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Britain’s biggest private equity groups face new scrutiny from the City regulator as it attempts to come to grips with the possible risks to the stability of the financial system posed by the industry’s growth.

The Financial Services Authority inquiry, which started last month, is the latest step in the watchdog’s efforts to keep tabs on the ever-increasing amounts of money being raised for alternative investments, which have generally enjoyed a lower level of regulatory scrutiny. Last week the FSA concluded a lengthy investigation of hedge funds by recommending that retail investors be given access to the fast-growing asset class.

John Tiner, chief executive, said in an interview that the FSA was planning to look at disclosure by private equity groups and their impact on the transparency of the financial markets. However, he said the regulator had no preconceptions about what it might find.

The FSA’s interest stems from the growing amounts of money flowing into private equity funds in the UK. The private equity industry raised £9.7bn in 2004, according to internal FSA research, while the total amount raised on the London Stock Exchange that year was £16.1bn. “That tells us we ought to go and have a look,” Mr Tiner said.

Private equity groups have been eager participants in the recent boom in mergers and acquisitions and are increasingly targeting public companies. In the past few weeks, private equity consortiums have made offers for ITV, the UK commercial broadcaster, and HMV, the music retailer. On Monday a consortium led by Goldman Sachs, the investment bank, said it was considering a bid for Associated British Ports, the UK port operator.

The FSA’s move is likely to be watched closely by other financial regulators which are also grappling with the growing power of private equity firms. As the regulator responsible for one of the world’s biggest financial centres, the FSA is increasingly at the vanguard of international regulation.

Mr Tiner said the regulator had to be careful not to drive potential investors away. “What we don’t want to do is to regulate to a level that drives them all offshore,” he said. “Because what would happen then is that they would all go and set up somewhere else and still trade into London, and still produce 50 per cent of London’s liquidity, but we would have no oversight at all.”

The regulator has begun visiting private equity firms to ascertain the systemic risks raised by their growing influence.

Private equity executives argue that the industry has proper controls and does not threaten the stability of the financial system. They also say that, in spite of the industry’s growth, its total funds under management are small compared with sums invested in public markets. “It’s a flea bite in terms of the total equity base,” said one executive.

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