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 at SOFR + 550 bps, takes a first lien on all assets, and negotiates quarterly maintenance covenants. The borrower gets its capital. The fund earns 9-10% with structural protections public bond buyers never see. That gap between bank retreat and borrower demand is the entire private credit market.
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 (firms with $10 million to $1 billion in revenue) 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 roughly $1.6 trillion in 2024, with an estimated $400 billion of dry powder 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 triggers. An incurrence covenant at the same threshold does not fire. Candidates who miss the word "maintenance" or "incurrence" in the stem pick the wrong answer.
- 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. Candidates sometimes split the residual across both classes.
- Calculating unitranche interest using only the spread. A $50M loan at SOFR + 550 bps with SOFR at 4.25% earns $4,875,000 annually. The trap answer is $2,750,000, which uses only the 5.50% spread and ignores the 4.25% SOFR base rate. Both components generate cash interest.
Bottom line
- Private credit grew because post-GFC bank rules (Basel III, Dodd-Frank) raised capital requirements and created a middle-market lending gap; the market expanded from $200B in 2007 to ~$1.6T in 2024.
- Direct lending = senior secured, first-lien, floating-rate loans with maintenance covenants; mezzanine = subordinated, higher-yield, often with warrants, PIK, step-up, or profit participation.
- Maintenance covenants test continuously and trigger on passive leverage drift; incurrence covenants fire only on borrower action (new debt, dividends).
- Covenants control risk five ways: preservation of collateral, appropriation of excess cash flow, control of business risk, performance requirements, and reporting requirements.
Exam shortcut
When a question asks about passive leverage deterioration, check whether the covenant is maintenance or incurrence. Maintenance triggers; incurrence does not. This is the single most common trap in private credit questions. For recovery calculations, work the waterfall mechanically: subtract senior secured claims from enterprise value first, then divide the residual by the next class's total claims.
The full lesson (about 6,813 words, 45 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
- asset based lending
- abs risks
- abs
- mortgage overview
- residential mortgages
- mortgage reit returns
- cat bonds
- cat trigger types
- cat valuation
- longevity mortality
- life settlements
- viatical
- structuring overview
- cmos
- cdo intro
- cdo variations
- balance sheet arbitrage cdo
- arbitrage cdo mechanics
- cash flow vs market value cdo
- other cdos
- cdo risks
- credit enhancements
- credit deriv markets
- cds
- cds index
- other credit derivs
Browse all free CAIA Level I lessons or jump into free CAIA Level I practice questions.