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The EU is clamping down on the fast growing $1.5trn private credit market with new rules intended to curb leverage and reduce risks to financial stability.
Under draft legislation agreed by member states and European parliament negotiators this week, private debt funds will face restrictions on the amount of borrowed money they can invest, according to people familiar with the matter. Open-ended credit funds — which are more liquid than traditional private credit funds and increasingly aimed at retail investors — will also be subject to new restrictions yet to be agreed, the people said.
The rules, finalised on Wednesday night after almost five months of talks but not yet published, mark a significant ramping up in regulatory oversight of a relatively opaque asset class that has grown significantly in the wake of the global financial crisis as more traditional lenders like banks have pulled back.
Private credit includes a range of strategies like direct lending for leveraged buyouts and lending to distressed businesses, and the market is dominated by Wall Street firms including Apollo Global, Blackstone and Carlyle Group, who are increasingly looking to raise money from retail investors. The global market reached $1.5trn at the end of 2022, according to data provider Preqin, while European private credit has grown 79 per cent over the past five years to $221bn.
Regulators have grown increasingly concerned about the risks to financial stability posed by the industry, particularly the potential for rapid withdrawals from funds that hold hard-to-sell assets. In a jointly agreed negotiating position published last year, EU member states argued that leveraged private credit funds could “contribute to the build-up of systemic risk or disorderly markets”.
Leverage for funds which do not allow investor withdrawals until the underlying loans have matured will be capped at 300 per cent, while funds that permit redemptions will be allowed 175 per cent leverage.
The rules also include a pledge to bar private credit funds from allowing investor withdrawals before the loans they hold have matured, unless they meet as of yet unspecified criteria which will be outlined by EU regulators.
Blackstone and Goldman Sachs are among the firms to have launched so-called “open-ended” funds in the past few years to attract capital from a wider range of investors, and will have to meet the new rules to keep operating.
Blackstone declined to comment, and Goldman Sachs did not respond to a request for comment.
“Open-ended funds will have to demonstrate they have adequate liquidity risk management tools,” said Jiri Krol, deputy chief executive of hedge fund and private credit industry body AIMA. “There will be a five-year transitional period for funds that are already in existence.”
Krol said that most funds already operate within the leverage limits, but that the limits could cause issues when loan values decrease, potentially leaving funds needing to sell assets or raise extra cash from investors.
“The net asset value of a fund can fluctuate even if the loans are not traded,” he said. “For example we saw during the 2008 financial crisis that performing loan values can fall by as much as 20 per cent. When the value of your loans decreases, your leverage automatically increases. The limits are likely to have a restrictive bearing on parts of the industry.”
Rising interest rates can mean that lenders can charge borrowers more but there are also concerns around rising defaults at some highly leveraged companies that private credit firms have leant money to.
The new legislation is part of efforts to harmonise the EU’s approach to fund management, in an attempt to better integrate member state economies.
The European Commission proposed the private credit reforms in November 2021. MEPs are also working on a so-called “listing act” to make it easier for small and medium-sized businesses to raise funds on stock exchanges and a proposal on the harmonisation of corporate insolvency laws, ahead of European elections next summer when lawmaking will grind to a halt.
The new rules on private credit needs to be formally adopted by the European parliament and EU council before they become effective. An EU official said it was unlikely that a final text would appear before September.
The spelling of the name of the AIMA’s Jiri Krol has been corrected since original publication of this article
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