Private credit is an important change in corporate finance — perhaps the most important in corporate debt since the emergence of the syndicated loan markets — and it could be a mixed bag for markets and the economy, argues Jared Ellias, the Scott C. Collins Professor of Law at Harvard Law School.
“There’s not a single story of the way that private credit is transforming American capitalism,” says Ellias, co-author of “The Credit Markets Go Dark,” published in the Yale Law Journal last year.
The paper, written with Elisabeth de Fontenay of Duke Law School, was recently selected by a jury of faculty members as one of Corporate Practice Commentator’s top ten articles of the year. It also received the American College of Commercial Finance Lawyers’ Gilmore Award for superior writing in corporate law.
Ellias says that, in the wake of the 2008 financial crisis, American companies have increasingly turned away from traditional bank financing toward private credit, which is typically backed by investment funds.
While private credit is not new, its scale and scope is, Ellias argues. Private debt now totals more than $1.5 trillion in the U.S., comprising “a gigantic part of the debt market,” he adds.
This move from “public” to private debt mirrors an earlier shift by companies away from public ownership, he and de Fontenay argue.
“Since the 2010s, the same trends of privatization and concentration that reshaped corporate equity are now reshaping corporate debt,” they write in their paper.
For example, twenty years ago, a significant business might have looked first to the bank-centric syndicated loan market or the bond market to finance its activities with debt, Ellias says. Today, that business is increasingly likely to turn to an investment fund that makes the loan itself without the help of a bank, which can deliver cash more quickly and with fewer bureaucratic hurdles.
But these benefits also come with strings for the company and the broader market, Ellias adds. Private credit loans usually have higher interest rates, and creditors often wield more control over borrower companies. And as his paper’s title hints, less regulatory oversight means that information about the health of many companies is quickly disappearing from public view.
“The world is more impoverished in terms of information than it used to be,” Ellias says.
In an interview with Harvard Law Today, Ellias explains what he and de Fontenay meant by credit markets “going dark” — and what this potentially permanent shift could mean for markets and the economy.
Harvard Law Today: Why did you and your coauthor decide to write about this issue?
Jared Ellias: My co-author and I had both heard from lots of people that private credit was this new, important addition to the debtor-creditor landscape, but neither one of us had a good understanding of what private credit investing was. We spoke to some people in the industry, and we found that they really couldn’t explain it very well either. So, we set out to understand what’s changed about investing and the world of corporate debt, such that private credit is now a gigantic part of the industry.
HLT: And what were some of the big things you learned?
Ellias: The first thing we learned is that, to some extent, the notion of private credit as a new phenomenon is overstated. That’s because the core private credit investment is a boring, senior secured loan to a company that will mature in a few years. The company’s value can go down by a lot before the lender will be forced to take a loss. Investment funds have always made loans like that.
What’s changed is that private credit has emerged as a distinct product category for asset allocators — the big pension funds and asset and investment funds that give money to investors. In other words, private credit has acquired a scale and scope that is new. You now have private credit funds, such as Blackstone Private Credit Fund, Apollo, Aries, or Blue Owl, that collectively manage hundreds of billions of dollars. They can make loans that are much larger than what those investment funds, acting alone or even in groups, could make in the past.
HLT: Are there particular industries that are relying more on private credit, or is this phenomenon happening everywhere?
Ellias: There definitely are industries that attract private credit investors. One that has been in the news lately is software, but I think that it’s much bigger than that. Private credit investors have become a major source of capital for leveraged buyouts across industry, for lots of firms that find themselves wanting to borrow money.
HLT: Why has private credit become more prominent over the last decade or two?
Ellias: After the financial crisis of 2008, regulators all over the world put pressure on banks to take fewer risks. And one consequence of that is like mid-market banks, which used to be the major capital providers for mid-market business, became harder to borrow money from. Simultaneously, these gigantic asset managers who raised these huge funds became really good sources of capital for many mid-market firms. They have the money in their pockets. They can write loans very quickly. Although borrowers pay a little bit more for the money, the speed is attractive, so it’s a model that works well for borrowers and lenders alike. Another factor could be that there is more money — more savings — to go around, and people who make money in the stock market are investing it in private credit.
HLT: What might be lost in this shift from public to private debt?
Ellias: It’s important to note that asset managers executing a private credit investment strategy have moved into multiple segments of the debt market. They’ve moved into big loans, where companies used to borrow money on the syndicated loan market or in the high yield bond market. And they also have moved into the smaller loans, too. Oh, and by the way, instead of lending to these companies directly, the banks are also lending to private credit firms now.
What’s lost? Well, I think regulators now know much less about what’s going on in corporate lending, because regulated banks are doing so much less of it. I don’t think we have firm numbers, but that’s everyone’s sense. For some of the larger firms that used to finance their activity in the syndicated loan market, their debt doesn’t trade anymore, and because their debt doesn’t trade, they aren’t providing disclosures of their activities to groups of lenders. The world is more impoverished in terms of information than it used to be. This is why the title of the article is “The Credit Markets Go Dark.” Just 20 years ago, even a firm that was owned by private equity often had publicly traded bond debt, and they reported information about themselves to at least some people. Right now, private credit firms keep information in-house. It’s a different information environment for regulators and for investors.
HLT: In your estimation, is this shift toward private credit permanent?
Ellias: It feels permanent. It feels a lot like we’ve entered a new world where investment funds making loans are going to be a larger and more important part of the debt capital market. Already, the investment funds that do this collectively manage more than $1 trillion.
HLT: What impact do you predict this will have on markets and on the public at large?
Ellias: There’s not a single story of the way the private credit is transforming American capitalism. Instead, there are many stories about why it happened, and many stories about what the consequence is and will be. As a lawyer, I would predict that we could see a body of cases involving the governance of private credit funds and the rights of limited partners — those contracts might make it hard to sue, but lawyers are creative and are sure to find ways to do so.
In terms of the impact on the market, it’s clear that now there’s this third stool of the debt market for riskier firms, in addition to the high-yield bond market and the leveraged loan market. We’re going to have to watch what happens, because private credit lenders often have the right to replace a company’s board as part of their collateral package — we call this a board flip right. While banks have had something like this for a long time, they traditionally don’t use it. Private credit lenders are nimbler and more aggressive in many ways than banks, and so they’re willing to do it. Private credit lenders are also less afraid to own assets than mid-market banks. Private credit funds are also willing to put people on the board of directors. Banks don’t do that for the most part.
HLT: What impact could this shift have in the event of an economic downturn?
Ellias: It’s hard to know, because the industry hasn’t seen a down cycle yet. There are segments of the economy where private credit lenders are now major capital providers, and what happens if private credit funds take a bunch of losses, and they’re less able to make loans to those companies? Are there other investors that will step in, in different ways? Will traditional banks step back in?
One thing to mention is that private credit funds have a lot of control over when they realize losses, because they can choose to kick the can down the road. One possibility is that private credit-backed firms will be more likely to become zombie firms, because private credit funds are well situated to be patient when a company runs into trouble. Those same dynamics exist outside of private credit, but they could be especially acute in private credit.
HLT: In your view, is our regulatory apparatus set up to address any issues that arise from this new regime?
Ellias: Because private credit is multiple things at the same time, it’s hard to generalize. The consequences of private credit gaining market share in the middle market are different than private credit becoming major creditors of larger companies in Chapter 11 bankruptcy.
Just as an example: When companies file for bankruptcy, since the early 2000s, judges could assume that if you have bank debt, it’s probably trading. What that means is that if there’s somebody out there who really wants to be involved with this company, they’re going to be at the bargaining table, because they’ll have bought the debt from someone else. But with private credit being a larger share of the creditor body, sometimes you only have private loans, and so private equity companies that end up in Chapter 11 are going to need more from the judge to teach the world about those companies, to provide disclosure, so that if there is someone out there who could do a better job with the assets than the private credit firm could, they can bid to become the owner of the company.
In the mid-market, the story might be different: It may be the private credit firms who are nimbler and often more capable — and certainly less regulated than commercial banks — who might be more willing to own assets, and they also might be more willing to delay a day of reckoning than traditional banks are. We don’t really know yet which of those two impulses will be dominant.
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