A relatively new and growing form of lending in Europe is enabling banks to reduce costs, get around provisioning requirements and potentially boost returns by classifying certain debts as lower risk than they otherwise would. The new financing structure, known as “back leverage,” involves borrowers securing a loan from a private credit fund, which in turn borrows from a bank. The loan amount issued by the bank to the credit fund is rated as less risky than an equivalent loan issued directly to the borrower, according to nearly a dozen sources CNBC interviewed for this story. The lower-risk rated debt means banks are required to set aside a smaller amount of regulatory capital, relative to debt that is classified at a higher risk. “Back leverage generally benefits from a more favorable capital treatment than direct lending, meaning it costs banks less to provide back leverage facilities in comparison to direct lending,” said Jessica Qureshi, an associate at Knight Frank’s capital advisory division. “As a result, banking lenders are able to offer more competitive pricing for back leverage transactions in comparison to direct lending.” Back leverage deals are more commonly structured as “loan on loans” in Europe. CNBC understands that Wall Street giants Citi , Bank of America and JPMorgan, as well as Germany’s Deutsche Bank , the U.K.’s Standard Chartered , NatWest , Shawbrook, and OakNorth, are among the banks providing these loans in the London market. What are ‘loan on loans’? Lending deals that involve borrowers taking out a loan from a private credit fund, which has partly funded the transaction by borrowing from a bank, are called “loan on loans.” These back leverage structures often use special-purpose vehicles to advance the loan as well as hold the underlying assets. For a credit fund, the deals are advantageous since they can use their investors’ capital to advance more loans and boost their returns. Why the loan-on-loan market is growing Lending in the form of loan on loans began appearing in the United States soon after the global financial crisis of 2008. As regulators around the world began implementing the Basel III framework , banks shied away from lending to sectors that were perceived to be at greater risk under the new regime. In the U.K., for instance, commercial real estate has been one sector where banks have had to lower their exposure as a result of the regulations, and where private credit funds have been used to help fill the gap. The debt funds, initially using their investors’ capital, began lending to borrowers who could no longer access credit from banks at attractive rates since they were deemed to be risky, industry experts told CNBC. “Private credit/debt funds have steadily increased market share in the CRE [commercial real estate] lending market,” said Philip​​​​ Abbott, partner at law firm Fieldfisher, which has acted for banks and credit funds on deals. “As a general rule, these lenders are more expensive to borrow from than a bank, but can move higher up the risk curve and will often commit to fast deal execution.” Credit funds initially competed with banks to attract borrowers, but they are now developing a symbiotic relationship through their use of leverage, the industry specialists said. Borrowers also value the relationship-driven approach of most credit funds, and their specialist expertise particularly in alternative real estate sectors. at finance partner at Macfarlanes Laura Bretherton The availability of loans through debt funds is also advantageous to borrowers as companies would otherwise not have access to credit, or would likely be paying punitive interest rates to banks. Without loan on loans, borrowers would also have to approach multiple lenders if loans have high loan-to-value ratios and negotiate bespoke deals commonly known as a “mezzanine” structure. “Borrowers are attracted to whole loan solutions offered by credit funds, under which they may be able to achieve a similar LTV level to a … mezzanine structure, but with increased certainty of execution with a single finance provider,” said Laura Bretherton, a finance partner at law firm Macfarlanes which predominantly works with credit funds. “Borrowers also value the relationship-driven approach of most credit funds, and their specialist expertise particularly in alternative real estate sectors.” Could it boost bank returns? Banks are likely to need significantly less capital to make loans to debt funds, relative to other borrowers. One pillar of the Basel III reforms changed the way banks calculated risk to commercial real estate. For instance, in the U.K., banks tend to mark about 70% to 115% of the loan as a risk-weighted asset, depending on the loan duration, probability of default and other credit risk factors . In theory, for a 10-year loan of $100 million to purchase commercial real estate, the bank would assume about 100% of the loan amount as a risk weighted asset. It would then need to set aside a minimum of 8% of the RWA — or $8 million in our example — as regulatory capital. Regulatory capital has been created to act as a loss-absorbing mechanism to prevent bank failures. However, if the bank were to make the loan to a credit fund instead, the risk weighted asset assessment could fall to as low as 20%. That means the regulatory capital that needs to be set aside could be as little as $1.6 million, using the above (simplified) example. If a default were to occur, banks would also be the first to be paid which lowers their risk. “Simply, it usually means [banks] can deploy capital in a deal they would not be part of at a lower risk attachment point which improves their risk adjusted return on equity,” said Mohith Sondhi, senior director of debt finance at U.K.-based bank OakNorth , which provides financing to debt funds. Banks also benefit from diversification of exposure through loan on loans with relatively little effort. Loans to credit funds are often collateralized across multiple underlying assets in the credit fund, with the credit fund’s, as well as the borrower’s track record, also assessed. The loans could also be securitized, which further lowers the perceived risk for banks. “By lending to private credit funds, the bank reduces its risk via the diversification achieved by investing in a portfolio (rather than a single borrower), which then reduces the capital requirement and at the same time helps the bank to gain exposure to a high-yielding portfolio,” said Alvin Abraham, CEO of Katalysys, a prudential risk management and regulatory reporting advisory firm. Equity analysts at Barclays suggest banks are also at risk of losing market share to private credit funds in markets where they are currently dominant, such as corporate loans to small and medium enterprises. Partnering up private credit funds with back leverage to facilitate these loans could be one way to mitigate the risk. “The conclusion of our analysis is that EU banks would be entering into lower-RoE business by an average of 5% (from 21% on average to 16%) if this happened, with an above-average impact on SEB, SWED, ING , ABN and NWG ,” said Namita Samtani, equity analyst at Barclays, referring to Sweden’s SEB Group and Sweden Bank, Dutch banks ING and ABN Amro and the U.K.’s NatWest Group. If banks do end up getting “out competed,” then “the alternative would be not to lend at all,” Samtani added. How big is the market? Data on private market debt is hard to come by. Academics, analysts as well as the industry itself, are piecing together a picture of the sector through surveys. Equity analysts at Barclays estimated in 2024 that bank lending to private credit funds in Europe stood at about 100 billion euros ($105 billion), which would be less than 2% of traditional bank lending. The Bayes Business School Commercial Real Estate Lending Report, which surveyed about 80 lenders, showed that debt funds now account for more than a fifth of the money lent to the U.K. commercial real estate sector. Nicole Lux, the report’s director and senior research fellow at the City University of London, speculated that when debt funds use loan-on-loan structures, it could represent “up to 50-60% of their total capital.” Another recent survey of 100 lenders by Knight Frank , the global real estate consultancy, suggested that more than £100 billion ($126.4 billion) was raised by debt funds capable of using £200 billion in back leverage from banks. The report also said 90% of those surveyed said back leverage is set to become “the market standard” of commercial real estate lending if it hasn’t already. “It is our firm belief that the back leverage market will continue to amplify, fast becoming a core component dictating liquidity within the CRE debt market,” the Knight Frank Capital Advisory report said. Barclays analysts say that globally, private credit funds have gone from managing $138 billion in 2006 to $1.7 trillion in 2023. Private market data broker Preqin has forecast that the sector will grow to $2.8 trillion by 2028. However, an executive at Apollo Global Management, one of the world’s largest private asset managers, has reportedly said that the true size of the market was closer to $40 trillion in 2023 .
