Lending power and limitations of bank loans and

private credit: an explorative study

Deals&Mandates
- Summary

Premises and disclosures

1. Credit industry: banking

1.1 Maturity transformation
1.2 The role of Central Banks
1.3 Banking financing: main solutions
2. Private Credit financing
2.1 Private Credit financing: main solutions
3. Private Credit financing: features
3.1 Banking Credit financing: features and fractional reserve
3.2 Private Credit financing: advantages and the use of leverage
4. Lending Power: banks vs private credit funds

Final remarks

Deals&Mandates
 - Premises and disclosures

The content on this blog, including any related materials such as newsletters, is provided for
informational and educational purposes only. It is not intended as financial, legal, or professional
advice. Readers should consult with their own advisors before making any decisions based on this
information. The author disclaims all responsibility for any actions taken or decisions made based
on the content of this blog. All information is shared with the intention of fostering understanding
and knowledge.

The following is an independent, not academical or industry-sponsored study. All the information
quoted and used is from reliable, verified sources. This study does not provide any financial nor
legal nor regulatory advice. This study is an original of Deals & Mandates.

This study analyzes the ways in which banking and private credit create liquidity and lend capital to
other firms. The purpose of the study is to compare the economic and regulatory environment of the
banking and private credit industry, underlining the strengths and weaknesses in relation to loans
origination, capital availability, access, flexibility and options to access credit solutions. The
geographical focus of the industry, economic, financial and regulatory data is the European Union
and the United States, with few mentions to the United Kingdom and the Cayman Islands.

Deals&Mandates
 1. Credit industry: banking

The credit industry is massive and certainly one of the strongest and more profitable in the world.
Just in the US, in Q2 2024, total household debt reached an unmatched value of almost $18 trillion,
with almost $13 trillion being housing debt.1

Undoubtedly, the main way through which people and investors can have access to capital is
through banks. Commercial, retail banks and small financing firms (which are usually owned by
banks) have a leading position in the market for retail investors, account holders and small to
medium capitalization firms. Consumer loans in the US have steadily grown in the last two decades,
surpassing one trillion dollars.

All the ups and downs in the charter are easily traceable to periods of growth and depression in
economy and consumers trust in their ability to repay, together with the impact of the FED’s
interest rates. Commercial and industrial loans have followed a similar trend, gaining traction not
only from favorable interest rates at certain times but also from economic distresses, like the Covid
pandemic or the 2008 financial crisis, when access to capital was a fundamental condition for
enterprises to bear the losses in revenues, caused by externalities dramatically lowering consumers
purchase power.

Banks’ lending power is mostly driven by three factors: maturity transformation, central banks’
intervention, fractional reserve.

1
Federal Reserve Bank of New York, Household debt and Credit Report (Q2 2024),
https://www.newyorkfed.org/microeconomics/hhdc
2
Federal Reserve Bank of Saint Louis, https://fred.stlouisfed.org/series/CCLACBW027SBOG#

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 3

1.1 Maturity transformation

Maturity transformation is simply and universally defined as the usage of short term deposits to
finance long term borrowings. A more comprehensive and classical definition can be the following
“ A defining function of banks is maturity transformation—borrowing short term and lending long
term. This function is important because it supplies firms with long-term credit and households with
short-term liquid deposits”.4

To put it simply, maturity transformation is what leads commercial banks to work and the backbone
of the entire banking system in the world: an investor deposits, for instance, a thousand dollars
within an account with 3% interest rate. The deposit will be a high liquid and low-risk instrument
for the investor and the profit for the bank. The latter will then lend those money to a borrower, for
a longer period, charging usually a higher interest rate than the one of first investor. The difference
between the interest given to the lender and the interest earned from the borrower will be the profit
for the bank, together with service fees charged to both. This short and extremely simplistic
scenario where taxes, fractional reserve, maturity mismatch and all relevant risks are excluded for
the sake of the example, shows how the banking system generates not only most of its profits but
also boosts the economy, by generating and making available more and more capital for lenders and
borrowers.

3
Federal Reserve Bank of Saint Louis, https://fred.stlouisfed.org/series/BUSLOANS#
4
Itamar Drechsler, Alexi Savov, Philipp Schnbal, Banking on Deposits: Maturity Transformation
without Interest Rate Risk, Introduction, THE JOURNAL OF FINANCE • VOL. LXXVI, NO. 3 • JUNE 2021

Deals&Mandates
Banks today possess several other ways of generating income. However, for the purpose of this
study, the one that originates from maturity transformation is relevant.

Maturity transformation consists of a sustainable mechanism to inject capital into economies,

proven to be effective, reliable and even more functioning if properly surveilled and regulated. But
the savings and capital provided by investors are not always sufficient. Because banks are tough
businesses to manage, particularly commercial banks are subject not only to several structural and
external risks but also investors’ confidence and trust: people and institutional investors may less
and less opt to keep their money in banks due to better financial gains of the alternatives, being
mutual funds, stocks, indexes, ETFs, private credit funds, actively managed investments accounts of
any kind and even more exotic options such as cryptocurrencies. But still, all those options have a
more or less important level of risk which may discourage retail investors, particularly the working
class, which mostly looks for a safe place to deposit their money and earn good interest to shield
from inflation.

1.2 The role of Central Banks

So banks are still the major players when it comes to capital and wealth creation. Being massively
exposed to economic and financial shocks, banks can have an hard time standing by themselves.
Here Central Banks come into play. To foster the economy, providing more capital to banks
especially during uncertain and complex times and reducing the global risks for the economy,
central banks usually inject liquidity into banks through open market operations, discount window
lending and quantitative easing.

Open market operations are defined as the purchase and sale of securities in the open market by a
central bank5. The main way OMOs work is the following: central banks either buy or sell bonds to
banks. So banks will have more robust reserves and will be able to provide capital at lower interest
rates.

Open market operations are usually targeted at addressing specific needs for the economy by
lowering interest rates and increasing general available money supply and so also economic
activities. The European Central Bank, for instance, adopts regular and nor-regular open market
operations. Regular operations use Euro and consist of one-week liquidity providing operations
(MROs, main refinancing operations) and three-months liquidity providing operations (LTROs,
long-term refinancing operations). Non-regular operations can employ US dollar refinancing and

5
https://www.federalreserve.gov/monetarypolicy/openmarket.htm#:~:text=Open%20market%20operations%2
0(OMOs)%2D%2D,the%20implementation%20of%20monetary%20policy.

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have different durations and specific purposes. The ECB has conducted six main regular operations
with maturity date set for 2024, injecting into economy more than €1636 billion7.

A second way through which central banks inject liquidity into the economy through banks and
credit institutions is discount window lending. Discount window lending offers banks and other
lending facilities short-term and easy-to-access capital from the central bank, typically at a rate that
is higher than the federal funds rate (the rate at which banks lend to each other). The borrowing is
collateralized and the capital is granted quickly, even overnight, to address the needs of banks with
short-term liquidity issues. Discount window lending helps with liquidity risks and make accounts
safer and more stable. The Federal Reserve, for instance, has three kinds of discount window
lending programs8: primary credit lending (for depository institutions in sound financial
conditions), secondary credit lending (short-term, at higher rates that primary credit lending, for
institutions not qualifying for primary credit) and seasonal credit lending (for small institutions with
demonstrated liquidity pressures). Through discount window lending programs, in the second
quarter of 2022, the Federal Reserve has lent close to $57 billion, to hundreds of institutions, with
an average interest rate of 1,03%, mostly with primary credit lending programs.9

A third, largely discussed and powerful mean for helping banks liquidity and supporting economy is
quantitative easing. Quantitative easing (QE) , also definable as assets purchasing, involves the
central banks buying significant amounts of debt instruments and securities from banks, providing
more liquidity, lowering interest rates of debt instruments and allowing consumers and firms to
borrow more, spend more and finance projects, consumption and investments, all while bringing
the inflation rate to the world-wide agreed target of 2%.

Quantitative easing has been frequently used by the major central banks in the world and while it
may seem similar to open market operations, it actually quite differs. Open market operations
involve both buying and selling government bonds, frequently and on a smaller scale, while
quantitative easing involves central banks buying many kind of securities from banks and credit
institutions on a much larger scale and on extraordinary needs and market conditions. Famously,
QE has been employed by the Federal Reserve to address the 2008 financial crisis consequence and
by the European Central Bank to help the economy during and at the aftermaths of the European
Sovereign Debt Crisis of 2010-2011.

6
Allotted amount
7
European Central Bank, Eurosystem, Open Market Operations,
https://www.ecb.europa.eu/mopo/implement/omo/html/index.en.html
8
Discount Window Lending, https://www.federalreserve.gov/regreform/discount-window.htm
9
https://www.federalreserve.gov/regreform/files/dw_data_2022_q2.xlsx

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 1.3 Banking financing: main solutions

Large banks offer a wide spectrum of credit financing products to firms, ranging from
straightforward loans to more intricate financial instruments, designed to address diverse business
needs. Private equity (PE) firms may also provide some of these financing solutions, though their
role typically focuses on more structured and equity-related finance. Also, PE firms differ in terms
of contractual freedom, interest rates on debt, rights and obligations of lenders and buyers and the
size of loans.

Business Loans: Large banks offer term loans, typically used for capital investments such as
acquisitions, expansion, or equipment purchases. An example: a bank provides long-term loans with
fixed or variable interest rates. A manufacturing firm might secure a $5 million loan to purchase
new machinery. PE firms, however, often participate in mezzanine financing, a hybrid of debt and
equity financing that allows companies to raise capital with fewer restrictions than traditional loans,
but with higher interest rates. This option is frequently used in leveraged buyouts (LBOs)
orchestrated by PE firms, where debt is used to finance a portion of the acquisition.

Lines of Credit: Banks offer revolving credit lines, which provide flexible funding for short-term
needs like working capital or inventory management. A retailer, for instance, might use a $2 million
line to handle seasonal inventory purchases.

Commercial Mortgages: Banks offer commercial real estate loans for purchasing or refinancing
properties. A bank can provide loans to companies looking to acquire office buildings or
warehouses. A tech firm might take a $10 million mortgage for a new headquarters.

Syndicated Loans: For large-scale financing, banks participate in syndicated loans, where multiple
lenders share the risk of a significant loan. These loans are common in mergers, acquisitions, and
large capital projects. For instance, a $1 billion syndicated loan might fund a multinational
corporation’s acquisition. PE firms also regularly engage in syndicated loans for LBOs, especially
when financing large transactions, partnering with banks to distribute the risk across multiple
lenders.

Asset-Based Lending (ABL): This type of lending allows companies to borrow against assets such
as accounts receivable or inventory. A company may secure a $20 million loan against its
receivables to improve cash flow.

Trade Finance Products: Banks provide letters of credit and other trade finance instruments to
facilitate international transactions. These products are critical for companies engaging in cross-
border trade, ensuring that exporters receive payment upon shipment of goods.

So, it is rather clear that the banking system by its nature, major and historical involvement in the
economy, close ties with central banking systems and so adaptability to financial and economic
shocks and conditions, represents the largest and arguably best way for investors, people and firms

Deals&Mandates
to lending, borrowing, financing and depositing. And the data confirms it: as of August 2024, there
is more than $17 trillion as deposits in US commercial banks 10.

2. Private Credit financing

Private credit is a way of financing that began to gain traction in the early 1990s, particularly with
mezzanine debt financing instruments.11 Part of the broad group of alternative finance solutions,
private credit does not involve traditional banking and credit institutions, provides more agile and
tailored solutions to borrowers and given its flexibility and less regulatory and risks burden,
represents a competitive and attractive financing alternative than traditional banking solutions. The
sector has grown massively in the last two decades, especially driven by Private Equity firms with
private credit funds: famous are the Oaktree Mezzanine Funds, (launched between 2001 and 2006,
with over $4bn AUM and more than 190 transactions),12 BCRED, Blackstone Private Credit Fund
(one of the major products of the firm, with more than $58 bn AUM as of June 2024)13 and the
Apollo Diversified Credit Fund (with more than $1bn AUM and part of the Apollo Global Credit
Platform, managing $502bn AUM, being the first credit platform in the world by AUM)14. Private
credit is forecasted to grow significantly, reaching as much as $3.5 trillion AUM by 202815.

The data of the industry today signal a solid and fast growing sector. Despite a decline, private
credit funds have raised almost $200 bn in 2023 and, between retail and institutional investors, the
industry has around $1.9 trillion AUM globally as of 2023.

10
Federal Reserve Bank of Saint Louis, Deposits, all Commercial Banks,
https://fred.stlouisfed.org/series/DPSACBW027SBOG
11
Mezzanine financing: Mezzanine financing is a hybrid of debt and equity financing that gives a lender the
right to convert debt to an equity interest in a company in case of default (…) (Investopedia)
12
Oaktree Capital Management, https://www.oaktreecapital.com/docs/default-source/default-document-
library/strategy-primer_mezzanine-finance_objective_rebrand-04-2017.pdf, Total Assets
13
Blackstone, BCRED Prospectus, Financial Information, page 4, https://www.bcred.com/ , Total Assets
14
Apollo Global Management, Apollo Diversified Credit Fund,
https://www.apollo.com/wealth/strategies/products/apollo-diversified-credit-fund
15
Bloomberg, BlackRock Says Private Debt Will Double to $3.5 Trillion by 2028,
https://www.bloomberg.com/news/articles/2023-10-26/blackrock-says-private-debt-will-double-to-3-5-trillion-
by-2028

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 16

2.1 Private Credit financing: main solutions

Private Credit financing usually involves direct lending and special situations lending.

Direct lending provides easy access to capital usually for SMEs through complex tailor-made
solutions which are unavailable from banks due to regulatory, risk and capital structure
requirements.

Some of the main direct lending solutions are: senior secured loans, mezzanine financing, public
syndication, sponsor-backed lending, unitranche debt, second lien debt, bridge loans.

Special situations debt financing can be adapted to a large variety of situations. Some of the main
special situations financings are distressed financing, turnaround financing, debtor-in-
possession financing.

Companies can secure capital either through corporate credit lending (whose ability to repay is
determined by borrowers’ cash flow, enterprise value and performance) or ABF (asset based
finance, loans which are collateralized by borrowers’ hard, commercial, contractual and
consumer/mortgages assets).

16
PitchBook, 2023 Global Private Debt Report, pp. 6-7.

Deals&Mandates
Private Credit has historically been attractive to borrowers and investors for a series of reasons.
Here we consider the major reasons why private credit financing is more attractive for borrowers.

Regulatory Flexibility: Private Credit is much less regulated than traditional lending. Banks are
subject to Central Banks supervisions, capital requirements which may strongly vary in different
jurisdictions, borrowers protection standards, reporting duties and many more. So, getting capital
financing from banks may be more burdensome and slower than PE Credit financing

Private Credit belongs to the category of alternative finance. So, both in Europe and the US but also
around the world, is standardly addressed to institutional and well-informed investors (as the ones
famously defined in Annex II of the MiFID II Directive in the European Union): that allows for
longer tenure of capital into private credit funds (which are usually blocked and invested capital
cannot be redeemed for years), easier access for asset managers to capital for financing borrowers
and vast amount of capital contributions by stable and strong investors.

Longer Tenure of Capital: Investors' capital in private credit funds is usually locked in for years,
allowing private credit providers to offer more stable and substantial capital sources to borrowers.

Leverage Usage: Even though private credit funds may use leverage, regulatory and contractual
limitations shield borrowers from the higher interest rates typically associated with bank loans,
making private credit a more competitive option.

Flexibility: given its nature and complexity, Private Credit financing allows for more flexibility for
borrowers which can negotiate duration, interest rates, collateralization and claims, benefiting of
highly customized and so more effective financing solutions.

Hybrid solutions: through hybrid solutions with equity, private credit can strengthen companies’
capital structure, finances and ownership and also improve operational and financial choices.

3. Private Credit financing: features

Retail consumers credit is one of the major segments of the credit industry worldwide. Mortgages,
car loans, student loans and personal loans, as seen in the data above, represent trillion dollars
industries. And the attractiveness of return and high demand of retail credit has also reached Private
Equity firms17. However, the direct lending and special lending of capital of PE firms to borrowers
stays confined to enterprises and institutional borrowers. Conceiving a private credit platform
accessible to retail borrowers remains challenging and also impracticable as of today, considering
the current state of the industry. While some funds are already accessible for investments to retail
investors, lending to retail borrowers through private seems not yet realistic.

Some of the reasons are the following:

17
WJS Pro Private Equity, Student Loan Debt Attracts Private-Credit Investors,
https://www.wsj.com/articles/student-loan-debt-attracts-private-credit-investors-1831735e

Deals&Mandates
Capital Size: PE firms will only lend vast amounts of capital for industrial or other investments
operations. PE financing involves large capitals, expensive financial and legal actions and
requirements and also lots of time;

Limited Capital Availability: PE firms credit platforms have reached all-time-high during the past
10 years in terms of capital raised and available for investments but, considering that those are
investment firms and not banks, those have significantly less amount of capital available in
comparison to commercial banks and credit institutions . Lending capital availability of PE firms
and banks is a more complex aspect which is analyzed further below;

Regulatory Requirements: as for investing, borrowing from PE firms is restricted to larger and
institutional borrowers and subject to different laws than traditional borrowing, making it
unavailable to retail borrowers;

Local and Global Presence: through local branches and a far more established presence and
branding, traditional commercial banks and credit institutions would still be far more competitive
and agile in the market for retail borrowers than PE firms;

Established Alternatives: crowdfunding platforms and other authorized credit institutions

constitute already reliable substitutes for banks for access to capital for particular needs and projects
of retail borrowers.

Given that, it is clear that, unless there are significant changes in the industry and regulation, PE
firms may be missing trillionaire opportunities by not addressing also retail borrowers. However, in
recent years trends of PE firms has been to coexist with banks and not replacing them, even if
competition for certain segments is ongoing. Particularly, banks have still a key role in commercial
and industrial loans18, accounting for trillions of dollars only in the United States. But the fast
growth rate of the private credit industry poses serious questions for large, institutional borrowers:
who will dominate the future of financing?

In order to create credit and lend money, financing institutions, whether PE firms or banks, need to
have capital to lend or the possibility to create credit. Borrowers need more capital that what lenders
can provide and here the main difference between banks and PE firms arise: who is able to lend
more capital?

3.1 Banking financing: characteristics and fractional reserve

The banking system operates through fractional reserve: banks can create liquidity by lending
money they do not currently have, keeping small reserves as depending on minimum requirements
set by jurisdictions and the type of institution. Reserve requirements consist of the minimum
amount set by central banks that banks and credit institutions are required to have in liquid assets. In

18
See note 3

Deals&Mandates
the Eurozone, for instance, it is set at 1% of specific liabilities (mostly customer deposits and short-
term maturity debt securities) on the balance sheets before reserve maintenance periods.19 In the
US, for instance, as from 2020, the Federal Reserve has eliminated reserve requirements for all
depositary institutions.20 This was due also to substantial changes in needs of liquidity, also
following the COVID-19 pandemic; the data prior to 2020 shows that between 2011 and 2020, US
banks have created on average $10.7 trillion of liquidity per year, a huge amount, not even close
that the liquidity that PE firms can provide.

So the banking system has some relevant strengths:

 Banks can lend all (or almost all) of their capital to borrowers, counting on a strong influx of
liquidity coming from account holders deposits and emission of obligations and other debt
instruments;
 Advantageous interest rates from Central Banks make borrowing significantly easier and
more convenient for both consumers and firms;
 Central Banks can inject liquidity into the banking systems through operations such as
discount window lending, open market operations, quantitative easing (as explained in
previous paragraphs), repurchase agreements (Repos, banks selling securities to central
banks and repurchasing those later at slightly higher price for immediate liquidity, a kind of
open market operation);
 Banks have a more stable presence on territories and can have easier access to account
holders through vicinity and knowledge of local market conditions;
 Banks are more regulated: while this may result in less flexibility and more costs, it actually
enables banks to engage in more operations and having stronger ties with authorities and
regulators;
 Authorized banks are the only credit institutions which can count on these strengths, having
a competitive advantage on other credit and lending institutions.

Banks have also some more and less notorious weaknesses which are intrinsically part of the
banking activity itself and the banking system. Particularly, some of those are:

 Banks have relevant liquidity risks which are due to its structure. While commercial banks
have to put in place risk management and mitigation measures (like Tier 1 and Tier 2
Capital under the Basel accords of the Basel International Committee on Banking
Supervision21), economic and financial shocks together with the risk of bank-run may
seriously damage the financial health and stability of banks, hampering access to credit;

19
European Central Bank, Minimum Reserve Requirements, https://www.ecb.europa.eu/ecb-and-
you/explainers/tell-me/html/minimum_reserve_req.en.html
20
Federal Reserve System, Reserve Requirements,
https://www.federalreserve.gov/monetarypolicy/reservereq.htm
21
Components of Regulatory Capital, Tier 1 and Tier 2, Basel III, Bank for International Settlements,
https://www.bis.org/fsi/fsisummaries/defcap_b3.pdf

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  Regulatory burdens: banks may be subject to a series of fines, investigations and expensive
regulatory and capital requirements set by financial regulators, Central Banks and
governments; those may decelerate credit activities and even force banks to interrupt those,
creating serious issues for borrowers;
 Interest rates and inflation: high interest rates and high inflation make capital more
expensive to borrow and discourage potential borrowers which may resort to alternative
lenders;
 Market exposure: while this impacts all financial institutions and not only those, market
shocks, fluctuations and accidents can create serious losses and issues for banks which in
turn may severely restrict or interrupt credit access.

3.2 Private Credit financing: advantages and the use of leverage

Private Equity firms provide a distinct type of capital access. While businesses, especially early-
stage ones, can raise funds through crowdfunding, issuing debt securities and bonds, or through
IPOs, private credit has become a preferred source of capital for large and institutional borrowers.

Private credit has generally higher interest rates on borrowed capital but longer tenure and more
flexibility. While interest rates for borrowers from private credit financing are usually slightly more
than 10%22, which is rather higher than most of commercial and industrial banks interest rates
loans; private credit financing allows for more flexible covenants and negotiations, re-payment and
re-financing options, a variety of debt instruments not available for banks, more dynamic and need-
based clauses in financing contracts and access to the expertise of private equity firms together with
mixed options combining the best of credit, equity and leverage.

The private credit market, so, offers competitive solutions to borrowers and takes advantage both of
institutional (and recently also some retail) investors capital and leveraged capital from banks.
Considering the attractive returns private credit funds provide, investors are considerably more and
more investing in those, so the abundance of investors capital and leveraged one creates a
competitive and financially thriving platforms to borrow capital from.

A crucial aspect is also represented by the regulatory environment around leverage, which can
enable or restrict access to more capital, determining more flexibility but also higher risks.
Considering that most private credit funds are domiciled in the US, Cayman Islands and the
European Union (mostly Ireland and Luxembourg) 23, an overview of the regulatory frameworks for
funds leverage of those jurisdictions illustrates how leverage contributes to private credit success.

22
Data based on average interest rates of capital lent by some major Private Credit Funds. See BCRED
Prospectus (Schedule of Consolidated Investments) and Apollo Diversified Credit Fund Semi Annual Report
(June 30, 2024 – Schedule of Consolidated Investments).
23
Navigating Fund Domicile Choices in Private Credit: Why Familiarity Matters, Dechert LLP,
https://www.dechert.com/knowledge/the-cred/2024/3/navigating-fund-domicile-choices-in-private-credit--why-
familiarity-matters.html

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The Cayman Islands do not have prescriptive statutory limits for the use of leverage, and generally
very limited commercial, trading, diversification and investment objectives limits. 24 That explains
why the Cayman Islands, among all other non-EU and non-US countries, are privileged as choice of
domiciliation non only for alternative (so private credit) but also for mutual and hedge funds.

The US rules on leverage tend to be more conservative and allow for less flexibility. Given the
rather complex structure of the US banking system but also the large availability of capital from
institutional and retail investors, the US regulators have a cautious approach and stricter rules on the
use of leverage for investment funds. Investment funds in the US, particularly alternative
investment funds, do not enjoy a single piece of legislation as the EU but the relevant rules for our
purpose are the ones in the Investment Company Act 1940. Most private credit funds are registered
with the SEC and regulated by the 1940 Act 25. Funds in the US can leverage up to 50% of the total
assets through issuance of preferred shares (200% Asset Coverage rule) and up to 33% of the total
assets through debt borrowing (300% Asset Coverage rule)26 . In practice, it means that if a fund
after fundraising from investors has $100m in Net Assets (total assets minus all liabilities), it will be
able to issue $100m in preferred shares (200% asset coverage) and it can borrow up to $50m in
debt (300% asset coverage), resulting in $200m of total assets in the first case and $150m in the
second case. If a fund leverages in both ways, with $100m in Net Assets, it would have $250m in
total assets, summing $100m of preferred shares and $50m of debt.

So, the maximum amount of leverage for a US based fund is not fixed and shall be determined by
combining the preferred shares and debt leverage limits. However, US based private credit funds
not falling into the scope of the 1940 Act do not have such limitations.

The situation in the European Union is rather different. Greater flexibility in use of leverage for
alternative investment funds, so also credit funds, is allowed in the EU. While every EU country has
set some specific limits and risk profiles for leverage, the AIFMD II27, which has entered into force
in April 2024, sets quite attractive leverage limits for the so-called loan originating AIFs, so private
credit funds: 175% of NAV (net asset value) for open-ended funds and 300% of NAV for close-
ended funds. Considering private credit funds tend to be mostly close ended, the second limit
applies, which makes private credit fund domiciliation in the EU more flexible and attractive on a
leverage perspective: if a fund collects €100m from investors, it can borrow up to €300m, with a 3:1
debt-to-equity ratio and a total capital of €400m.

Which jurisdiction allows PE firms to collect the most capital for borrowers? The EU and the
Cayman Islands provide a more versatile and leverage friendly environment: however, being most
private credit funds set-up by US based asset managers and US-domiciled, those have to undergo

24
Mutual Funds in the Cayman Islands, March 20234, Mourant, https://www.mourant.com/media---
guides/mourant---mutual-funds-in-the-cayman-islands.pdf
25
Investment Company Act 1940, Section 18, Capital Structure, Asset Coverage (some instruments can be
considered senior securities)

27
Alternative Investment Fund Managers Directive II, Directive (EU) 2024/927, paragraph (7) 4b, p. 17

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stricter borrowing rules which actually are compensated by the larger availability of capital of US
based investors. Considering the different options of each jurisdiction, an answer to the above
question would rank:

1. Cayman Islands
2. European Union
3. The US

But given the huge differences in the markets, capital availability and other regulatory
requirements, the best answer would be a combination of the three, as illustrated below.

Most PE firms, in order to collect the most possible amount of capital to lend and generate returns
from, usually set-up complex multi-jurisdictional based structures, taking advantage of the
regulatory attractiveness of different jurisdictions. A very simplified and only illustrative structure
for a close-ended private credit fund which maximizes leverage opportunities, tax efficiency and
regulatory flexibility, providing a reliable both investing and borrowing structure, can look like the
below.

Deals&Mandates
 MAIN CREDIT FUND

Cayman ELP United States Ireland L-QIAIF ICAV (Loan

(Exempted Limited Originating Qualifying Investor
Partnership) Delaware LP (Limited Alternative Investment Fund,
Partnership) Irish Collective Alternative
For third countries Investment Vehicle)
investors, tax transparent For US investors, tax transparent
Or

Luxembourg SCSp (Société

en commandite spéciale)

For EU investors, both tax

transparent

No Leverage For
Leverage limits:
limits
50% of total assets Leverage limits:
(preferred shares) 300% of NAV, 3:1
Debt-to-Equity ratio
33% of total assets (debt)

In an hypothetical scenario, the main credit fund, close-ended, would have a tripartite structure and
different leverage options. The fund would raise a total of $300m, main currency USD. After
exemplifying the fund financial situation and estimating total liabilities (operational costs,
management fees, taxes and others) at 10% of capital for each vehicle, there would be a similar pre-
leverage situation:

Deals&Mandates
 Vehicle Capital Raised Estimated Liabilities Net Assets
Cayman ELP $40 million $4 million $36 million
Delaware LP $200 million $20 million $180 million
Luxembourg SCSp $60 million $6 million $54 million
Total Fund $300 million $30 million $270 million

Each vehicle of the fund uses leverage at the maximum possible limit prescribed by law. The
Cayman vehicle, having no statutory leverage limits, borrows $25m in debt and $15m through
issuance of preferred shares, adding 100% to the total capital. The Delaware vehicle can leverage
either through preferred shares issuances or through debt borrowing: both cases allow to leverage at
most $100m without exceeding asset coverage rules. The EU vehicle (in this case a Luxembourg
limited partnership) can leverage, either through preferred shares issuance or debt borrowing, up to
300% of the raised capital, so in this case, up to $180m. 28

Vehicle Capital Raised Estimated Net Assets Leveraged Total

Liabilities Capital assets
Cayman ELP $40 million $4 million $36 million $40 million $80
million
Delaware LP $200 million $20 million $180 million $100 million $300
million
Luxembourg $60 million $6 million $54 million $180 million $240
SCSp million
Total Fund $300 million $30 million $270 million $320 million $620
million

So, in this very exemplified and fictitious case, a fund can have more than 50% of its total capital in
leverage. Depending on the structure and the investors geography and commitments, leverage can
be higher, but practice shows that, due to risk management reasons and internal policies, asset
managers tend not to have too much leveraged capital: relevant industry data shows how most US
funds have between 30% and 40% of debt to total capital while European funds are around more

28
The structure above is fictitious and does not represent any real fund structure. It is not intended as either
financial or legal advice of fund structuring.

Deals&Mandates
than 60%29, which can find an explanation in the regulatory framework which allows for more
leverage in the EU.

4. Lending power: banks vs private credit funds

Stating that either the banking system or private credit financing has more lending power and
provides better financing opportunities for borrowers would too simplistic and incorrect. As can
inferred from the paragraphs above, the reasons driving the competitiveness and attractiveness of
banking and private credit financing for borrowers are several and ultimately, the geography,
borrowers financial situation and contractual conditions.

BANKS CREDIT PRIVATE CREDIT

Larger liquidity and more credit generation Less liquidity and different credit generation
products products by jurisdiction
Stricter risk management and capital structure More flexible risk management and capital
rules structure rules
Larger geographical presence Only in major cities and financial centers
Financing solutions available to all kind of No retail borrowers financing, more scrutiny
borrowers and borrowers’ selection
Standard and less customizable financing Financing options with high flexibility, tailor-
options made
Major supervision and high scrutiny of Central Less scrutiny and supervision of authorities due
Banks and Financial Regulators to less regulatory burden and requirements
Heavily regulated industry, with centuries of Young industry, regulation in development
practice
More than $4 trillion between consumer and Set to reach $3.5 trillion AUM by 2028
commercial and industrial loans only in the US globally
Stable interest rates, shorter tenure and flexible Higher interest rates, longer tenure and high
options flexible options
Higher exposure to Central Banks interest Less exposure to Central Banks interest rates
rates, inflation and market shocks and inflation
Capital from both retail and institutional Mostly institutional lenders, only recently some
lenders options for retail
Capital injection from Central Banks, higher Tied to leverage rules, locked-in investors
liquidity capital for lending

29
Becker Friedman Institute, University of Chicago, A Survey of Private Debt Funds, Working Paper NO
2023-10, January 2023, Joern Block, Young Soo Jang, Steven N. Kaplan, and Anna Schulze, p.53

Deals&Mandates
Final remarks

This study has analyzed the loan and credit origination options of commercial and industrial banks
and private equity firms. The role of maturity transformation, fractional reserve and central banks
for the banking system liquidity, together with data on current debt lending of banks, has been
essential to set the foundations for a comparison with private credit financing, its possibilities and
recent developments.

The study has shown how the major strengths of the banking system are its capital availability, due
to central banking supply of liquidity options, geographical presence, reserve requirements and
solutions available to both retail and institutional borrowers and lenders. Banking financing remains
the best options for retail and smaller borrowers, with higher risk profiles, shorter credit and
financial history and in less strategic locations, considered geographical presence as a strength of
commercial and industrial banks.

Private credit financing, instead, offers more flexible solutions to larger borrowers, not retail, with
longer credit and financial history and complex financing needs, by combining less regulatory
requirements than banking with more agile options, locked-in capital of investors and leverage use,
which significantly increases capital available for lenders, more flexible and tailor-made financing
options, which can fit the situations of more senior and financially distressed companies, adding to
this hybrid options with equity.

The future of the industry, as other credit professionals reckon, will not result in aggressive
competition between banks and PE firms for attracting both borrowers and lenders but on strategic
cooperation: recently, the announcement of a $25bn private credit direct lending program by Citi
and Apollo, which will expand to other geographies with strategic partners, such as Mubadala
Investment Company and Athene 30. The strengths of the two, like wise use of leverage,
geographical expansion, capital availability, retail solutions and flexible lending options can
revolutionize the industry.

30
Citi and Apollo Announce $25 Billion Private Credit, Direct Lending Program, Citi,
https://www.citigroup.com/global/news/press-release/2024/citi-and-apollo-announce-25-billion-private-credit-
direct-lending-program

Deals&Mandates
Author: Antonio Maggio

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