0.9%, while after violations of incurrence covenants the drop can reach 1.8% (Federal Reserve Bank of Dallas). Breach events also tend to push companies to delever, restrict operations, and in many cases undergo forced restructuring.

In light of these risks, the scenario that emerges is potentially critical: a weak macroeconomic environment, with high rates and market volatility, could transform private equity from an engine of growth to an amplifier of instability. The large dry powder reserves accumulated in funds may be deployed hesitantly or under overly selective conditions, while pressure on fragile companies could generate a wave of defaults. In the absence of prudent governance, contractual transparency, and targeted regulatory interventions, what today appears to be a “return” asset class risks becoming a hub of financial contagion with high systemic impact.

SYSTEMIC RISKS AND COLLAPSE SCENARIOS

What would happen in the event of a serious economic crisis? And what are the channels of contagion for the financial system and the real economy?

When a severe economic crisis occurs — such as a sharp slowdown in GDP, a global recession, or a sudden shock in interest rates — the architecture of the private equity sector can reveal significant systemic vulnerabilities. Private equity firms often operate with a high degree of leverage and are subject to debt constraints that are triggered under stressed conditions. If one or more portfolios show difficulties, the problem can propagate through multiple channels.

A first important channel of contagion is direct exposure: an investee company gets into difficulty, fails to generate sufficient cash flows to service the debt, and therefore defaults. Creditors and the funds that control it suffer losses, which can weaken their balance sheets. If these operators are large and interconnected with other assets, the loss can lead to chain reactions. “Direct contagion” models show that the presence of financial linkages — loans, derivatives, off-balance-sheet commitments — can quickly amplify the number of entities in crisis.

A second channel concerns overlapping portfolios / common exposures: many investee companies, private equity funds and credit funds may hold similar assets or be exposed to the same risk classes. In a stressed environment, fire sales of illiquid assets can depress prices, affecting other investors holding the same exposures. This creates a domino effect across distinct financial markets. The literature shows that systemic risk is not only created by the first firm in difficulty, but by the overlap of positions and forced liquidation mechanisms.

A third channel is liquidity and refinancing: if numerous investee companies must refinance debt in a context of high costs or limited access to credit, a “maturity wall” emerges. Companies that cannot obtain sustainable financing conditions risk bankruptcy or drastic investment cuts, with effects on employment, productivity, and aggregate demand. The deterioration of firms operating in the real economy can be reflected in the balance sheets of banks, intermediaries, and credit funds.

From a scenario perspective, it can be assumed that in the event of a deep recession and persistently high interest rates:

Many investee companies are unable to generate sufficient flows to cover high financial costs, triggering defaults or restructuring.
Private equity and credit funds that financed them suffer losses that weaken their ability to support new investments or exit strategies.
Institutional investors (pension funds, insurance companies) that allocated capital to these vehicles experience write-downs and may require liquidity or reallocations, putting pressure on illiquid structures.
Related financial instruments — such as the private credit market, Collateralized Loan Obligations (CLOs), and other alternative vehicles — can trigger contagion mechanisms to banks, insurance companies, and bond markets, if forced selling, rating downgrades, or runs on illiquid vehicles emerge.

All this can generate an amplification of the negative economic cycle: reduced investment, falling productivity, job losses, and contraction of aggregate demand.

Ultimately, it is not just a question of the risk that one company or one fund ends up in difficulty: the danger is that many companies and funds face distress simultaneously, giving rise to a domino effect that overwhelms sectors and markets. Interconnections, high leverage, homogeneity of investments, lack of transparency, and access to credit on less regulated private markets all amplify the systemic vulnerability of the sector.

Reports from rating and research agencies confirm this: for example, Moody’s recently warned that private equity and private credit are becoming increasingly interconnected with the traditional banking system, creating potential “contagion loci” for a future crisis.

Market Size and Exposure

In 2023, the global private equity market had a huge amount of committed capital. According to the 2023 Bain report, the dry powder accumulated by private capital strategies — i.e., capital promised but not yet invested — accounted for about $3.7 trillion. This underlines not only the financial size of the sector, but also the potential pressure on managers and funds to translate these resources into concrete operations.

However, the most recent analyses show that this amount has started to shrink slightly: as of June 30, 2025, the global dry powder pile is estimated at around $2.515 trillion, down 7.7% from the 2023 peak (S&P Global). This does not mean the reserve is exhausted — the level is still historically high — but it suggests that some of the capital is beginning to be deployed, and that the timing for allocation has become tighter.

On the real exposure side of companies, in the United States more than 12,000 companies are controlled by private equity funds (a figure frequently cited in sector debates). Such companies employ tens of millions of workers and generate a significant aggregate turnover. Empirical analysis confirms that these companies often operate with high levels of structured debt, using instruments such as leveraged loans and covenant-lite debt structures, which increase their sensitivity to interest rate changes and market deterioration.

In terms of related credit markets, the total value of leveraged loans securitized in CLOs already exceeds $1 trillion in the United States, while in Europe the structured private credit segment (including similar vehicles) is estimated at around $400–500 billion, although estimates vary depending on whether hybrid and cross-border structures are included. The IMF points out that the private credit market (including non-tradable direct loans) in the US has an AUM comparable to leveraged loans, and in Europe it has become increasingly large, though still smaller than traditional corporate credit.

Another critical measure is the degree of connection between private credit and the traditional financial system. As interconnectedness grows, private credit funds, specialized debt funds, banks, and other intermediaries forge ties that can act as a bridge for financial contagion if shocks hit the more vulnerable segments of private credit. Recent studies show that while private credit is still relatively modest in leverage, the direction of the market points to increasing systemic importance.

Ultimately, the private equity and private credit landscape in 2023–2025 presents itself with impressive asset values, still very significant dry powder reserves, and a substantial exposure of companies financed with structured debt. This combination makes the sector vulnerable to shocks to rates, liquidity, or market confidence, amplifying the risk that isolated difficulties could evolve into systemic instability.

The initial shock

Imagine that a deteriorating macroeconomic situation manifests itself in a prolonged recession or in a regime of persistently high interest rates. In this scenario, the most indebted companies find themselves in a critical condition: their cash flows are no longer sufficient to cover financial costs, and the refinancing of maturing debt becomes onerous or even impracticable. When maturing liabilities cannot be rolled over on sustainable terms, the risk of default increases rapidly.

Companies that have recently undergone dividend recapitalizations (i.e., additional debt aimed at distributing profits to shareholders) or those acquired through leveraged buyouts (LBOs) with covenant-lite structures (with less restrictive debt constraints) are particularly exposed. These operations reduce financial flexibility and increase the fragility of the company in adverse situations. When the benchmark interest rate rises, the incremental charges are passed on to the company, further compressing operating margins.

To give an order of magnitude, if a 5 percentage point increase in the interest rate were applied to a universe of leveraged loans with an aggregate value of $1 trillion, the increase in interest due would amount to about $50 billion per year. This additional pressure on operating cash flow risks absorbing almost all of the net operating margin of many companies, exposing them to immediate liquidity crises.

Empirical data suggests that the leveraged lending market is already under strain: according to the Leveraged Loan Market Survey 2025, the default rate on leveraged loans in the United States has reached a ten-year high of around 5.6%, driven by distressed exchanges and weak operating conditions (FTI Consulting). This indicates that, even in the absence of a massive shock, a significant portion of the portfolio is already vulnerable. In addition, in the US markets, the yield profile of leveraged loans — consisting of a variable component linked to the increased base rate plus a spread — tends to remain elevated precisely because of restrictive monetary policy (Fidelity Clearing Custody).

The initial shock is the financial upheaval of the most fragile companies, which are unable to bear the burden of higher interest rates or refinance maturing debt. These companies “start to fall” at an early stage, generating losses for creditors and the funds invested in them, and potentially sowing the ground for systemic contagion, which we will analyze in the next phase.

The default wave

When companies owned by private equity funds begin to fail, the effect can quickly spread throughout the entire financial system. Estimates indicate that during a recessionary cycle, the default rates of companies in PE fund portfolios can be almost double those of non–fund-controlled companies (Iyengar, n.d.). These failures result in a significant reduction in the value of underlying assets, compromising the ability of funds to meet their financial obligations and maintain liquidity for ongoing operations.

In parallel, the increase in defaults translates into high losses for creditors, particularly for holders of the junior and mezzanine tranches of CLOs. These instruments, designed to absorb early losses, quickly become vulnerable if the wave of defaults exceeds the forecasts of risk models. Asset losses accumulated by funds and institutional investors can trigger a chain reaction, with forced sales and reduced credit availability, further amplifying stress on the financial system and, consequently, on the real economy.

In this context, the default of private equity–owned companies acts as a detonator, transforming individual vulnerabilities into systemic risks that simultaneously affect markets, institutions, and economic output.

The collapse of the CLOs and the contagion

The CLO mechanism recalls in many respects the CDO “cousins” of the 2008 crisis: loans (often leveraged loans) from companies financed by private equity are aggregated, divided into tranches with differentiated risk, and risk is transferred to the holders of the different classes. Junior tranches (equity) bear losses first in the event of default; the mezzanine tranches absorb part of them; and only if shocks exceed certain thresholds do even the senior tranches — traditionally considered “safe” — suffer losses.

The central problem is that, in an environment of widespread defaults higher than expected by stress tests, senior tranches can also be hit. When many underlying loans go into difficulty simultaneously, the aggregate loss can exceed the absorption capacity of the riskier tranches, pushing the damage even to investors traditionally considered protected.

To complicate the picture, the transparency of the underlying loans is often very limited: investors — and in many cases even regulators — do not have full visibility on the quality of the loans contained in the pools. This hampers the ability to accurately assess exposure and the resilience of CLO vehicles.

The global CLO market has grown to a considerable size: according to S&P, by 2025 the total market covers about $1.33 trillion between the United States and Europe. BlackRock reports that at the beginning of 2025, the amount of CLOs was approximately $1.38 trillion. Industry sources indicate that the global market has risen to around $1.3 trillion, reflecting the rapid expansion of this structured asset class. In addition, new CLO issuances were significant in 2024: that year, the leveraged loan market exceeded $1.3 trillion, and new CLO issuance was just under $500 billion.

In the United States, the CLO market is highly developed and liquid; monthly issues, resets, and refinancings are active. In Europe, the market is more fragmented and shallower: portfolios are more concentrated, pools are less diversified, and secondary-market liquidity is weaker. Research from the Bank for International Settlements shows that European CLOs are more vulnerable to correlated defaults and volatility, precisely due to their limited diversification and high overlap between portfolios.

When the shock hits, the equity tranches are the first to be wiped out or extremely devalued. Holders of mezzanine tranches are affected next. At that point, if the volume of defaults is high, even the senior tranches can record unexpected losses. The huge risk is that these losses generate a domino effect:

Funds that hold CLO tranches (both equity and senior) suffer write-downs on their balance sheets, losing assets and commitment power.
These funds may be forced to sell other assets to cover losses or margin calls, generating fire sales that depress related asset prices.
Institutional investors (pension funds, insurance companies) relying on these returns face asset losses, affecting their risk appetite, portfolio rebalancing, or capital calls.
Financial intermediaries (banks, specialized vehicles, credit funds) with indirect exposures to CLOs, or that provided financing or leverage, may see their balance sheets deteriorate, reducing their capacity to absorb shocks.
Private equity–owned companies affected by worsening credit risk experience reduced access to debt, operational constraints, investment delays, and potentially chain insolvencies in vulnerable sectors.

These effects can spill over into the real economy: job losses, credit crunch for healthy companies, reduced investment, and contraction in aggregate demand.

Contagion is therefore fueled not only through direct losses, but through forced liquidations, overlapping portfolios, loss of confidence, credit tightening, and the systemic fragility embedded in interconnected balance sheets. In an extreme scenario, a wave of bankruptcies and devaluations in the CLO world can become a detonator for a far broader financial crisis.

Institutional contagion and negative spiral

When losses begin to manifest themselves on CLO tranches and structured assets related to private credit, the institutional system enters a phase of high stress, with mechanisms that can activate a true negative spiral. Pension funds and insurance companies, often the main holders of the senior (but also mezzanine) tranches of CLOs, find themselves with significant asset write-downs. This reduction in capital generates pressure to de-risk, i.e., the need to lighten exposure to risky instruments, generating sales and divestments on a larger scale.

The market is not transparent: many positions in CLOs, private credit, and leveraged loans are valued using internal models rather than actual market prices, and these stagnant valuations can hide latent losses until a triggering event occurs. Faced with uncertainty, investors tend to react with panic: the propensity to finance new transactions declines, credit lines are withdrawn, and credit tightens, partly replicating the credit freeze observed in 2008.

Meanwhile, banks, which have exposures to the private capital segment (through subscription lines, loans to special purpose vehicles (SPVs), direct loans or financing lines supporting fund structures), react by reducing credit supply and withdrawing funding lines. The squeeze on lending to SPVs means that funds cannot fulfill capital calls or support distressed portfolios, aggravating the vehicles’ liquidity crisis. This mechanism reinforces the negative dynamic: distressed funds and vehicles sell assets (often at distressed prices), further depressing market values and triggering additional write-downs.

In addition, the interconnection between institutions — banks, funds, insurance companies — makes contagion particularly rapid: losses suffered by one actor can propagate through counterparty relationships, interbank financial lines, or exposures in structured securities, amplifying the systemic impact (as shown in analyses of financial networks and risk propagation mechanisms). The sophisticated intertwining of modern financing makes it difficult to defuse the crisis once it begins.

In the final phase, the real economy enters the vortex: even healthy companies may lose access to ordinary credit, financial costs rise, investments are postponed or canceled, and unemployment increases. Weaker lenders are overwhelmed, and in this downward spiral the system as a whole can enter a deep recession.

Impact on the real economy

The impact on the real economy of a systemic crisis in Private Equity would be exceptional. In the United States, it is estimated that Private Equity funds control about 12,000 companies, which together employ almost 12 million people and generate an aggregate turnover of more than $3,500 billion per year (Cera et al., 2025). These companies, often operating in key sectors such as manufacturing, healthcare, services and technology, represent a structural component of the American economy and, by extension, of the global economy.

A crisis that simultaneously affected a significant part of these companies would therefore have direct consequences on employment, potentially putting millions of jobs at risk. The effects would also quickly spread to related industries, affecting suppliers, subcontractors and local services, in a negative multiplier effect already observed in previous recessionary phases (Blanchard & Johnson, 2023).

On a macroeconomic level, a wave of insolvencies and corporate restructuring within the Private Equity portfolio could have a significant impact on Gross Domestic Product (GDP). According to estimates by the International Monetary Fund (IMF, 2024), even a partial contraction in this production segment would potentially have an impact of several percentage points on US GDP, given the importance of employment and the sector’s connection with financial and credit flows. This would be compounded by a secondary effect of reduced consumer confidence and declining private investment, exacerbating the slowdown.

Finally, the cyclical and financially complex nature of private equity firms — often characterized by high leverage, small capitalization, and reliance on refinancing — would amplify the fragility of the system as a whole. The transmission of the crisis from the financial to the productive level would be rapid and pervasive, affecting not only investee companies but the entire national and international economic network.

An element that is often underestimated, but crucial, concerns the credit crunch, i.e., the contraction of the supply of credit to the private sector. When funds and banks involved in funding leveraged buyouts or private credit transactions come under pressure, their priority becomes reducing exposure. This leads to a generalized tightening of credit conditions, extending well beyond companies directly owned by Private Equity, affecting in particular small and medium-sized enterprises (SMEs), which are already more fragile in terms of liquidity and access to financial markets (OECD, 2024).

SMEs, which form the backbone of the real economy in many countries, often depend on short-term bank credit lines to finance working capital, wages, and ordinary investments. In a context of stress, the withdrawal of these lines can lead to a rapid deterioration in solvency, causing chain bankruptcies and job losses. According to the Bank for International Settlements (BIS, 2024), a 10% credit contraction can translate, within a few quarters, into a GDP reduction of 1.5% to 3%, with particularly severe impacts in manufacturing and services.

In emerging markets, where private equity and private credit are playing an increasing role in corporate financing, the effects could be even more pronounced. The absence of sound financial infrastructure and dependence on international capital make these countries vulnerable to sudden outflows and exchange rate volatility. A liquidity crisis in developed markets tends to trigger a flight to quality, leading to abrupt capital withdrawals from riskier investments and a surge in financing costs for emerging economies (World Bank, 2025).

In this scenario, the credit crunch acts as a crisis multiplier: companies are unable to refinance debt, investments are suspended, domestic demand contracts, and unemployment rises. This creates a negative spiral that drags entire segments of the real economy down. As Reinhart (2023) notes, in highly leveraged crises, the transmission from the financial system to the productive economy is rapid and difficult to reverse without coordinated monetary and fiscal policy intervention.

Lessons of 2007 and future scenarios

The financial crisis of 2007–2008 taught a fundamental lesson: the entire system does not need to be insolvent to trigger an economic and financial collapse. Often, it is enough that transparency is insufficient and that the true value of assets is not known to investors and regulators. The lack of reliable information generates uncertainty, panic, and collective de-risking behaviors, which can lead to forced selling, credit contraction, and rapid shock propagation.

Today, the financial landscape displays characteristics that recall, in part, those historical risks. The growing weight of private credit, the expansion of CLOs and other securitization structures, coupled with largely deregulated private markets, has concentrated risk in relatively opaque and poorly supervised segments. Pension funds, insurance companies, and large institutional investors hold significant exposures to these structures, and a sudden panic event, even without widespread defaults, could trigger ripple effects similar to those seen in the global financial crisis (Cera et al., 2024; Goria, 2025).

Systemic risk, therefore, is no longer a theoretical concept. The high leverage of private equity companies, growing securitization, and low market transparency can turn the sector into an amplifier of global instability. A sudden crisis could spread rapidly, affecting both financial markets and the real economy, with significant impacts on employment, production, and investment. This context confirms the importance of careful supervision, appropriate regulatory tools, and more transparent risk management practices to mitigate the potential effects of a large-scale crisis.

In recent years, Private Equity has acquired a central role in the global economy, financing growing companies, facilitating restructuring, and supporting innovation and industrial development. However, the very structure of the sector — characterised by high leverage, increasing securitisation, and often limited transparency — introduces systemic vulnerabilities that can amplify macroeconomic shocks.

Imagining a stress scenario, a prolonged recession or persistently high interest rates could make it difficult for companies to refinance maturing debt or bear borrowing costs, particularly affecting companies that have undergone dividend recapitalizations or covenant-lite LBOs. The initial shock, amplified by the high volume of leveraged loans and the weight of dry powder, can quickly turn into a domino effect involving not only PE-owned companies, but also structured credit markets and the real economy.

The collapse of CLOs represents a critical node in this chain. As in the case of the 2008 CDOs, the tranche structure of CLOs can turn concentrated losses into widespread shocks, especially when senior tranches are impacted more than expected by stress tests. The lack of transparency of underlying loans and the concentration of risk among pension funds, insurance companies, and other institutional investors create conditions for rapid contagion, which can spread through forced sales, credit restriction, and de-leveraging.

Institutional contagion then feeds a negative spiral: the reduction of credit lines and the de-risking reactions by institutional investors generate effects on both the banking system and the real economy. In the United States, the approximately 12,000 companies controlled by Private Equity employ almost 12 million people and produce over $3,500 billion in annual turnover. A systemic crisis could put a large part of these jobs at risk and have measurable impacts on GDP, with secondary effects on related industries and global markets. Credit tightening would also affect SMEs and emerging markets, where access to capital is more fragile, creating an additional negative multiplier.

However, the foreseeability of such a collapse remains uncertain. On one hand, the risks are concrete and measurable: high leverage, opaque securitisation, and risk concentration make the sector vulnerable to simultaneous shocks. On the other hand, several factors make it difficult to anticipate when or how a crisis might materialize. The geographical and sectoral diversification of portfolio companies, the ability of funds to adapt management and operations, and the presence of capital buffers and credit lines can mitigate the immediate impact. Moreover, the industry has developed increasingly sophisticated monitoring and stress-testing tools, which allow early risk signals to be identified — even though they cannot eliminate uncertainty altogether.

Conclusion

Where are we today?

Private equity remains a powerful driver of growth and innovation, but its complex financial architecture can act as an amplifier of instability in crisis scenarios. Analysis of the shock, contagion and impact mechanisms on the real economy shows both the scale of potential risks and the mitigation capabilities inherent in the sector. The main challenge is to balance supporting economic growth and prudently managing systemic risks, through a combination of transparency, regulatory oversight and risk management tools, without falling into a defeatist or overly alarmist approach.

The financial architecture of private equity, analyzed in this study, has ceased to be a purely theoretical construct of risk. The systemic vulnerabilities described, excessive leverage, structural opacity, regulatory arbitrage and reliance on securitisation through Collateralised Loan Obligations (CLOs), are transitioning from a latency phase to one of overt manifestation. As happened in 2007, the mechanisms were not corrected but simply transferred: from the real estate market to the private credit market.

Today, private credit represents over $1.5 trillion of assets globally, and projections estimate an expansion of up to $3 trillion in the coming years (Paul Weiss, 2025). The global CLO issuances exceeded $400 billion (Nuveen, 2025), while in the European Union, assets managed by non-bank financial institutions (NBFI) have reached €50.7 trillion, now surpassing the traditional banking system (ESRB, 2025). Banks, meanwhile, maintain significant indirect exposures: in the United States, credit lines and loans granted to private credit funds amount to more than $95 billion (Federal Reserve, 2025). This confirms that the risk is not confined to an alternative sector, but propagates silently through the conventional financial structure.

The events of autumn 2025 – particularly the collapses of First Brands Group and Tricolor Holdings – are not isolated incidents, but represent the first significant cracks in the private credit edifice. These failures, largely financed outside the traditional banking system, have revealed the contagion dynamic this study hypothesized: the opacity of interconnectedness. As highlighted by JPMorgan Chase analysts in October 2025, banks’ “lack of transparency” and “hidden exposures” to private capital – the so-called Non-Depository Financial Institutions (NDFIs) – triggered a crisis of confidence. The market, suddenly aware that it could not price this hidden risk, reacted by raising the cost of financing for the banks themselves: the first tangible cost of systemic contagion.

The reaction of the industry has been symptomatic and dangerously reminiscent of 2008. On one hand, industry leaders such as Goldman Sachs CEO David Solomon have downplayed the incident, publicly denying the presence of systemic risk; on the other, international regulators – including the IMF and the Federal Reserve Bank of Boston – have voiced growing alarm. The latter pointed out that the rapid expansion of private credit, while generating yield and liquidity, is creating a new perimeter of vulnerability, since bank liquidity remains the implicit engine of the shadow system (Boston Fed, 2025).

At the same time, while the institutional system is showing the first signs of stress, the industry — driven by market saturation (in the United States today there are more private equity funds than McDonald’s restaurants) — is desperately searching for new sources of capital. The “machine” expands by attempting to retailize risk. Derivative instruments such as Invesco’s triple-A CLO ETF, once reserved for institutional investors, are now accompanied by products such as Goldman Sachs Asset Management’s ETFs designed to replicate private equity returns, while retail platforms like Trade Republic and Scalable Capital open access to private markets. It is a paradigm shift: illiquid, opaque and long-term risk is packaged into highly accessible financial products.

In conclusion, the system is not yet facing a collapse, but is going through a phase of increasing stress and structural reconfiguration. Private equity and alternative credit remain pillars of the contemporary economy, but their integration with the banking system and traditional capital markets amplifies their contagion potential. Systemic risk, far from being mitigated, has been redefined and redistributed: more branched, less visible, but more pervasive. The next shock will not necessarily arise within the banking system — but, in all likelihood, from the sector that today represents the new frontier of financial capitalism: the private credit market.