A mid-market manufacturer needs $50 million to fund an acquisition. Banks pass because post-GFC capital rules make the loan uneconomical. A private credit fund steps in. In this illustration it prices the loan at SOFR (the Secured Overnight Financing Rate, a floating benchmark rate) plus 550 basis points (bps; one basis point is 0.01%). It takes a first lien on all assets and negotiates quarterly maintenance covenants (financial tests, such as a leverage cap, that the borrower must pass every quarter). The borrower gets its capital.
After the 2008 financial crisis, Basel III and the Dodd-Frank Act raised capital requirements for banks. European banks alone reduced balance sheets by roughly EUR 600 billion. Loans to middle-market companies became expensive to hold on bank balance sheets. Banks pulled back. Hedge funds, private equity funds, and private credit funds stepped in. The market grew from about $200 billion at the end of 2007 to over $2.0 trillion through 2025. An estimated $400 billion of dry powder (capital committed to funds but not yet invested) is still available.
Common mistakes
- Confusing maintenance and incurrence covenants. When a question describes leverage rising passively (EBITDA declines, no new debt issued), only a maintenance covenant can trigger, and only once the ratio crosses its threshold. An incurrence covenant at the same threshold does not fire.
- Applying the absolute priority rule incorrectly by giving partial recovery to subordinated holders. If senior unsecured claims total $150M but only $80M is available, unsecured recovery is 53 cents. Subordinated gets zero, not "whatever is left." There is nothing left. Splitting the residual across both classes overstates subordinated recovery and understates unsecured recovery.
- Calculating unitranche interest using only the spread. A $50M loan at SOFR + 550 bps with SOFR at 4.25% earns $4,875,000 annually. Using only the 5.50% spread produces $2,750,000, which ignores the 4.25% SOFR base rate. Both components generate cash interest.
Bottom line
- Post-GFC bank rules (Basel III, Dodd-Frank) raised capital requirements and opened a middle-market lending gap, one major driver of private credit growth alongside borrower demand. The market expanded from $200B at the end of 2007 to over $2.0T through 2025.
- Credit risk is left-skewed dispersion driven by macro and borrower-specific shocks. A credit spread is the yield gap over matched-maturity riskless debt and must cover losses through the cycle.
- Direct lending relies on sourcing, cash-flow or asset-based underwriting, and workout skill, and is predominantly senior secured, floating-rate lending with maintenance covenants. Mezzanine is subordinated, higher-yield, often with warrants, PIK, step-up, or profit participation.
- Maintenance covenants test continuously and trigger when passive leverage drift breaches the threshold; incurrence covenants fire only on borrower action. Covenants control risk five ways: preservation of collateral, appropriation of excess cash flow, control of business risk, performance requirements, and...
Exam shortcut
When a question asks about passive leverage deterioration, check whether the covenant is maintenance or incurrence. Maintenance triggers if the ratio breaches its threshold; incurrence does not. For recovery calculations, work the waterfall mechanically from the top of the stack. Pay each class the lesser of its total claim and the distributable value still remaining, then move to the next class.
The full lesson (about 11,689 words, 78 min read) adds 2 worked examples, all 8 common mistakes, a self-check, free in the app.
Learning objectives
- strategies
- credit risk bankruptcy
- bonds loans
- direct lending
- mezzanine
- advanced mezzanine
- venture debt
- distressed debt
- infrastructure debt
- asset based lending
- abs risks
- abs
- mortgage overview
- residential mortgages
- mortgage reit returns
- cat bonds
- cat trigger types
- cat valuation
- structuring overview
- cmos
- cdo intro
- cdo variations
- cash flow vs market value cdo
- other cdos
- cdo risks
- credit enhancements
- credit deriv markets
- cds
- cds index
- other credit derivs
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