(Bloomberg) -- Private credit funds for professional investors are facing their first set of stricter rules under a European Union proposal slated for approval this week, as their growth has fueled questions about potential risks.

EU governments are set to sign off on a regulatory update for managers of alternative investments such as direct lenders. It includes caps on leverage — the use of borrowed money to juice returns — for private credit funds and other restrictions that the industry warns will be onerous.

The new rules are arguably the biggest concerted effort by authorities to put guardrails in place for an asset class that has grown rapidly since the financial crisis, with private credit increasingly replacing bank lending in areas such as leveraged buyouts. The idea is to get a handle on risks outside of banks before they precipitate a crisis, without choking off a still fledgling market that offers alternative sources of funding.

Recent bouts of market turmoil such as the dash for cash at the onset of the pandemic or the 2021 collapse of family office Archegos Capital Management brought the disparate group of firms formerly known as shadow banks into greater focus for watchdogs. The Financial Stability Board, which brings together regulators from around the world, is currently working on recommendations for addressing leverage at non-banks including private credit shops and hedge funds. 

Private credit asset managers in the US and Europe are already subject to certain requirements for conducting their business and reporting data to regulators. The EU is going further with standards for funds targeting professional investors. Other rules already apply to funds for retail investors.

The new EU directive would cap leverage of closed-ended loan origination funds at 300% of their net asset value and that of open-ended ones at 175%, according to a text published ahead of the vote by governments on Wednesday. Those ceilings are higher than private credit funds’ typical borrowing levels, industry lobby group say, meaning they would probably only rein in outliers or deter higher levels of indebtedness in the future.

Private credit has maintained low levels of leverage even as the industry tripled in size, says Jiří Król, deputy chief executive officer of the Alternative Investment Management Association, a lobby group for the industry. A survey last year by he Alternative Credit Council, the private credit affiliate of London-based AIMA, found that 36% of responding firms used no leverage and that debt levels of the “vast majority” that do are below 1.5 times their equity. 

Banks are the main creditors, according to the survey. Yet for a bank to be exposed to losses, a fund would have to burn through its equity, implying “a catastrophic economic scenario or extremely bad underwriting skills of the fund,” Król said. While the new directive stops short of the most onerous rules proposed during negotiations, Król said similar leverage limits don’t apply to other types of funds.

The package contains other restrictions such as a requirement that funds retain 5% of the notional value of each loan they originate, unless there are specific circumstances. To limit the risk of interconnections, funds would also have to diversify their risk and limit exposures if the borrower is a financial institution. 

Earlier this month, the European Parliament signed off on the rules which have been more than two years in the making. They’ll probably enter the EU’s official journal in March or April and be adopted in national laws within two years, according to EU officials who asked to remain anonymous. Funds would have a further year to meet requirements for reporting more data to regulators, they said.

That data may help address the concerns of authorities around the world who say they don’t have sufficient information to judge whether private credit poses a threat to financial stability. National watchdogs who receive information from funds will be able to share more of that with peers, the text shows. It isn’t yet clear how granular that data will be, said the EU officials.

A key step will now be work by the European Securities & Markets Authority to set definitions for whether loan origination funds are closed or open-ended, according to the officials. They will likely include evidence of liquidity management tools, given the underlying assets are typically illiquid, they said.

(Updates with details of restrictions in ninth paragraph)

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