Private credit gives European banks backdoor into property deals
Known as back leverage, the opaque system lets banks apply more favourable capital treatment to lending
[LONDON] When developers needed an extra £500 million (S$863.5 million) for a state-of-the-art revamp of Deutsche Bank’s former London headquarters this year, adding a roof garden and three storeys on top, the financing did not come from a regular commercial real estate loan.
Instead, the money arrived via a multi-layered structure set up by NatWest Group and Cheyne Capital Management that has become an increasingly popular form of financing in Europe. Known as back leverage, the complex and relatively opaque system allows banks to apply more favourable capital treatment to their lending.
Driven by a funding vacuum caused by post-financial crisis banking regulations, back leverage allows banks to maintain some exposure to real estate while helping debt funds juice returns. But what began as a relatively niche form of financing has become an important part of the property lending landscape, giving rise to rivalry between funds and concerns creditor protections will be eroded.
”The back-leverage space in Europe has become a lot more competitive,” said AJ Storton, a partner at real estate debt advisory firm Art Capital and a former JPMorgan Chase back-leverage broker.
With more banks entering the market, some are pushing down margins and even dropping protections such as margin calls and recourse to funds – the legal right to pursue a borrower’s other assets if a loan defaults – according to people familiar with the matter, who asked not to be named because details are private.
Back leverage, which has long been common practice in the US, is being used more and more in Europe due to tightened regulations and the rise in non-bank lending. Under the structure, a bank and a private credit fund usually team up to supply funding to a special purpose vehicle (SPV), which then provides a loan to the borrower.
Because the SPV is securitised, lenders generally only have to set aside a fraction of the capital required under a direct loan. They also get an inbuilt safety net because the bank provides the biggest but safest part of the debt, while the private credit fund lends the junior portion, shouldering most of the risk. For private credit funds, the set-up creates an opportunity to compete in an increasingly crowded marketplace.
A survey by CREFC Europe showed that banks on the continent have at least 31 billion euros (S$46.9 billion) of loans tied to back-leverage financing, and the trade association said that figure likely underestimates the total.
In a February poll, real estate brokerage Knight Frank found that 90 per cent of banks providing back leverage in Europe expected to increase lending in the next 12 months.
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”It’s a massive trend that we expect will continue to grow,” said Jacky Kelly, who heads the London structured finance practice at Weil, Gotshal & Manges. “It’s really taken off in the last two or three years.”
Other banks that have recently used back leverage to lend to European commercial real estate projects include Barclays and Goldman Sachs Group, according to people familiar with the transactions, who asked not to be named because details are private.
Goldman teamed up with PGIM to provide about £110 million in financing for the construction of The Other House, a luxury apartment hotel in Covent Garden that is due to open in 2026, the people said. NatWest, Cheyne Capital, Barclays, Goldman Sachs and PGIM all declined to comment.
Proponents of back leverage say private credit funds are simply filling a lending gap left by banks in the wake of the financial crisis, and using back leverage allows them to deploy cash more effectively. It also helps developers and real estate owners save on debt costs, helping to boost investment volumes that have slumped since the pandemic.
”Our pitch to banks is that by providing us with back leverage, they get access to deals they wouldn’t usually get sight of,” said Dan Smith, chief executive at private credit firm Broadwood Capital. “It improves returns, and allows us to stretch our capital further.”
While margins differ widely depending on the structure of the loan and the type of borrower, people familiar with the transactions said some could now be between 100 and 150 basis points over a benchmark borrowing rate such as the Sterling Overnight Index Average. That would translate to a yield of around 5 to 5.5 per cent at current levels.
Critics warn that those depressed margins are also cause for concern, because they show that competition is heating up among lenders to secure deals, potentially pushing up loan-to-value ratios.
Peter Cosmetatos, chief executive officer of CREFC Europe, said his sense is that UK and European regulators currently see back leverage to real estate finance as too small to be systemically problematic, though he added that they are not yet collecting broad-based data on the sector. Both the European Central Bank and Bank of England declined to comment for this story.
Another concern is that private credit funds – some of which have only recently started taking back leverage – have not yet had their investments tested in a sharp market shock.
A restructuring could put them in the difficult position of having to negotiate with both the borrower and the bank that supplied the senior tranche of the loan, according to Cyrus Korat, a partner at DRC Savills Investment Management, a commercial real estate investor which does not currently use back leverage.
In the event of defaults across multiple real estate projects, private credit funds would likely have to turn for extra capital to their investors – a group that is known in the industry as limited partners (LPs) and typically includes pension funds, insurance companies and sovereign funds.
That could potentially result in a situation where some investors are called upon by multiple funds, resulting in a liquidity squeeze, according to Ben Barbanel, head of debt finance at UK-based lender OakNorth Bank, which has done about £2.5 billion worth of back-leverage lending over the past several years.
”Those LPs have got billions and billions and billions of exposure and, in a huge downturn, that’s correlated across all of their exposures,” Barbanel said. “In the back of my mind, I’m always a bit nervous that risk potential is not necessarily well enough tracked.” BLOOMBERG
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