September 2, 2024 • 54 mins
There's been a lot of talk about private credit in recent years. The market has exploded in size, and there are worries that it could be a bubble that eventually bursts and sparks disaster. But there are other negative effects from private credit that might already be happening. In a new paper called "The Credit Markets Go Dark," co-authors Harvard Law School professor Jared Ellias and Duke University School of Law professor Elisabeth de Fontenay argue that the $1.5 trillion market for private credit is already having a big impact on the economy — and not in a good way. They say that the rise of private credit marks a seismic change for corporate governance and dynamism.
Read More:
Odd Lots Newsletter: The Black Hole of Private Credit
Private Credit Pushes Deeper Into Risk That Wall Street Is Fleeing
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Speaker 1 (00:03):
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:20):
Hello and welcome to another episode of the All Thoughts Podcast.
I'm Tracy Alloway.
Speaker 3 (00:25):
And I'm Joe whysant Thal.
Speaker 2 (00:26):
Joe, do you remember reading headlines like the incredible shrinking
stock market?
Speaker 3 (00:31):
Yes, I forgot about that whole period a lot in
the twenty ten's in which there were not a lot
of new IPOs companies that were waiting longer in their
life cycle to go public. It's kind of crazy, you know.
Now you have these multi billion dollar companies that are
still private, and then you like look at like, you know,
(00:52):
when Microsoft and Apple and all those went public, and
it was like no one knew anything about them when
they first came out.
Speaker 2 (00:59):
Yeah, that's true. And I think it's still pretty much
an ongoing trend where you do have more companies deciding
not to raise public stock at all, so they'll just
stay at private forever. They'll tap venture capital or whatever
for their funding needs. And obviously the stock market has
grown in size in terms of market cap, but maybe
(01:19):
not necessarily in terms of absolute available shares. And this
has been a sort of ongoing trend and discussion.
Speaker 3 (01:26):
Totally private financing has just gotten so huge. You know,
we talk about private equity and VC and all of
this stuff, that there is an incredible amount of money.
In fact, the one time when the public market spigot
opened like crazy was the SPAC mania, and so many
of those companies turned out to be total garbage. So
there's obviously some reason why, at least in the stock
(01:49):
market side. You know, it's almost like opting to go
the public route is almost like a red flag.
Speaker 2 (01:55):
Oh that's a terrible thought, but you're right.
Speaker 3 (01:58):
But there seems to be something to that, right, Well,
that's what we've seen in the last several years.
Speaker 2 (02:01):
Okay, what if I told you that a similar trend
to the one that has played out in the stock
market is now happening in the corporate debt market.
Speaker 3 (02:10):
We've obviously talked about private credit affair amount on the show,
but it had not occurred to me until you just
put it that way, the idea that maybe there's some
sort of like parallel here about the way in which, yes,
the incredible shrinking stock market might at some point reflect
maybe we'll talk about the incredible shrinking bond market.
Speaker 4 (02:29):
One.
Speaker 2 (02:29):
Yeah, both bonds and loans, right, And I think the
way you could maybe summarize what's been going on with
the corporate debt market is for a long time, up
until relatively recently, we had a lot of companies that
were issuing bonds, so selling those two investors, or they
were taking out loans from banks, or they were taking
(02:51):
out loans that would be intermediated by banks and then
sold on to more investors. Those are called leverage loans.
And this was kind of what we had seen in
the stock market in like the eighties, the nineties, maybe
the early two thousands, lots of companies coming to the
public market via debt. But now with the rise of
(03:13):
private debt again, the clue is kind of in the name.
More and more loans and bonds are instead being made
by what are known as direct lenders, you know, private equity,
this sort of shadow finance group of financial entities, and
they're doing more of this, and there's less bonds and
loans that are actually being publicly distributed to investors.
Speaker 3 (03:36):
Right, And we've sort of talked a lot about the
why of private credit and various advantages and you know,
certain types of companies and industries that maybe banks don't
service directly, or maybe some flexibility we haven't really talked
about like the consequences or some of the like, all right,
what does that then mean about if so much of
the credit market goes private like this?
Speaker 2 (03:58):
Yeah, And this is the thing I find and really
interesting because there's so much handwringing about the financial stability
concerns of private debt. So is this just a gigantic
bubble and everything's going to blow up one day? But
there are actually immediate concerns things that are happening right now.
So I'm very pleased to say that we have the
perfect guests. We are going to be speaking with the
(04:20):
authors of a paper called the Credit Markets Go Dark.
It's a really great paper. I wrote about it a
few weeks ago in the All Loots newsletter, which you
should all subscribe to, and we're going to be diving
into it in some more detail now. So we're speaking
to Jared Elias. He is the Scott C. Collins Professor
of Law at Harvard Law School, and his co author
(04:42):
Elizabeth Defontine. She is the Carl W. Leo Professor of
Law at Duke University School of Law. So, Jared and Elizabeth,
thank you so much for coming on All Bots.
Speaker 4 (04:52):
Thank you so much.
Speaker 2 (04:54):
So, first of all, how did this get on your
radar as law professors? How did this become so thing
that you were both interested in doing research on.
Speaker 5 (05:03):
My research focuses on corporate bankruptcy, and I'm always interested
in what's going on in the debt markets because what
happens in bankruptcy is really downstream of what's going on
in death right. There's constant innovation and depth, and that
shows up in innovation and bankruptcy. And something that I
kept hearing from ourket participants was increasingly important was private credit,
private credit, private credit.
Speaker 6 (05:23):
And that made me want to learn about it.
Speaker 5 (05:25):
And what you do and you're the member of a
faculty and you want to learn about something is you
try to find a way to write about it.
Speaker 4 (05:31):
So I came at this a little bit differently, which
is Jared and I are both recovering big law firm lawyers,
So we practiced in this area for a long time
before becoming academics. And when I was in practice, it
was all private equity all the time, and it was
a very exciting time. Lots of transactions, lots of deals,
lots of innovation in the financial markets, and one piece
(05:53):
of it that was changing really rapidly was the private
credit funds. So these you know, the big private equity funds,
you know, the bins and TPGs and others. They had
these private credit arms that were appearing and getting bigger
and bigger and bigger. And I started becoming more of
the story, and that to me was very interesting because
(06:15):
private what do you behaves in such a unique way,
so differently from the rest of the way we're used
to big companies operating and so on, And it was
really interesting to me to try to figure out why
this was happening now on the credit side and what
the implications of that would be.
Speaker 5 (06:29):
Elizabeth and I both left practice around the same time,
like right after the financial crisis, and this is one
of the real changes that has changed the way that.
Speaker 6 (06:38):
Corporate finance has done over the past ten years.
Speaker 5 (06:41):
Like when I started to hear from people about private credit,
I realized, I'm on a date. Something new is going on,
and I need to get smart on it.
Speaker 2 (06:49):
Okay, So both of you just set the scene for
why you're interested in it, and it sort of reflects
our feelings about private credit as well. You know, we
hear about this market, you hear things like outstanding private
credit is now bigger than the publicly issued market for
high yield bonds, which just as a longtime credit reporter,
kind of blows my mind that that's the case. But
(07:12):
talk to us about what you've seen and observed in
terms of the evolution of the credit market. So I
mentioned that we're sort of moving away from a lot
of these publicly issued or syndicated bonds and loans to
something that is much more difficult to keep track of.
And I know I said that the private debt market
or the private credit market is bigger than publicly issued
(07:35):
high yield but that's just going off of like a
couple estimates that I've seen, and I'm sure, as you know,
having written this paper, the estimates of the size of
this market are kind of all over the place.
Speaker 4 (07:46):
I think that's exactly the message that we one of
the messages of this paper, which is that one of
the interesting things about the private credit market is that
it is so private that the data just isn't there
to try to figure out how big the market is,
is what's going on with all of these loans. So
there are some ways indirect ways of trying to access
what's happening, but there's no centralized database that you can
(08:07):
look to even to say how big this market is.
But in terms of what's going on and what's new,
we kind of think of the debt markets as evolving
in stages, and so the sort of original granddaddy of
the mall was kind of the classic bank loan, where
you have a really tight, intense relationship between a company
and its relationship bank, and this can go on for
(08:30):
decades and you know it's just a single loan, and
that's a big piece of their debt puzzle. For the
very largest companies, they went totally the other direction and
they could issue, of course, corporate bonds in the public
bond markets. And then you had this period started in
the very late eighties, but more so in really got
going in the nineties and especially in the early two thousands,
(08:52):
which was the syndicated loan market. So they're what you
see is these are in fact still loans, but they
are arranged by a big investment bank and they are
syndicated out to a really really large set of predators,
and then the debt can be traded. So this was
sort of a big innovation that you could actually have
really diversified portfolios of loans and lots of active trading
(09:15):
and loans, and a very large group of creditors, even
for what we used to call, you know, senior bank loans.
And to this day this market is still called bank
debt from that legacy of relationship banking. But then what's
so interesting about private credit is that now everything is
going in the other direction, which is to say, instead
of going for trading markets and diversification and really liquid investments,
(09:41):
very large group of creditors, now everything is shrinking and
contracting and going private. So that's what private credit really
means is now suddenly instead of having a very very
large group of creditors for your company, you can, in theory,
find one single private credit fund that funds your entire
(10:01):
the entire debt.
Speaker 6 (10:02):
Piece of your capital structure.
Speaker 4 (10:04):
So you have a single holder, and that holder is
a private credit fund, which is usually a private investment fund,
and that is a single holder of your debt. So
you know, no trading. We'll talk about exceptions to all
of the things that I just said at some point,
I'm sure, but one single holder of your entire debt,
and it's a private holder not subject to bank regulation
(10:26):
not subject to any of the usual things that we're
seeing in the debt market.
Speaker 5 (10:29):
We shouldn't understate just what a radical change this is
in debt. So the way that we teach corporate finance
and law schools and business schools is that when we
had a single lender, it was really bad because that
single lender was then exposed to all of the risk
of the loan, and that was a bad thing, right,
And so we got broadly syndicated debt as a solution
to that problem. And that was awesome, right because broadly
(10:51):
syndicated debt meant the bankloads could be much bigger. The
risk has dispersed over many people, everybody wins, right, And
all of a sudden we retreated from that vision to
a totally different vision where they spread risk over people
by making them investors in a fund, and where you
have these funds that can make loans that are, you know,
(11:11):
becoming bigger than any kind of loan that any bank
could have ever.
Speaker 6 (11:14):
Made on their own. So it's a total revolution and
the way that we think about debt.
Speaker 5 (11:19):
And now you listen to some of the podcasts, and
obviously you know, you guys have had a few of
these with people who work in the industry, and they
just think, like, of course, a single lender can make
big loans and that's great.
Speaker 6 (11:31):
Well, ten years ago, we didn't think that was the
right thing to do.
Speaker 7 (11:34):
At all, and now all of a sudden, we do.
Speaker 3 (11:53):
You spell out this evolution of the debt markets and
the historical things you're taught in law school about the
danger of single lenders. We've talked to people in the
industry and they have their explanations for why this particular
market has boomed. But from your research, what would you
say are the drivers of this or when you talk
(12:14):
to people, what problems does the private credit market solve
for them.
Speaker 4 (12:19):
The interesting thing about this is that there's multiple stories
going on at the same time. So one is that
this is just actually substituting for a lot of the
activity that banks did because the banks, ever since the
financial crisis, have been really constrained for a lot of reasons. One,
they've primarily been constrained because of regulation and sort of
(12:41):
regulation designed to discourage them from making risky loans and
from you know, to have divestigation in their portfolio and
so on, and just their evolving model of doing business
that they prefer to be sort of the middleman and
get some fees rather than lend directly. All kinds of
reasons why banks have retrived from particularly the lower middle market,
(13:04):
but also all the way to the largest companies. A
second story is just that there's been too much bank regulation.
So I'm not going to take a position on whether
that's true or not, but that bank regulation is stifling
the banks and they can't really lend and so on.
A third story is one that we find really interesting
and appealing, which is that it may just be that
(13:24):
it never really made all that much sense to fund
loans using bank deposits that essentially you have a very
short term liability which is customer deposits, and very long
term assets. So some of these loans, of course, our
multi year loans. And that's just a fundamental mismatch that
(13:45):
banks have always struggled with and that bank regulation has
always struggled with. And this is a really nice, neat
solution to that. And the reason it's showing up now
is that thanks to sort of loosening of some of
the security laws and other things, it's finally the case
that you can get these investment funds that are big
enough to actually take over the role of banks and
(14:06):
for them. You know, the sort of positive side of
private credit is that you now have a better match
between the sort of funding source, which is you have
these big institutional investors putting capital into private credit funds
that is locked in for a number of years, and
you're matching that really well against the loans that are
also a multi year So in some sense it's actually
(14:28):
a better fit than banks for financing this type of
We'll talk about some of the issues with that and
open ended funds and so on. And I think the
last part of the story is one that Jared can
tell better than I can, which is that it may
be actually that if you have creditors that are too dispersed,
it becomes inefficient. And that's sort of a different part
of the story that Jrek can tell.
Speaker 5 (14:50):
Yeah, So when you talk to people in this business,
and we did a lot of we had a lot
of conversations with people in the process and working on
this paper, one of the things you hear over and
over is that private credit just a better user experience.
It's a better user experience at the beginning when the
CFO of a company comes in and says I need
a loan, and you say, no problem, we can give
you one, and like, here's a check a few days later.
(15:11):
You know that's not always the process, but you know,
people said, you know, we can do that. You're not
going to have to go through the credit committee a
Bank of America. You're not going to have to go
through a loan syndication process, and you're not going to
have to like have Bank of America go round looking
for investors. Instead, we've got the money, it's sitting in
our bank accounts.
Speaker 6 (15:29):
We're ready to give it to you.
Speaker 5 (15:30):
And that better user experience kind of also applies to
the life cycle of the loan, where you know you
have a problem, you run into trouble, you need to
get an extension to something, or you need to have
a covenant default excused. You call your private credit lender.
They're your partner, they're not just your lender. They're there
to help you. And you say, hey, I got this problem.
You know, well, you help, and the private credit lender
(15:52):
is helpful. And the thinking there is that private credit
lenders are in the business of originating loans, that's what
they do, and holding them to maturity. And one of
the ways that they compete with each other is by
being good partners when times are bad, and then when
times get really bad and need to look at some
sort of restructuring, the private credit lender is there to
be helpful and they are going to do things like
(16:16):
give you longer to run on the loan, to give
you a chance to try to turn the business around.
And most especially, what they're not going to do is
check your loan, chop it into fifteen pieces and sell
it to fifteen really nasty hedge funds will then become
impossible for you to negotiate with. Right, so you have
this kind of user experience feature to private credit that
you know everyone in the business. And obviously they have
(16:38):
their own selfish motivations for saying this, that we should
be a sent skin a little skeptical, but they say,
you know, basically, you know, you want to come to
us roll like the Apple Store for credit. You know
those other values like Bank of America. You know, that's
like going to buy something at the used car dealership.
You don't want that, right, you want the Apple Store.
And there really is something to this idea that they're
(16:59):
trying to compete on service.
Speaker 2 (17:00):
I love the idea of like the user experience, or
maybe even the user interface, so you know, I can
go to chat GPT, ask a question and get a
direct answer really quickly that goes to the heart of
whatever I'm asking, versus like do a Google search and
then sift through all the results and it takes much
longer and there are much more articles to work with,
(17:22):
and that sort of thing. Jared, I'm glad you brought
up mean hedge funds because this is something I wanted
to ask you, which is how much of the booming
private debt market or private credit market has to do
with recent responses to a recent strategies around bankruptcy and
(17:42):
I guess creditor on creditor violence, where you end up
having people like fighting over the collateral or the things
that are like backing a specific company when it's in bankruptcy.
I get the sense that one of the reasons private
credit has become such a thing is because people want
to be as secured as possible and as high up
(18:03):
in the payment or bankruptcy waterfall as they possibly can be.
Speaker 5 (18:07):
Yeah, So when we went into this research project, I
think Elizabeth and I were both kind of hoping that
we could tell the following story, and the story would
be something like this. Over the twenty tens, you had
this deterioration in norms between debtors and creditors where all
of a sudden, debtors started doing really nasty things to
creditors that they'd never done on a regular basis before,
(18:27):
like stealing their collateral, stripping the firm of assets when
it became distressed, and all these other things that were
just new behaviors that we hadn't seen before, this sort
of like hardball, scorched earth bargaining environment that became the
story of debtor creditor law.
Speaker 6 (18:42):
Like the story of debtor creditor law today to a
very large extent, is really.
Speaker 5 (18:46):
Smart people looking for problems and documents so they can
take advantage of other investors in the debt. Like that
is very much the story at the moment, and it's
very strange that wasn't the story ten years ago. That's
a story. So I think we went into this really
hoping that that story would be the story of private credit.
And I think that would be wrong if you were
(19:08):
to say that, it would really go too far.
Speaker 6 (19:10):
I think it's a story of private credit.
Speaker 5 (19:12):
Is you have this response to what one hedge fund
manager described to me as I can't afford anymore to
invest in a small loan because unless it's a big loan,
I won't be able to pay the legal expenses of
defending it while still earning a return, because it's just
become so expensive and lintigious to invest in debt. Poof
(19:33):
solution private credit. Right, instead of negotiating with multiple lenders,
there's one lender. All of the investors who want exposure
to fixed income, they give their money to the private
credit asset manager.
Speaker 6 (19:45):
The private credit asset manager.
Speaker 5 (19:47):
Isn't going to do bad things to some of its
fund investors to the detriment of other fund investors, and
so all of a sudden, many.
Speaker 6 (19:54):
Of those tricks allegedly go away.
Speaker 5 (19:56):
Now the caveat to this is recently we did a
company do some sort of you know, hardball debt maneuver,
which we weren't expecting to see, but we saw, and
some of the reporting around it suggested that we're there's
been others too. You know, it's hard to tell because
this space, like we've said, is private. We don't know
(20:17):
what goes on.
Speaker 6 (20:19):
So it does seem like the market has learned how
to do this kind of aggressive reading of debt documents
and to look for ways to borrow incremental money without.
Speaker 5 (20:28):
The consent of its existing lenders, and do all these
other tricks that have become normal. But certainly, if you
invest in private credits, you're much you're not being kept
up at night nearly as much by shenanigans and the
debt markets as you are if you invest in like
broadly syndicated.
Speaker 3 (20:43):
Debt, it sounds pretty good to me. Okay, so less
legal fees, less creditor on credit or violent liability, asset matching,
the better user experience. So what's the catch. I don't
see any problems.
Speaker 4 (20:57):
One potential problem is, of course these are are in
some cases absolutely massive loans, and so you do lose
the diversification benefit. These are very risky investments. I would
say the private credit structure has a partial solution to
that problem, which is that the investors themselves in a
private credit fund oftentimes are so massive themselves that they
(21:22):
really don't lose diversification, which is to say, their portfolios
are so large that they can make this enormous investment
in one private credit fund. Because that's a tiny piece
of their portfolio. So that's one downside of private credit.
The other, of course, is the absence of trading. So
before you had pretty good signals of what your position
(21:43):
was worth, there were lots of syndicated loans that had
pretty active trading, and there were indices tracking all of this.
The LSTA provides lots of data on the loan market,
and of course the bond market, of course, is public
in terms of the pricing there. Exit is always going
to be a concern in this market, and I don't
think this market really has been truly tested yet, so
(22:03):
we'll have to find out. But that illiquidity can be
an issue depending on what kind of investor you are
and what your expectation is for getting out of these things.
Speaker 2 (22:14):
Joe's being facetious by the way. He says he doesn't troll,
but he trolls.
Speaker 1 (22:19):
You know.
Speaker 3 (22:19):
I'm saying, there's like a whole you know, you just
check go down to listen. It all sounds good.
Speaker 2 (22:24):
Well, I'll tell you one problem, Joe, which is okay,
if you look at Boeing, for instance, on the terminal,
and if you type ddis you see the distribution of
its bonds maturing that's all based on public info.
Speaker 5 (22:39):
Right.
Speaker 2 (22:39):
If everything becomes private, then we don't have as much
information about how levered or indebted companies actually are. Sure,
is that right?
Speaker 4 (22:50):
That is a concern. So you can have concerns both
for the investors themselves and for sort of the broader
economy or the broader market. And that's the issue with
private credit. We have heard a lot from people about
concerns about the marks that people are carrying these private
credit loans at, and that they might be entirely stale,
(23:11):
they might be largely overstated. There's really no way to
know until you exit that investment. And that's that's exactly
how it is on the private equity side. That you know,
if a private equity fund buys a portfolio company, who
on earth knows what that company is worth until they
actually finally exit that and there is some misvaluation and
so on. That's the question is can we have that
(23:32):
both on the equity side and on the debt side.
What does that mean for our economy if we are
suddenly just very liquid for almost all of the companies.
Speaker 5 (23:42):
Yeah, and so something that to think about is the
broadly syndicated debt world and the high yield world of
debt in created this benefit for all of us. And
that benefit was we could follow the trading prices of
debt and real time and get a sense of where
are their problems in our economy, what sectors are in trouble.
Like I think about COVID nineteen, so COVID nineteen hits.
(24:03):
We're all watching, like, what are the debt prices of
the big hotel companies telling us about the likelihood these
those hotel companies go into bankruptcy. Congress and regulators can
look at those signals and say, okay, we've got to
do something really special for the airlines, We've got to
do something really special here. And when the airlines go
to Congress and say we need something special, they can
point to their debt prices and say, look what is
(24:26):
going on regulators, Look what's going on in Congress.
Speaker 6 (24:29):
Our debt is trading down.
Speaker 5 (24:30):
You know, to zero, like please, we need special treatment.
Investors looking for a deal can say, hmm, the debt
of this company is trading at a really low level.
I think I could do really well if I owns
that asset. I'm going to go make that board and offer.
And so all of those price signals just disappear from
the allocation of capital, from policymaking, and I think it
(24:53):
poses a real.
Speaker 6 (24:54):
Challenge to what are you a really.
Speaker 5 (24:57):
Well functioning set of capital markets to lose those signals?
I mean, just very selfishly in my own research, something
that I often run into and I'm trying to decide, okay,
like how good a job is the bankruptcy system doing well?
The vast majority of companies that file for bankruptcy leave
bankruptcy these days as private equity portfolio companies in one
way or the other, and so you actually can't follow
(25:19):
them after bankruptcy to figure out, okay, is the bankruptcy
system doing a good job or reorganizing these companies? If
there are policy buttons to push in the way the
system is run, what should we push. We just don't
see the information, so we don't know. We have to
make guesses based on a little bit we can see.
And I think our worry is that that's what a
lot of policy making in the debt space is going
to turn into, or we're just going.
Speaker 6 (25:40):
To guess, oh, yeah, that whole industry is funded by
private credit, how's it doing.
Speaker 4 (25:44):
We have no.
Speaker 2 (25:45):
Idea do you imagine there'd be a knock on effect
to stock valuation as well. If you have a company
that maybe still has publicly traded stock, but all of
its debt financing comes from I don't know, a business
development company or private equity or something like that, it
must be hard for the equity investors to make a
realistic or accurate assumption about the health of the company
(26:08):
too without that debt knowledge.
Speaker 4 (26:10):
Certainly the equity markets and the debt markets inform one another,
and so yes, the stockholders are constantly looking to see
what's going on in the credit markets for signals and
vice versa. And I would say, actually, the one that
worries us more sort of the opposite, where you have
a lot of privately owned companies, so either they're venture
capital funded or their private equity owned, but they still
(26:33):
have today a public debt piece, either fully public in
terms bonds or something like that, or even high yield
bonds which were a bit of a hybrid or syndicated
loans that at least have those trading prices. If now
their debt becomes private as well, if they go the
private credit route, that's the concern that then you lose
(26:53):
really all information about this company that is used to
be visible to investors, to regulators, to the broader public.
Speaker 3 (27:00):
You know, I'd never really thought about the question of, like,
how are we measuring the efficacy of existing bankruptcy law
or how are we measuring how well the courts are doing?
So I guess a two part question would be like,
as professors, as academics, how do you think about assessing
the success of the existing bankruptcy regime? And then how
(27:24):
does a private credit versus tradable instruments, how do you
anticipate it or how is it already changing how a
bankruptcy process might look.
Speaker 6 (27:36):
Sure, so bankruptcy success is somewhat hard to measure. There's
not one way to do it.
Speaker 5 (27:41):
The definition I make the best is is the bankruptcy
system misallocating assets? Is it producing companies that come out
and they're thriving, or is it taking companies that are
struggling pre bankruptcy and then they continue to struggle after bankruptcy? Right,
So there's a real bias in the system towards reorganization,
which always makes you work that the system isn't liquidating
(28:01):
companies that are bad companies. And what I mean by
that is Let's say that I work for some company
that's not doing well. They have a bad business, bad idea,
it can't be fixed. Well, I might be best off
if that company dies. It's going to be terrible for
me to be unemployed, but then I'll find new work
and maybe now I will be at a company that's
growing where my skills can help it grow. So what
(28:23):
you want is a bankruptcy system that reallocates assets efficiently.
Speaker 6 (28:27):
And the worry is that, you know the bankruptcy system
doesn't always do that.
Speaker 5 (28:31):
But there's really no way to know that about our
current bankruptcy system because we just don't see enough companies
come out that with public equity or will be able
to learn a lot about how they're doing. To go
to the question of like, how does private credit change bankruptcy,
a simple answer is that, you know, we no longer
have this trading market for the debts of companies that
(28:51):
are in trouble or are in Chapter eleven. So judges
have counted on being able to run the bankruptcy system
assuming that whoever the smartest and most capable investor who
really understood how to reorganize that company, that person's in
the room right, because that person bought the debt of
other investors who.
Speaker 6 (29:09):
Weren't too smart and capable. At least, this is the theory.
Speaker 5 (29:12):
And so when the banks stand up and say, hey, judge,
here's how we think this company should be organize.
Speaker 6 (29:17):
It should be sold, it should be liquidated, it.
Speaker 5 (29:19):
Should be organized, whatever it is, the judge says, okay, like,
you probably know what you're doing because I can count
on the fact that if somebody had a better idea,
they'd come and buy your claims. But that just goes away,
right because we no longer have trading in the same way,
So the judge is going to have to do a
lot more to make sure that assets are properly marketed.
You also won't have rating agencies covering these companies on
(29:41):
a lead up to bankruptcy, right, So you're just going
to many more companies filing for bankruptcy that the world
knows less about, right, And like the bankruptcy system is
assumed that a company with syndicated debts, the world knows
a lot about this company. A lot of that's going
to change, and you know that's something that I think
judges are going to have to.
Speaker 6 (29:58):
Adapt to.
Speaker 2 (30:14):
Just to play devil's advocate first. A second, I think
this is something you actually deal with in the paper,
But one of the things you hear from people in
the private credit industry is that, oh, well, if you're
getting funding from a private entity, maybe a single lender
or maybe a club of lenders, but it's a smaller
(30:35):
group than you would have in the public market, maybe
there's greater potential for working out your issues if you
get into trouble, so you can renegotiate your debt with
a smaller group of creditors, and maybe they know your
business better than like, you know, a big fund that
is buying pieces of all these different types of bonds
(30:57):
and things like that. What's your response to that argument,
this idea that well, private credit actually allows you to
have more room for workouts or maybe even stave off
bankruptcy for longer.
Speaker 5 (31:09):
So I guess my answer is that that all sounds great,
but it'll depend and it's hard to really understand which
way any of these sort of course is cut.
Speaker 6 (31:18):
The one thing that's clearcuts.
Speaker 5 (31:20):
That's important is we're losing, you know, the claims trading market,
like that's just going to look a lot different like
the active market. And the claims of Chapter eleven debtors
when that debtor is a private credit funded firm. But
you know, as to the question of well, you know,
aren't these private credit lenders smarter, more versatile, more nimble,
able to commit capital, and won't that be good for companies?
Speaker 6 (31:40):
You know, at the end, it depends. So something you
worry about is.
Speaker 5 (31:44):
Well, maybe private credit lenders will have incentives not to
adjust their marks on their books and instead just to
do amend and extends and just keep loans going when
the company really needed to liquidate or should have filed
for bankruptcy sooner. You know, think about how different the
GM bankruptcy would have in had they filed for bankruptcy
in like two thousand and five versus two thousand and nine,
(32:04):
when their business had already erode in so much so
we think of that erosion as something that limits reorganization options.
And it's not necessarily obvious how private credit interacts with that,
because private credit lenders have their own incentives, and maybe
their incentives are to say, look, you know, we make
loans to sponsor backed companies, and if the sponsor wants
(32:26):
to continue, we're going to keep doing that. Because we
really want to participate in their next deals, or they
could say, like, let's pull the plug on these things earlier.
So something that I've heard from lawyers working in the
space is that when private credit lenders replace like your
mid market banks, like your citizens and that kind of bank,
when you have like a private credit lender with a
thirty million dollar loan that might have been done by
(32:47):
a syndicate of two regional banks, the private credit lenders
are much more aggressive and much more willing to pull
the plug on the company and to own the asset
then that bank might have been. But the world's look
very different for larger companies, where private credit lenders might
be easier for companies to do workouts with. So it's
really hard to tell, but I'm certainly a bit skeptical
(33:09):
the idea that all of this is uni directional and
the private credit is just better in every way for everything.
It's different, and there'll be different pros and cons and
we'll learn more about them, and the law will adapt
and hopefully deal with some of the ways in which
the incentives of private credit lenders distort bankruptcy outcomes.
Speaker 2 (33:28):
Since you mentioned GM, could you maybe talk about another
specific example of a liquidation kind of playing out a
bit late as you describe it, I'm still I'm still
salty over the collapse of Red Lobster, which you mention
in your paper. So could you talk a little bit
about that one and what it tells us about private credit?
Speaker 5 (33:47):
Sure, So, something that has been the case over the
past few years is you've had private equity owned restaurants
and retailers that just ended up doing quick liquidations after
stalling for a very long time. Red Lobster is really interesting.
Red Lobster have been struggling for a little while, and
then it's Fortress Investment Group, which was its private credit lender,
(34:10):
came in and took over the company and basically just
owned the asset very quickly.
Speaker 6 (34:15):
And something that is so.
Speaker 5 (34:17):
Interesting about that is that traditionally, you know, other lenders
would have been a lot more cautious about doing that,
because other lenders are very cognizant of what we called
lender liability and this line of law that suggests that
you shouldn't if you're a lender played too much of
a role in business decisions of companies that you lend to.
Speaker 6 (34:39):
And like there's an example of like a private.
Speaker 5 (34:41):
Credit lender just behaving in this really aggressive way, which
you know is interesting. Again, it's hard to tell exactly
what's going to happen, but certainly that example doesn't fit
well with the story of well, you know, the private
credit lender is just like the banker, and you know
it's your corner bank in nineteen twenty five.
Speaker 6 (35:00):
Who's going to work with you on your farm?
Speaker 5 (35:02):
You know, the answer is maybe some of the time
that's the story, but other of the time you're dealing
with a very sophisticated party who may have different incentives
and be worried about different things than traditional bank lenders
or investors in the broadly syndicated market.
Speaker 2 (35:15):
Jared, the other thing you just mentioned was the idea
of bankruptcy law adapting to private credit. So it's a
growing market, it's becoming more of a thing. Certainly in
the bankruptcy process. Law doesn't necessarily have the best history
of adapting quickly and efficiently to new situations. But is
(35:36):
there a possibility that in the future you could see
bankruptcy law start to change to take into account more
of these new players in the way the market actually
works now.
Speaker 5 (35:46):
I do think that will happen. I think bankruptcy judges
are very sophisticated and they've proven very very worthy over
time of adapting to lots of changes in credit markets, securitization,
syndicated lending, claims trading like you sort of name it,
like the.
Speaker 6 (35:59):
Law eventually adapts. So here, you know, one.
Speaker 5 (36:02):
Could imagine judges being stronger advocates for the company. You
could imagine judges being stronger advocates for employees, slowing down
bankruptcy processes to make sure that whoever's going to own
this asset. On the other side, they're the right person
to own it's mindful of the fact that there isn't
claims trading.
Speaker 6 (36:20):
So those are all ways in.
Speaker 5 (36:21):
Which I can easily see judges sort of stepping in
and saying, something new is happening in credit and we're
going to be a part of, you know, helping with
some of the problems it creates, which is what judges
have always done.
Speaker 4 (36:34):
I should add that, you know, there's a couple of
different questions. One is what happens once you're in bankruptcy,
which is what we've been talking about. But another question
is who actually enters bankruptcy and in what condition, and
so one you know, open question is are we going
to see potentially fewer bankruptcies because with private credit it should,
in theory be a little bit easier to renegotiate dead
(36:56):
and so on with your creditor, So you could it
could be the case that we have a lot fewer
bankruptcy is more out of court restructurings. But it could
also be that once you do reach bankruptcy, if you
go to private credit route, you're likely to be in
far worse condition than other bankrupt companies because we just
don't have this visibility into the company's valuation and there's
(37:17):
an ability to kind of keep things going, keep things going,
and you could in fact have a wave of zombie
companies by the time that they enter into bankruptcy. And
that of course is the question. So just to get
contentious and get everyone mad at me, some of the
concerns that we've had on the equity side, again we
think could play out on the credit side. So you know,
(37:37):
I think people are well aware than on the venture
capital side. There have been a lot of misvaluation, so
a lot of cases where what people thought was a
successful company really wasn't or it was engaged in fraudulent
or legal activity, and so on and so on. The
sort of list there is quite long. The common theme
is we are less certain about valuation in the private markets.
(38:01):
That's just sort of corporate finance one oh one. When
you have less information and less trading, we can be
less confident in the valuations. And again now we're going
to see that on the credit side, and it's going
to be especially acute for companies that are private, on
both the equity side and the debt side.
Speaker 3 (38:16):
Yeah, I was really intrigued by the callback to GM,
which I had, you know, so long ago I'd sort
of forgotten about. But I do remember that in the
mid two thousands, even well before the financial crisis, there
were really serious concerns about, you know, the health of
the company and whether it was already heading for insolvency
for various reasons. Can you talk a little bit more
(38:39):
about this idea, this notion that you just talked about,
which is that you know, the incentive is from the
private credit fund standpoint to extend and pretend I could imagine,
for example that a private credit fund, you know, just
for reputational purposes, would not want a high profile or
any profile bankruptcy among their investment to the point where
(39:02):
they make purposefully bad bets. Yes, extending this loan is
going to be a money loser or not a money maker,
but it's better than having the headline of one of
our portfolio companies go bankruptcy. And so you sort of
push that further on. And then also maybe as part
of that, like in your conversations, is the flexibility real,
Because again you talk to people in the industry and
(39:23):
they're like, Oh, it's so great, we work with our
lender and they can modify the loans or they understand
our condition. Does it play out in practice that the
borrowers in the private credit market do get that sort
of additional flexibility to start with.
Speaker 6 (39:38):
Their first point?
Speaker 5 (39:39):
Yeah, So you absolutely worry in the world of corporations
that it could be as simple as vanity on the
part of the CEO.
Speaker 6 (39:46):
They just don't want to file for bankruptcy, they don't
want to restructure.
Speaker 5 (39:50):
Another recent example Seers, which filed for bankruptcy maybe eight
years ago or something like that. Seers limped along for
many years, you know, one of the great American retailers,
selling store after store, and it.
Speaker 6 (40:03):
Became this miserable experience.
Speaker 5 (40:05):
I don't know if you shocked at Sears recently, but
I remember, up to.
Speaker 2 (40:08):
Bankruptcy, my dad always used to park by Sears because
he always said that's where it was empty and there
were available spots. I was always a strategy.
Speaker 5 (40:19):
Yeah, I hope you shorted them when you heard that.
Speaker 6 (40:24):
But if you went to a Sears like in the
leadup to bankruptcy, which you would have discovered was empty shelves, like,
it was a bad experience.
Speaker 5 (40:31):
And that's what happens when companies take too long to
file for bankruptcy. They need capital, they try limping along
and it hurts everybody. So imagine you worked for Sears
during that period. Your career was stunted by the fact
that you're stuck there and I'm not going to promote
people into management, and they're not giving people bonuses, and
there are no growth opportunities, like there are all these
(40:53):
ways in which it's bad, and so, like you said,
the worry is that private credit companies are going your
private credit backed firms because their lenders will want to
be more agreeable, they may wait longer to reorganize than
they would have otherwise.
Speaker 6 (41:07):
You know, whether or not that's true.
Speaker 5 (41:09):
Who knows, And like, one of the things that is
important to emphasize is that all of the fears we
have about private credit, they all may be true in
individual cases, just like when you know the people you've
had on your show who work in the business, how
you've upgrade it is, And like you know when God
stopped on the seventh day after creating the world, he
then created private credit because we needed loans from investment
(41:30):
funds in order for the world to be a more
perfect place.
Speaker 6 (41:33):
Those people are right to some of the time. The
question is, well, what does it look like when we're
not all right?
Speaker 5 (41:38):
And that really remains to be seen. I think we're
at the very early stage of an important shift in
corporate finance whose implications are hard to truly understand. And
the worry at the stage is that, like in our
incomplete understanding and our incomplete narratives, that we make bad
policy decisions, like we create regulations that aren't needed, or
we miss the opportunity to create regulations.
Speaker 6 (41:59):
That are needed.
Speaker 5 (42:00):
You do hear in this space that there is flexibility
and that lenders are helpful, and that that that does
seem to be the dynamic at least for some borrowers
at least some of the time. But again, what's generalizing,
you know, that's as a social scientist, that's always the
question you want to know, is you know, if you
hear about this one story, you know, you hear about
the plural site example that I mentioned earlier, where you're
(42:22):
like a private credit backed company where the lenders are
doing liability management stuff. You have this very aggressive these
aggressive debt market transactions.
Speaker 6 (42:31):
So you know, is that representative of something?
Speaker 5 (42:34):
It's hard to know and a real challenge to knowledge
creation in this context is we don't even know how
big the market is. We're missing basic statistics. When Elizabeth
and I started this research project, we were looking for
commercial resources to learn how big this market is. And
what we found is that when we interrogated each of
the sources that are commonly cited you, we didn't have
(42:55):
any confidence that we were capturing something real. Like you know,
if you follow the trajector of this, it's something real.
We know it's been getting bigger. How big has it gotten?
I don't think anybody really knows.
Speaker 2 (43:06):
You anticipated. My next question, which is the number you
cite in the paper is one point five trillion dollars,
So how did you end up with that specific number.
Speaker 4 (43:18):
In the end, I think actually what we did was
choose the most conservative one. So there's so much disagreement here,
we figured, all right, I think everyone's going to believe
us with the sort of lowest number that's getting thrown
around right now, but again, could be significantly bigger than that.
Speaker 5 (43:34):
Yeah, And again a big challenge here is that if
you talk to people in this business, a lot of
them will how you private credit is brand new, Like,
that's not true. Investment funds have been originating loans, you know,
for a very long time. Like, this is not a
new thing. What's new is the size and the scale.
And given that, like it's not even clear like exactly
who is a private credit lender?
Speaker 6 (43:54):
What does that mean?
Speaker 5 (43:56):
These sort of basic definitional questions. There's not agreement with
syndicated lending. You could say, okay, there's a handful of
money market banks they run this similar process for these
broadly syndicated loans.
Speaker 6 (44:09):
And all of that. That's a thing in the financial market.
Speaker 5 (44:11):
It's like here, I don't even know, like if you
were to ask, well, how big is it? Well, there
are investment funds out there that'll make loans to corporations.
Are they doing something called private credit? Well, on the
fundraising side, I'm sure that the answer right now is yes,
because allocators launch exposure.
Speaker 6 (44:27):
To this asset class. But apart from that, it's really
hard to tell.
Speaker 2 (44:32):
So just to press on this point, and once again
you've anticipated my next question, but what does it mean
if debt is issued by an investment fund or an
investment firm versus say a bank or a traditional buyer
of a syndicated loan or a publicly issued bond or
(44:52):
something like that. Are there specific concerns depending on the
type of lender that is involved in these deals.
Speaker 4 (45:00):
To take the last part first, I would say yes,
there are clear differences. So if you believe that incentives matter,
and I think we all do, then we can look
at each of these different types of funding structures, figure
out what the incentives are of the parties, and trace
through what we think the implications are. So in terms
of what the differences are, I think the easy cases
(45:21):
are the extreme ones. So if you think of sort
of a bank, that is an institution that is funding
loans basically with customer deposits, and that is subject to
very heavy regulation as a bank credit funds. If they
really are a private investment fund, that's sort of a
very different model. That is poled capital from a big
(45:43):
of typically large institutional investors, and they are usually closed
end funds, so the capital is locked in for at
least ten years, and they take that money, that equity
that provided by those investors, they might borrow from a
bank on top of that, and they use that to
go make loans. And the regulation of private investment funds
(46:05):
is relatively speaking, incredibly light. Right, every investment fund manager
is going to say, no, no, we're subject to all
this regulation. Sure, there is some regulation, but compared to
everything else, like banks or like investment funds that take
retail investment, the regulation is very very light. So those
are sort of some easy extremes in terms of what
(46:25):
you see, and then to follow through what the incentives
are of private investment funds for them, there's multiple things
going on. So one question is where are they in
their life cycle. So if they are at a point
where they're trying to fund raise for their next fund,
just as you mentioned earlier, they are really not going
(46:47):
to want to recognize a big loss and so that's
where their incentives are probably the worst in terms of
trying to keep an investment going, to not send something
into bankruptcy, to not have the bad head lines and
so on. That's one potential worry. Another is when you're
reaching the end of the fund's life and so there
(47:07):
they might actually be forced to sell things when they
are not quite at an optimal time to do that.
Those are some of the questions that you have with
private investment funds. The other big differences in terms of
the incentives of the managers. So you have the classic
private equity style compensation structure.
Speaker 6 (47:24):
You have a management.
Speaker 4 (47:25):
Fee, so that means the bigger you are, the more
money you make. But especially what you have is a
performance fee, and that is really you know, it's just
like a stock option. It's you get all the upside,
you bear none of the downside. So that's what really
encourages them to hit for the fences and so on.
And there's many, many, many academic studies looking at again
(47:45):
private equity and showing that the way the carry is
set up, that carried interest, that performance fee, that drives
behavior of private equity funds. They try to recognize winners
quickly hold on to losers longer. You're going to see
a lot of that same stuff on the credit side.
Speaker 2 (48:02):
All right, Elizabeth, I love that you mentioned Authoughts's unofficial tagline,
which is incentives Matter. So we kind of came full
circle on that conversation. That was a fantastic overview of
the impact of private credit and also some of the
incentives that might be driving it. So Jared and Elizabeth,
thank you so much for coming on all thoughts.
Speaker 6 (48:22):
It was great.
Speaker 3 (48:22):
Thank you, Thank you so much much.
Speaker 6 (48:37):
Joe.
Speaker 2 (48:37):
I thought that conversation was fascinating. And I know we've
said this on a number of episodes by now, but
to some extent, the rise of private credit is what
regulators wanted, yes, for two thousand and eight, right, you know,
regulatory capital rules were engineered for this specific outcome, getting
risky loans off of bank balance sheets, pushing them on
(49:00):
to less regulated or even unregulated financial intermediaries where if
they failed it wouldn't be such a massive problem. But
I think you can say like two things, and Elizabeth
brought up this point, but one, the size and the
speed of the market's growth kind of matters here, right,
So yes, maybe you want some non bank financial entities
(49:23):
to be making loans, But if they do so on
a particular scale, or if they do so in a
way where a huge amount of credit in the American
economy ends up being concentrated on like a very large
investors balance sheet, and they end up owning the entire
capital stack of a company, basically the equity and the debt,
(49:45):
that could be problematic. And then the second thing is
I cannot imagine that when bank regulators were making some
of these rules post two thousand and eight that they
were necessarily thinking of the bankruptcy implications or like the
informational disadvantages of not having a claims trading process totally.
Speaker 3 (50:05):
So first of all, I just want to say I
wasn't trolling when I said it sounded great, because there
were a number of things that from their perspective you
could see the appeal. So the idea of maybe this
is a better liability asset match than taking short term
deposits and made long term loans. The fact that the
user experience from the perspective.
Speaker 6 (50:25):
Of the borrower, you go to the.
Speaker 3 (50:27):
Fund and they can move a lot faster. That makes
a lot of sense to me. The fact that there
is less, as you put it, creditor on creditor violence,
such that the game is not all about who can
read you know, who finds something in the fine print
somewhere so that they can induce a bankruptcy and that
(50:47):
they can like, you know, get this claim on the
collateral that another entity can't. So it does really seem
like there are some very obvious reasons why this market
is appealing. Not to mention the point that you just made,
which is that, like, this is kind of what we
want from a financial stability perspective, that all of these
(51:07):
loans are not in the hands of you know, entities
that also have people's safe deposits. That being said, you know,
one of the things that I the arguments, you know,
there's obviously the lack of information and the lack of clarity,
and that's interesting from multiple perspectives, but also this idea
of like, well the sort of zombie company phenomenon, which
(51:29):
is that if you sort of declare bankruptcy at the
right time, there's still some sort of potentially turnaroundable company
by the time it hits bankruptcy court. But if you
wait too long and then it hits bankruptcy court, and
then there's really nothing. I think that argument. You know,
it's early, right, we haven't seen a ton of bankruptcies yet,
we haven't had a downturn yet since this market really boomed.
(51:52):
But that strikes me as something where while you could
really get serious like degradation of the quality of assets
that come into Yeah, and.
Speaker 2 (52:01):
I thought the Sears example was both harsh and powerful,
but it is true. And you do see that in
the discourse around zombie companies, this idea that like, well, okay,
if a company is just kind of limping along because
it's big creditor doesn't want to have to take a loss,
or it doesn't want to have to issue a press
release saying one of its portfolio companies has gone bankrupt,
(52:23):
that has real world implications for the people who work
at the company or at Sears who can't get a
promotion and are just working in a gosh, I'm just
imagining walking through the emptcerieses of the world now just
have a really like depressing retail experience.
Speaker 3 (52:38):
Totally.
Speaker 2 (52:39):
All right, shall we leave it there, Let's leave it there.
This has been another episode of the All Thoughts podcast.
I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 3 (52:47):
And I'm Jill Wisenth though you can follow me at
the Stalwart. Follow our guests Jared Elias, He's at Jared Elias.
It doesn't appear that Elizabeth is on Twitter, so that's
wise for her, but go check out her recent Follow
our producers Carmen Rodriguez at carman Erman dash Ol Bennett
at Dashbot and Kilbrooks at Kilbrooks. And thank you to
(53:07):
our producer Moses Ondem. For more Oddlots content, go to
Bloomberg dot com slash odd Lots, where we have transcripts
of blog and a newsletter and you can chat about
all of these topics twenty four to seven in our
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Speaker 2 (53:22):
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(53:44):
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Speaker 4 (54:06):
In e.
Bloomberg Audio Studios, Podcasts, Radio News.
Speaker 2 (00:20):
Hello and welcome to another episode of the All Thoughts Podcast.
I'm Tracy Alloway.
Speaker 3 (00:25):
And I'm Joe whysant Thal.
Speaker 2 (00:26):
Joe, do you remember reading headlines like the incredible shrinking
stock market?
Speaker 3 (00:31):
Yes, I forgot about that whole period a lot in
the twenty ten's in which there were not a lot
of new IPOs companies that were waiting longer in their
life cycle to go public. It's kind of crazy, you know.
Now you have these multi billion dollar companies that are
still private, and then you like look at like, you know,
(00:52):
when Microsoft and Apple and all those went public, and
it was like no one knew anything about them when
they first came out.
Speaker 2 (00:59):
Yeah, that's true. And I think it's still pretty much
an ongoing trend where you do have more companies deciding
not to raise public stock at all, so they'll just
stay at private forever. They'll tap venture capital or whatever
for their funding needs. And obviously the stock market has
grown in size in terms of market cap, but maybe
(01:19):
not necessarily in terms of absolute available shares. And this
has been a sort of ongoing trend and discussion.
Speaker 3 (01:26):
Totally private financing has just gotten so huge. You know,
we talk about private equity and VC and all of
this stuff, that there is an incredible amount of money.
In fact, the one time when the public market spigot
opened like crazy was the SPAC mania, and so many
of those companies turned out to be total garbage. So
there's obviously some reason why, at least in the stock
(01:49):
market side. You know, it's almost like opting to go
the public route is almost like a red flag.
Speaker 2 (01:55):
Oh that's a terrible thought, but you're right.
Speaker 3 (01:58):
But there seems to be something to that, right, Well,
that's what we've seen in the last several years.
Speaker 2 (02:01):
Okay, what if I told you that a similar trend
to the one that has played out in the stock
market is now happening in the corporate debt market.
Speaker 3 (02:10):
We've obviously talked about private credit affair amount on the show,
but it had not occurred to me until you just
put it that way, the idea that maybe there's some
sort of like parallel here about the way in which, yes,
the incredible shrinking stock market might at some point reflect
maybe we'll talk about the incredible shrinking bond market.
Speaker 4 (02:29):
One.
Speaker 2 (02:29):
Yeah, both bonds and loans, right, And I think the
way you could maybe summarize what's been going on with
the corporate debt market is for a long time, up
until relatively recently, we had a lot of companies that
were issuing bonds, so selling those two investors, or they
were taking out loans from banks, or they were taking
(02:51):
out loans that would be intermediated by banks and then
sold on to more investors. Those are called leverage loans.
And this was kind of what we had seen in
the stock market in like the eighties, the nineties, maybe
the early two thousands, lots of companies coming to the
public market via debt. But now with the rise of
(03:13):
private debt again, the clue is kind of in the name.
More and more loans and bonds are instead being made
by what are known as direct lenders, you know, private equity,
this sort of shadow finance group of financial entities, and
they're doing more of this, and there's less bonds and
loans that are actually being publicly distributed to investors.
Speaker 3 (03:36):
Right, And we've sort of talked a lot about the
why of private credit and various advantages and you know,
certain types of companies and industries that maybe banks don't
service directly, or maybe some flexibility we haven't really talked
about like the consequences or some of the like, all right,
what does that then mean about if so much of
the credit market goes private like this?
Speaker 2 (03:58):
Yeah, And this is the thing I find and really
interesting because there's so much handwringing about the financial stability
concerns of private debt. So is this just a gigantic
bubble and everything's going to blow up one day? But
there are actually immediate concerns things that are happening right now.
So I'm very pleased to say that we have the
perfect guests. We are going to be speaking with the
(04:20):
authors of a paper called the Credit Markets Go Dark.
It's a really great paper. I wrote about it a
few weeks ago in the All Loots newsletter, which you
should all subscribe to, and we're going to be diving
into it in some more detail now. So we're speaking
to Jared Elias. He is the Scott C. Collins Professor
of Law at Harvard Law School, and his co author
(04:42):
Elizabeth Defontine. She is the Carl W. Leo Professor of
Law at Duke University School of Law. So, Jared and Elizabeth,
thank you so much for coming on All Bots.
Speaker 4 (04:52):
Thank you so much.
Speaker 2 (04:54):
So, first of all, how did this get on your
radar as law professors? How did this become so thing
that you were both interested in doing research on.
Speaker 5 (05:03):
My research focuses on corporate bankruptcy, and I'm always interested
in what's going on in the debt markets because what
happens in bankruptcy is really downstream of what's going on
in death right. There's constant innovation and depth, and that
shows up in innovation and bankruptcy. And something that I
kept hearing from ourket participants was increasingly important was private credit,
private credit, private credit.
Speaker 6 (05:23):
And that made me want to learn about it.
Speaker 5 (05:25):
And what you do and you're the member of a
faculty and you want to learn about something is you
try to find a way to write about it.
Speaker 4 (05:31):
So I came at this a little bit differently, which
is Jared and I are both recovering big law firm lawyers,
So we practiced in this area for a long time
before becoming academics. And when I was in practice, it
was all private equity all the time, and it was
a very exciting time. Lots of transactions, lots of deals,
lots of innovation in the financial markets, and one piece
(05:53):
of it that was changing really rapidly was the private
credit funds. So these you know, the big private equity funds,
you know, the bins and TPGs and others. They had
these private credit arms that were appearing and getting bigger
and bigger and bigger. And I started becoming more of
the story, and that to me was very interesting because
(06:15):
private what do you behaves in such a unique way,
so differently from the rest of the way we're used
to big companies operating and so on, And it was
really interesting to me to try to figure out why
this was happening now on the credit side and what
the implications of that would be.
Speaker 5 (06:29):
Elizabeth and I both left practice around the same time,
like right after the financial crisis, and this is one
of the real changes that has changed the way that.
Speaker 6 (06:38):
Corporate finance has done over the past ten years.
Speaker 5 (06:41):
Like when I started to hear from people about private credit,
I realized, I'm on a date. Something new is going on,
and I need to get smart on it.
Speaker 2 (06:49):
Okay, So both of you just set the scene for
why you're interested in it, and it sort of reflects
our feelings about private credit as well. You know, we
hear about this market, you hear things like outstanding private
credit is now bigger than the publicly issued market for
high yield bonds, which just as a longtime credit reporter,
kind of blows my mind that that's the case. But
(07:12):
talk to us about what you've seen and observed in
terms of the evolution of the credit market. So I
mentioned that we're sort of moving away from a lot
of these publicly issued or syndicated bonds and loans to
something that is much more difficult to keep track of.
And I know I said that the private debt market
or the private credit market is bigger than publicly issued
(07:35):
high yield but that's just going off of like a
couple estimates that I've seen, and I'm sure, as you know,
having written this paper, the estimates of the size of
this market are kind of all over the place.
Speaker 4 (07:46):
I think that's exactly the message that we one of
the messages of this paper, which is that one of
the interesting things about the private credit market is that
it is so private that the data just isn't there
to try to figure out how big the market is,
is what's going on with all of these loans. So
there are some ways indirect ways of trying to access
what's happening, but there's no centralized database that you can
(08:07):
look to even to say how big this market is.
But in terms of what's going on and what's new,
we kind of think of the debt markets as evolving
in stages, and so the sort of original granddaddy of
the mall was kind of the classic bank loan, where
you have a really tight, intense relationship between a company
and its relationship bank, and this can go on for
(08:30):
decades and you know it's just a single loan, and
that's a big piece of their debt puzzle. For the
very largest companies, they went totally the other direction and
they could issue, of course, corporate bonds in the public
bond markets. And then you had this period started in
the very late eighties, but more so in really got
going in the nineties and especially in the early two thousands,
(08:52):
which was the syndicated loan market. So they're what you
see is these are in fact still loans, but they
are arranged by a big investment bank and they are
syndicated out to a really really large set of predators,
and then the debt can be traded. So this was
sort of a big innovation that you could actually have
really diversified portfolios of loans and lots of active trading
(09:15):
and loans, and a very large group of creditors, even
for what we used to call, you know, senior bank loans.
And to this day this market is still called bank
debt from that legacy of relationship banking. But then what's
so interesting about private credit is that now everything is
going in the other direction, which is to say, instead
of going for trading markets and diversification and really liquid investments,
(09:41):
very large group of creditors, now everything is shrinking and
contracting and going private. So that's what private credit really
means is now suddenly instead of having a very very
large group of creditors for your company, you can, in theory,
find one single private credit fund that funds your entire
(10:01):
the entire debt.
Speaker 6 (10:02):
Piece of your capital structure.
Speaker 4 (10:04):
So you have a single holder, and that holder is
a private credit fund, which is usually a private investment fund,
and that is a single holder of your debt. So
you know, no trading. We'll talk about exceptions to all
of the things that I just said at some point,
I'm sure, but one single holder of your entire debt,
and it's a private holder not subject to bank regulation
(10:26):
not subject to any of the usual things that we're
seeing in the debt market.
Speaker 5 (10:29):
We shouldn't understate just what a radical change this is
in debt. So the way that we teach corporate finance
and law schools and business schools is that when we
had a single lender, it was really bad because that
single lender was then exposed to all of the risk
of the loan, and that was a bad thing, right,
And so we got broadly syndicated debt as a solution
to that problem. And that was awesome, right because broadly
(10:51):
syndicated debt meant the bankloads could be much bigger. The
risk has dispersed over many people, everybody wins, right, And
all of a sudden we retreated from that vision to
a totally different vision where they spread risk over people
by making them investors in a fund, and where you
have these funds that can make loans that are, you know,
(11:11):
becoming bigger than any kind of loan that any bank
could have ever.
Speaker 6 (11:14):
Made on their own. So it's a total revolution and
the way that we think about debt.
Speaker 5 (11:19):
And now you listen to some of the podcasts, and
obviously you know, you guys have had a few of
these with people who work in the industry, and they
just think, like, of course, a single lender can make
big loans and that's great.
Speaker 6 (11:31):
Well, ten years ago, we didn't think that was the
right thing to do.
Speaker 7 (11:34):
At all, and now all of a sudden, we do.
Speaker 3 (11:53):
You spell out this evolution of the debt markets and
the historical things you're taught in law school about the
danger of single lenders. We've talked to people in the
industry and they have their explanations for why this particular
market has boomed. But from your research, what would you
say are the drivers of this or when you talk
(12:14):
to people, what problems does the private credit market solve
for them.
Speaker 4 (12:19):
The interesting thing about this is that there's multiple stories
going on at the same time. So one is that
this is just actually substituting for a lot of the
activity that banks did because the banks, ever since the
financial crisis, have been really constrained for a lot of reasons. One,
they've primarily been constrained because of regulation and sort of
(12:41):
regulation designed to discourage them from making risky loans and
from you know, to have divestigation in their portfolio and
so on, and just their evolving model of doing business
that they prefer to be sort of the middleman and
get some fees rather than lend directly. All kinds of
reasons why banks have retrived from particularly the lower middle market,
(13:04):
but also all the way to the largest companies. A
second story is just that there's been too much bank regulation.
So I'm not going to take a position on whether
that's true or not, but that bank regulation is stifling
the banks and they can't really lend and so on.
A third story is one that we find really interesting
and appealing, which is that it may just be that
(13:24):
it never really made all that much sense to fund
loans using bank deposits that essentially you have a very
short term liability which is customer deposits, and very long
term assets. So some of these loans, of course, our
multi year loans. And that's just a fundamental mismatch that
(13:45):
banks have always struggled with and that bank regulation has
always struggled with. And this is a really nice, neat
solution to that. And the reason it's showing up now
is that thanks to sort of loosening of some of
the security laws and other things, it's finally the case
that you can get these investment funds that are big
enough to actually take over the role of banks and
(14:06):
for them. You know, the sort of positive side of
private credit is that you now have a better match
between the sort of funding source, which is you have
these big institutional investors putting capital into private credit funds
that is locked in for a number of years, and
you're matching that really well against the loans that are
also a multi year So in some sense it's actually
(14:28):
a better fit than banks for financing this type of
We'll talk about some of the issues with that and
open ended funds and so on. And I think the
last part of the story is one that Jared can
tell better than I can, which is that it may
be actually that if you have creditors that are too dispersed,
it becomes inefficient. And that's sort of a different part
of the story that Jrek can tell.
Speaker 5 (14:50):
Yeah, So when you talk to people in this business,
and we did a lot of we had a lot
of conversations with people in the process and working on
this paper, one of the things you hear over and
over is that private credit just a better user experience.
It's a better user experience at the beginning when the
CFO of a company comes in and says I need
a loan, and you say, no problem, we can give
you one, and like, here's a check a few days later.
(15:11):
You know that's not always the process, but you know,
people said, you know, we can do that. You're not
going to have to go through the credit committee a
Bank of America. You're not going to have to go
through a loan syndication process, and you're not going to
have to like have Bank of America go round looking
for investors. Instead, we've got the money, it's sitting in
our bank accounts.
Speaker 6 (15:29):
We're ready to give it to you.
Speaker 5 (15:30):
And that better user experience kind of also applies to
the life cycle of the loan, where you know you
have a problem, you run into trouble, you need to
get an extension to something, or you need to have
a covenant default excused. You call your private credit lender.
They're your partner, they're not just your lender. They're there
to help you. And you say, hey, I got this problem.
You know, well, you help, and the private credit lender
(15:52):
is helpful. And the thinking there is that private credit
lenders are in the business of originating loans, that's what
they do, and holding them to maturity. And one of
the ways that they compete with each other is by
being good partners when times are bad, and then when
times get really bad and need to look at some
sort of restructuring, the private credit lender is there to
be helpful and they are going to do things like
(16:16):
give you longer to run on the loan, to give
you a chance to try to turn the business around.
And most especially, what they're not going to do is
check your loan, chop it into fifteen pieces and sell
it to fifteen really nasty hedge funds will then become
impossible for you to negotiate with. Right, so you have
this kind of user experience feature to private credit that
you know everyone in the business. And obviously they have
(16:38):
their own selfish motivations for saying this, that we should
be a sent skin a little skeptical, but they say,
you know, basically, you know, you want to come to
us roll like the Apple Store for credit. You know
those other values like Bank of America. You know, that's
like going to buy something at the used car dealership.
You don't want that, right, you want the Apple Store.
And there really is something to this idea that they're
(16:59):
trying to compete on service.
Speaker 2 (17:00):
I love the idea of like the user experience, or
maybe even the user interface, so you know, I can
go to chat GPT, ask a question and get a
direct answer really quickly that goes to the heart of
whatever I'm asking, versus like do a Google search and
then sift through all the results and it takes much
longer and there are much more articles to work with,
(17:22):
and that sort of thing. Jared, I'm glad you brought
up mean hedge funds because this is something I wanted
to ask you, which is how much of the booming
private debt market or private credit market has to do
with recent responses to a recent strategies around bankruptcy and
(17:42):
I guess creditor on creditor violence, where you end up
having people like fighting over the collateral or the things
that are like backing a specific company when it's in bankruptcy.
I get the sense that one of the reasons private
credit has become such a thing is because people want
to be as secured as possible and as high up
(18:03):
in the payment or bankruptcy waterfall as they possibly can be.
Speaker 5 (18:07):
Yeah, So when we went into this research project, I
think Elizabeth and I were both kind of hoping that
we could tell the following story, and the story would
be something like this. Over the twenty tens, you had
this deterioration in norms between debtors and creditors where all
of a sudden, debtors started doing really nasty things to
creditors that they'd never done on a regular basis before,
(18:27):
like stealing their collateral, stripping the firm of assets when
it became distressed, and all these other things that were
just new behaviors that we hadn't seen before, this sort
of like hardball, scorched earth bargaining environment that became the
story of debtor creditor law.
Speaker 6 (18:42):
Like the story of debtor creditor law today to a
very large extent, is really.
Speaker 5 (18:46):
Smart people looking for problems and documents so they can
take advantage of other investors in the debt. Like that
is very much the story at the moment, and it's
very strange that wasn't the story ten years ago. That's
a story. So I think we went into this really
hoping that that story would be the story of private credit.
And I think that would be wrong if you were
(19:08):
to say that, it would really go too far.
Speaker 6 (19:10):
I think it's a story of private credit.
Speaker 5 (19:12):
Is you have this response to what one hedge fund
manager described to me as I can't afford anymore to
invest in a small loan because unless it's a big loan,
I won't be able to pay the legal expenses of
defending it while still earning a return, because it's just
become so expensive and lintigious to invest in debt. Poof
(19:33):
solution private credit. Right, instead of negotiating with multiple lenders,
there's one lender. All of the investors who want exposure
to fixed income, they give their money to the private
credit asset manager.
Speaker 6 (19:45):
The private credit asset manager.
Speaker 5 (19:47):
Isn't going to do bad things to some of its
fund investors to the detriment of other fund investors, and
so all of a sudden, many.
Speaker 6 (19:54):
Of those tricks allegedly go away.
Speaker 5 (19:56):
Now the caveat to this is recently we did a
company do some sort of you know, hardball debt maneuver,
which we weren't expecting to see, but we saw, and
some of the reporting around it suggested that we're there's
been others too. You know, it's hard to tell because
this space, like we've said, is private. We don't know
(20:17):
what goes on.
Speaker 6 (20:19):
So it does seem like the market has learned how
to do this kind of aggressive reading of debt documents
and to look for ways to borrow incremental money without.
Speaker 5 (20:28):
The consent of its existing lenders, and do all these
other tricks that have become normal. But certainly, if you
invest in private credits, you're much you're not being kept
up at night nearly as much by shenanigans and the
debt markets as you are if you invest in like
broadly syndicated.
Speaker 3 (20:43):
Debt, it sounds pretty good to me. Okay, so less
legal fees, less creditor on credit or violent liability, asset matching,
the better user experience. So what's the catch. I don't
see any problems.
Speaker 4 (20:57):
One potential problem is, of course these are are in
some cases absolutely massive loans, and so you do lose
the diversification benefit. These are very risky investments. I would
say the private credit structure has a partial solution to
that problem, which is that the investors themselves in a
private credit fund oftentimes are so massive themselves that they
(21:22):
really don't lose diversification, which is to say, their portfolios
are so large that they can make this enormous investment
in one private credit fund. Because that's a tiny piece
of their portfolio. So that's one downside of private credit.
The other, of course, is the absence of trading. So
before you had pretty good signals of what your position
(21:43):
was worth, there were lots of syndicated loans that had
pretty active trading, and there were indices tracking all of this.
The LSTA provides lots of data on the loan market,
and of course the bond market, of course, is public
in terms of the pricing there. Exit is always going
to be a concern in this market, and I don't
think this market really has been truly tested yet, so
(22:03):
we'll have to find out. But that illiquidity can be
an issue depending on what kind of investor you are
and what your expectation is for getting out of these things.
Speaker 2 (22:14):
Joe's being facetious by the way. He says he doesn't troll,
but he trolls.
Speaker 1 (22:19):
You know.
Speaker 3 (22:19):
I'm saying, there's like a whole you know, you just
check go down to listen. It all sounds good.
Speaker 2 (22:24):
Well, I'll tell you one problem, Joe, which is okay,
if you look at Boeing, for instance, on the terminal,
and if you type ddis you see the distribution of
its bonds maturing that's all based on public info.
Speaker 5 (22:39):
Right.
Speaker 2 (22:39):
If everything becomes private, then we don't have as much
information about how levered or indebted companies actually are. Sure,
is that right?
Speaker 4 (22:50):
That is a concern. So you can have concerns both
for the investors themselves and for sort of the broader
economy or the broader market. And that's the issue with
private credit. We have heard a lot from people about
concerns about the marks that people are carrying these private
credit loans at, and that they might be entirely stale,
(23:11):
they might be largely overstated. There's really no way to
know until you exit that investment. And that's that's exactly
how it is on the private equity side. That you know,
if a private equity fund buys a portfolio company, who
on earth knows what that company is worth until they
actually finally exit that and there is some misvaluation and
so on. That's the question is can we have that
(23:32):
both on the equity side and on the debt side.
What does that mean for our economy if we are
suddenly just very liquid for almost all of the companies.
Speaker 5 (23:42):
Yeah, and so something that to think about is the
broadly syndicated debt world and the high yield world of
debt in created this benefit for all of us. And
that benefit was we could follow the trading prices of
debt and real time and get a sense of where
are their problems in our economy, what sectors are in trouble.
Like I think about COVID nineteen, so COVID nineteen hits.
(24:03):
We're all watching, like, what are the debt prices of
the big hotel companies telling us about the likelihood these
those hotel companies go into bankruptcy. Congress and regulators can
look at those signals and say, okay, we've got to
do something really special for the airlines, We've got to
do something really special here. And when the airlines go
to Congress and say we need something special, they can
point to their debt prices and say, look what is
(24:26):
going on regulators, Look what's going on in Congress.
Speaker 6 (24:29):
Our debt is trading down.
Speaker 5 (24:30):
You know, to zero, like please, we need special treatment.
Investors looking for a deal can say, hmm, the debt
of this company is trading at a really low level.
I think I could do really well if I owns
that asset. I'm going to go make that board and offer.
And so all of those price signals just disappear from
the allocation of capital, from policymaking, and I think it
(24:53):
poses a real.
Speaker 6 (24:54):
Challenge to what are you a really.
Speaker 5 (24:57):
Well functioning set of capital markets to lose those signals?
I mean, just very selfishly in my own research, something
that I often run into and I'm trying to decide, okay,
like how good a job is the bankruptcy system doing well?
The vast majority of companies that file for bankruptcy leave
bankruptcy these days as private equity portfolio companies in one
way or the other, and so you actually can't follow
(25:19):
them after bankruptcy to figure out, okay, is the bankruptcy
system doing a good job or reorganizing these companies? If
there are policy buttons to push in the way the
system is run, what should we push. We just don't
see the information, so we don't know. We have to
make guesses based on a little bit we can see.
And I think our worry is that that's what a
lot of policy making in the debt space is going
to turn into, or we're just going.
Speaker 6 (25:40):
To guess, oh, yeah, that whole industry is funded by
private credit, how's it doing.
Speaker 4 (25:44):
We have no.
Speaker 2 (25:45):
Idea do you imagine there'd be a knock on effect
to stock valuation as well. If you have a company
that maybe still has publicly traded stock, but all of
its debt financing comes from I don't know, a business
development company or private equity or something like that, it
must be hard for the equity investors to make a
realistic or accurate assumption about the health of the company
(26:08):
too without that debt knowledge.
Speaker 4 (26:10):
Certainly the equity markets and the debt markets inform one another,
and so yes, the stockholders are constantly looking to see
what's going on in the credit markets for signals and
vice versa. And I would say, actually, the one that
worries us more sort of the opposite, where you have
a lot of privately owned companies, so either they're venture
capital funded or their private equity owned, but they still
(26:33):
have today a public debt piece, either fully public in
terms bonds or something like that, or even high yield
bonds which were a bit of a hybrid or syndicated
loans that at least have those trading prices. If now
their debt becomes private as well, if they go the
private credit route, that's the concern that then you lose
(26:53):
really all information about this company that is used to
be visible to investors, to regulators, to the broader public.
Speaker 3 (27:00):
You know, I'd never really thought about the question of, like,
how are we measuring the efficacy of existing bankruptcy law
or how are we measuring how well the courts are doing?
So I guess a two part question would be like,
as professors, as academics, how do you think about assessing
the success of the existing bankruptcy regime? And then how
(27:24):
does a private credit versus tradable instruments, how do you
anticipate it or how is it already changing how a
bankruptcy process might look.
Speaker 6 (27:36):
Sure, so bankruptcy success is somewhat hard to measure. There's
not one way to do it.
Speaker 5 (27:41):
The definition I make the best is is the bankruptcy
system misallocating assets? Is it producing companies that come out
and they're thriving, or is it taking companies that are
struggling pre bankruptcy and then they continue to struggle after bankruptcy? Right,
So there's a real bias in the system towards reorganization,
which always makes you work that the system isn't liquidating
(28:01):
companies that are bad companies. And what I mean by
that is Let's say that I work for some company
that's not doing well. They have a bad business, bad idea,
it can't be fixed. Well, I might be best off
if that company dies. It's going to be terrible for
me to be unemployed, but then I'll find new work
and maybe now I will be at a company that's
growing where my skills can help it grow. So what
(28:23):
you want is a bankruptcy system that reallocates assets efficiently.
Speaker 6 (28:27):
And the worry is that, you know the bankruptcy system
doesn't always do that.
Speaker 5 (28:31):
But there's really no way to know that about our
current bankruptcy system because we just don't see enough companies
come out that with public equity or will be able
to learn a lot about how they're doing. To go
to the question of like, how does private credit change bankruptcy,
a simple answer is that, you know, we no longer
have this trading market for the debts of companies that
(28:51):
are in trouble or are in Chapter eleven. So judges
have counted on being able to run the bankruptcy system
assuming that whoever the smartest and most capable investor who
really understood how to reorganize that company, that person's in
the room right, because that person bought the debt of
other investors who.
Speaker 6 (29:09):
Weren't too smart and capable. At least, this is the theory.
Speaker 5 (29:12):
And so when the banks stand up and say, hey, judge,
here's how we think this company should be organize.
Speaker 6 (29:17):
It should be sold, it should be liquidated, it.
Speaker 5 (29:19):
Should be organized, whatever it is, the judge says, okay, like,
you probably know what you're doing because I can count
on the fact that if somebody had a better idea,
they'd come and buy your claims. But that just goes away,
right because we no longer have trading in the same way,
So the judge is going to have to do a
lot more to make sure that assets are properly marketed.
You also won't have rating agencies covering these companies on
(29:41):
a lead up to bankruptcy, right, So you're just going
to many more companies filing for bankruptcy that the world
knows less about, right, And like the bankruptcy system is
assumed that a company with syndicated debts, the world knows
a lot about this company. A lot of that's going
to change, and you know that's something that I think
judges are going to have to.
Speaker 6 (29:58):
Adapt to.
Speaker 2 (30:14):
Just to play devil's advocate first. A second, I think
this is something you actually deal with in the paper,
But one of the things you hear from people in
the private credit industry is that, oh, well, if you're
getting funding from a private entity, maybe a single lender
or maybe a club of lenders, but it's a smaller
(30:35):
group than you would have in the public market, maybe
there's greater potential for working out your issues if you
get into trouble, so you can renegotiate your debt with
a smaller group of creditors, and maybe they know your
business better than like, you know, a big fund that
is buying pieces of all these different types of bonds
(30:57):
and things like that. What's your response to that argument,
this idea that well, private credit actually allows you to
have more room for workouts or maybe even stave off
bankruptcy for longer.
Speaker 5 (31:09):
So I guess my answer is that that all sounds great,
but it'll depend and it's hard to really understand which
way any of these sort of course is cut.
Speaker 6 (31:18):
The one thing that's clearcuts.
Speaker 5 (31:20):
That's important is we're losing, you know, the claims trading market,
like that's just going to look a lot different like
the active market. And the claims of Chapter eleven debtors
when that debtor is a private credit funded firm. But
you know, as to the question of well, you know,
aren't these private credit lenders smarter, more versatile, more nimble,
able to commit capital, and won't that be good for companies?
Speaker 6 (31:40):
You know, at the end, it depends. So something you
worry about is.
Speaker 5 (31:44):
Well, maybe private credit lenders will have incentives not to
adjust their marks on their books and instead just to
do amend and extends and just keep loans going when
the company really needed to liquidate or should have filed
for bankruptcy sooner. You know, think about how different the
GM bankruptcy would have in had they filed for bankruptcy
in like two thousand and five versus two thousand and nine,
(32:04):
when their business had already erode in so much so
we think of that erosion as something that limits reorganization options.
And it's not necessarily obvious how private credit interacts with that,
because private credit lenders have their own incentives, and maybe
their incentives are to say, look, you know, we make
loans to sponsor backed companies, and if the sponsor wants
(32:26):
to continue, we're going to keep doing that. Because we
really want to participate in their next deals, or they
could say, like, let's pull the plug on these things earlier.
So something that I've heard from lawyers working in the
space is that when private credit lenders replace like your
mid market banks, like your citizens and that kind of bank,
when you have like a private credit lender with a
thirty million dollar loan that might have been done by
(32:47):
a syndicate of two regional banks, the private credit lenders
are much more aggressive and much more willing to pull
the plug on the company and to own the asset
then that bank might have been. But the world's look
very different for larger companies, where private credit lenders might
be easier for companies to do workouts with. So it's
really hard to tell, but I'm certainly a bit skeptical
(33:09):
the idea that all of this is uni directional and
the private credit is just better in every way for everything.
It's different, and there'll be different pros and cons and
we'll learn more about them, and the law will adapt
and hopefully deal with some of the ways in which
the incentives of private credit lenders distort bankruptcy outcomes.
Speaker 2 (33:28):
Since you mentioned GM, could you maybe talk about another
specific example of a liquidation kind of playing out a
bit late as you describe it, I'm still I'm still
salty over the collapse of Red Lobster, which you mention
in your paper. So could you talk a little bit
about that one and what it tells us about private credit?
Speaker 5 (33:47):
Sure, So, something that has been the case over the
past few years is you've had private equity owned restaurants
and retailers that just ended up doing quick liquidations after
stalling for a very long time. Red Lobster is really interesting.
Red Lobster have been struggling for a little while, and
then it's Fortress Investment Group, which was its private credit lender,
(34:10):
came in and took over the company and basically just
owned the asset very quickly.
Speaker 6 (34:15):
And something that is so.
Speaker 5 (34:17):
Interesting about that is that traditionally, you know, other lenders
would have been a lot more cautious about doing that,
because other lenders are very cognizant of what we called
lender liability and this line of law that suggests that
you shouldn't if you're a lender played too much of
a role in business decisions of companies that you lend to.
Speaker 6 (34:39):
And like there's an example of like a private.
Speaker 5 (34:41):
Credit lender just behaving in this really aggressive way, which
you know is interesting. Again, it's hard to tell exactly
what's going to happen, but certainly that example doesn't fit
well with the story of well, you know, the private
credit lender is just like the banker, and you know
it's your corner bank in nineteen twenty five.
Speaker 6 (35:00):
Who's going to work with you on your farm?
Speaker 5 (35:02):
You know, the answer is maybe some of the time
that's the story, but other of the time you're dealing
with a very sophisticated party who may have different incentives
and be worried about different things than traditional bank lenders
or investors in the broadly syndicated market.
Speaker 2 (35:15):
Jared, the other thing you just mentioned was the idea
of bankruptcy law adapting to private credit. So it's a
growing market, it's becoming more of a thing. Certainly in
the bankruptcy process. Law doesn't necessarily have the best history
of adapting quickly and efficiently to new situations. But is
(35:36):
there a possibility that in the future you could see
bankruptcy law start to change to take into account more
of these new players in the way the market actually
works now.
Speaker 5 (35:46):
I do think that will happen. I think bankruptcy judges
are very sophisticated and they've proven very very worthy over
time of adapting to lots of changes in credit markets, securitization,
syndicated lending, claims trading like you sort of name it,
like the.
Speaker 6 (35:59):
Law eventually adapts. So here, you know, one.
Speaker 5 (36:02):
Could imagine judges being stronger advocates for the company. You
could imagine judges being stronger advocates for employees, slowing down
bankruptcy processes to make sure that whoever's going to own
this asset. On the other side, they're the right person
to own it's mindful of the fact that there isn't
claims trading.
Speaker 6 (36:20):
So those are all ways in.
Speaker 5 (36:21):
Which I can easily see judges sort of stepping in
and saying, something new is happening in credit and we're
going to be a part of, you know, helping with
some of the problems it creates, which is what judges
have always done.
Speaker 4 (36:34):
I should add that, you know, there's a couple of
different questions. One is what happens once you're in bankruptcy,
which is what we've been talking about. But another question
is who actually enters bankruptcy and in what condition, and
so one you know, open question is are we going
to see potentially fewer bankruptcies because with private credit it should,
in theory be a little bit easier to renegotiate dead
(36:56):
and so on with your creditor, So you could it
could be the case that we have a lot fewer
bankruptcy is more out of court restructurings. But it could
also be that once you do reach bankruptcy, if you
go to private credit route, you're likely to be in
far worse condition than other bankrupt companies because we just
don't have this visibility into the company's valuation and there's
(37:17):
an ability to kind of keep things going, keep things going,
and you could in fact have a wave of zombie
companies by the time that they enter into bankruptcy. And
that of course is the question. So just to get
contentious and get everyone mad at me, some of the
concerns that we've had on the equity side, again we
think could play out on the credit side. So you know,
(37:37):
I think people are well aware than on the venture
capital side. There have been a lot of misvaluation, so
a lot of cases where what people thought was a
successful company really wasn't or it was engaged in fraudulent
or legal activity, and so on and so on. The
sort of list there is quite long. The common theme
is we are less certain about valuation in the private markets.
(38:01):
That's just sort of corporate finance one oh one. When
you have less information and less trading, we can be
less confident in the valuations. And again now we're going
to see that on the credit side, and it's going
to be especially acute for companies that are private, on
both the equity side and the debt side.
Speaker 3 (38:16):
Yeah, I was really intrigued by the callback to GM,
which I had, you know, so long ago I'd sort
of forgotten about. But I do remember that in the
mid two thousands, even well before the financial crisis, there
were really serious concerns about, you know, the health of
the company and whether it was already heading for insolvency
for various reasons. Can you talk a little bit more
(38:39):
about this idea, this notion that you just talked about,
which is that you know, the incentive is from the
private credit fund standpoint to extend and pretend I could imagine,
for example that a private credit fund, you know, just
for reputational purposes, would not want a high profile or
any profile bankruptcy among their investment to the point where
(39:02):
they make purposefully bad bets. Yes, extending this loan is
going to be a money loser or not a money maker,
but it's better than having the headline of one of
our portfolio companies go bankruptcy. And so you sort of
push that further on. And then also maybe as part
of that, like in your conversations, is the flexibility real,
Because again you talk to people in the industry and
(39:23):
they're like, Oh, it's so great, we work with our
lender and they can modify the loans or they understand
our condition. Does it play out in practice that the
borrowers in the private credit market do get that sort
of additional flexibility to start with.
Speaker 6 (39:38):
Their first point?
Speaker 5 (39:39):
Yeah, So you absolutely worry in the world of corporations
that it could be as simple as vanity on the
part of the CEO.
Speaker 6 (39:46):
They just don't want to file for bankruptcy, they don't
want to restructure.
Speaker 5 (39:50):
Another recent example Seers, which filed for bankruptcy maybe eight
years ago or something like that. Seers limped along for
many years, you know, one of the great American retailers,
selling store after store, and it.
Speaker 6 (40:03):
Became this miserable experience.
Speaker 5 (40:05):
I don't know if you shocked at Sears recently, but
I remember, up to.
Speaker 2 (40:08):
Bankruptcy, my dad always used to park by Sears because
he always said that's where it was empty and there
were available spots. I was always a strategy.
Speaker 5 (40:19):
Yeah, I hope you shorted them when you heard that.
Speaker 6 (40:24):
But if you went to a Sears like in the
leadup to bankruptcy, which you would have discovered was empty shelves, like,
it was a bad experience.
Speaker 5 (40:31):
And that's what happens when companies take too long to
file for bankruptcy. They need capital, they try limping along
and it hurts everybody. So imagine you worked for Sears
during that period. Your career was stunted by the fact
that you're stuck there and I'm not going to promote
people into management, and they're not giving people bonuses, and
there are no growth opportunities, like there are all these
(40:53):
ways in which it's bad, and so, like you said,
the worry is that private credit companies are going your
private credit backed firms because their lenders will want to
be more agreeable, they may wait longer to reorganize than
they would have otherwise.
Speaker 6 (41:07):
You know, whether or not that's true.
Speaker 5 (41:09):
Who knows, And like, one of the things that is
important to emphasize is that all of the fears we
have about private credit, they all may be true in
individual cases, just like when you know the people you've
had on your show who work in the business, how
you've upgrade it is, And like you know when God
stopped on the seventh day after creating the world, he
then created private credit because we needed loans from investment
(41:30):
funds in order for the world to be a more
perfect place.
Speaker 6 (41:33):
Those people are right to some of the time. The
question is, well, what does it look like when we're
not all right?
Speaker 5 (41:38):
And that really remains to be seen. I think we're
at the very early stage of an important shift in
corporate finance whose implications are hard to truly understand. And
the worry at the stage is that, like in our
incomplete understanding and our incomplete narratives, that we make bad
policy decisions, like we create regulations that aren't needed, or
we miss the opportunity to create regulations.
Speaker 6 (41:59):
That are needed.
Speaker 5 (42:00):
You do hear in this space that there is flexibility
and that lenders are helpful, and that that that does
seem to be the dynamic at least for some borrowers
at least some of the time. But again, what's generalizing,
you know, that's as a social scientist, that's always the
question you want to know, is you know, if you
hear about this one story, you know, you hear about
the plural site example that I mentioned earlier, where you're
(42:22):
like a private credit backed company where the lenders are
doing liability management stuff. You have this very aggressive these
aggressive debt market transactions.
Speaker 6 (42:31):
So you know, is that representative of something?
Speaker 5 (42:34):
It's hard to know and a real challenge to knowledge
creation in this context is we don't even know how
big the market is. We're missing basic statistics. When Elizabeth
and I started this research project, we were looking for
commercial resources to learn how big this market is. And
what we found is that when we interrogated each of
the sources that are commonly cited you, we didn't have
(42:55):
any confidence that we were capturing something real. Like you know,
if you follow the trajector of this, it's something real.
We know it's been getting bigger. How big has it gotten?
I don't think anybody really knows.
Speaker 2 (43:06):
You anticipated. My next question, which is the number you
cite in the paper is one point five trillion dollars,
So how did you end up with that specific number.
Speaker 4 (43:18):
In the end, I think actually what we did was
choose the most conservative one. So there's so much disagreement here,
we figured, all right, I think everyone's going to believe
us with the sort of lowest number that's getting thrown
around right now, but again, could be significantly bigger than that.
Speaker 5 (43:34):
Yeah, And again a big challenge here is that if
you talk to people in this business, a lot of
them will how you private credit is brand new, Like,
that's not true. Investment funds have been originating loans, you know,
for a very long time. Like, this is not a
new thing. What's new is the size and the scale.
And given that, like it's not even clear like exactly
who is a private credit lender?
Speaker 6 (43:54):
What does that mean?
Speaker 5 (43:56):
These sort of basic definitional questions. There's not agreement with
syndicated lending. You could say, okay, there's a handful of
money market banks they run this similar process for these
broadly syndicated loans.
Speaker 6 (44:09):
And all of that. That's a thing in the financial market.
Speaker 5 (44:11):
It's like here, I don't even know, like if you
were to ask, well, how big is it? Well, there
are investment funds out there that'll make loans to corporations.
Are they doing something called private credit? Well, on the
fundraising side, I'm sure that the answer right now is yes,
because allocators launch exposure.
Speaker 6 (44:27):
To this asset class. But apart from that, it's really
hard to tell.
Speaker 2 (44:32):
So just to press on this point, and once again
you've anticipated my next question, but what does it mean
if debt is issued by an investment fund or an
investment firm versus say a bank or a traditional buyer
of a syndicated loan or a publicly issued bond or
(44:52):
something like that. Are there specific concerns depending on the
type of lender that is involved in these deals.
Speaker 4 (45:00):
To take the last part first, I would say yes,
there are clear differences. So if you believe that incentives matter,
and I think we all do, then we can look
at each of these different types of funding structures, figure
out what the incentives are of the parties, and trace
through what we think the implications are. So in terms
of what the differences are, I think the easy cases
(45:21):
are the extreme ones. So if you think of sort
of a bank, that is an institution that is funding
loans basically with customer deposits, and that is subject to
very heavy regulation as a bank credit funds. If they
really are a private investment fund, that's sort of a
very different model. That is poled capital from a big
(45:43):
of typically large institutional investors, and they are usually closed
end funds, so the capital is locked in for at
least ten years, and they take that money, that equity
that provided by those investors, they might borrow from a
bank on top of that, and they use that to
go make loans. And the regulation of private investment funds
(46:05):
is relatively speaking, incredibly light. Right, every investment fund manager
is going to say, no, no, we're subject to all
this regulation. Sure, there is some regulation, but compared to
everything else, like banks or like investment funds that take
retail investment, the regulation is very very light. So those
are sort of some easy extremes in terms of what
(46:25):
you see, and then to follow through what the incentives
are of private investment funds for them, there's multiple things
going on. So one question is where are they in
their life cycle. So if they are at a point
where they're trying to fund raise for their next fund,
just as you mentioned earlier, they are really not going
(46:47):
to want to recognize a big loss and so that's
where their incentives are probably the worst in terms of
trying to keep an investment going, to not send something
into bankruptcy, to not have the bad head lines and
so on. That's one potential worry. Another is when you're
reaching the end of the fund's life and so there
(47:07):
they might actually be forced to sell things when they
are not quite at an optimal time to do that.
Those are some of the questions that you have with
private investment funds. The other big differences in terms of
the incentives of the managers. So you have the classic
private equity style compensation structure.
Speaker 6 (47:24):
You have a management.
Speaker 4 (47:25):
Fee, so that means the bigger you are, the more
money you make. But especially what you have is a
performance fee, and that is really you know, it's just
like a stock option. It's you get all the upside,
you bear none of the downside. So that's what really
encourages them to hit for the fences and so on.
And there's many, many, many academic studies looking at again
(47:45):
private equity and showing that the way the carry is
set up, that carried interest, that performance fee, that drives
behavior of private equity funds. They try to recognize winners
quickly hold on to losers longer. You're going to see
a lot of that same stuff on the credit side.
Speaker 2 (48:02):
All right, Elizabeth, I love that you mentioned Authoughts's unofficial tagline,
which is incentives Matter. So we kind of came full
circle on that conversation. That was a fantastic overview of
the impact of private credit and also some of the
incentives that might be driving it. So Jared and Elizabeth,
thank you so much for coming on all thoughts.
Speaker 6 (48:22):
It was great.
Speaker 3 (48:22):
Thank you, Thank you so much much.
Speaker 6 (48:37):
Joe.
Speaker 2 (48:37):
I thought that conversation was fascinating. And I know we've
said this on a number of episodes by now, but
to some extent, the rise of private credit is what
regulators wanted, yes, for two thousand and eight, right, you know,
regulatory capital rules were engineered for this specific outcome, getting
risky loans off of bank balance sheets, pushing them on
(49:00):
to less regulated or even unregulated financial intermediaries where if
they failed it wouldn't be such a massive problem. But
I think you can say like two things, and Elizabeth
brought up this point, but one, the size and the
speed of the market's growth kind of matters here, right,
So yes, maybe you want some non bank financial entities
(49:23):
to be making loans, But if they do so on
a particular scale, or if they do so in a
way where a huge amount of credit in the American
economy ends up being concentrated on like a very large
investors balance sheet, and they end up owning the entire
capital stack of a company, basically the equity and the debt,
(49:45):
that could be problematic. And then the second thing is
I cannot imagine that when bank regulators were making some
of these rules post two thousand and eight that they
were necessarily thinking of the bankruptcy implications or like the
informational disadvantages of not having a claims trading process totally.
Speaker 3 (50:05):
So first of all, I just want to say I
wasn't trolling when I said it sounded great, because there
were a number of things that from their perspective you
could see the appeal. So the idea of maybe this
is a better liability asset match than taking short term
deposits and made long term loans. The fact that the
user experience from the perspective.
Speaker 6 (50:25):
Of the borrower, you go to the.
Speaker 3 (50:27):
Fund and they can move a lot faster. That makes
a lot of sense to me. The fact that there
is less, as you put it, creditor on creditor violence,
such that the game is not all about who can
read you know, who finds something in the fine print
somewhere so that they can induce a bankruptcy and that
(50:47):
they can like, you know, get this claim on the
collateral that another entity can't. So it does really seem
like there are some very obvious reasons why this market
is appealing. Not to mention the point that you just made,
which is that, like, this is kind of what we
want from a financial stability perspective, that all of these
(51:07):
loans are not in the hands of you know, entities
that also have people's safe deposits. That being said, you know,
one of the things that I the arguments, you know,
there's obviously the lack of information and the lack of clarity,
and that's interesting from multiple perspectives, but also this idea
of like, well the sort of zombie company phenomenon, which
(51:29):
is that if you sort of declare bankruptcy at the
right time, there's still some sort of potentially turnaroundable company
by the time it hits bankruptcy court. But if you
wait too long and then it hits bankruptcy court, and
then there's really nothing. I think that argument. You know,
it's early, right, we haven't seen a ton of bankruptcies yet,
we haven't had a downturn yet since this market really boomed.
(51:52):
But that strikes me as something where while you could
really get serious like degradation of the quality of assets
that come into Yeah, and.
Speaker 2 (52:01):
I thought the Sears example was both harsh and powerful,
but it is true. And you do see that in
the discourse around zombie companies, this idea that like, well, okay,
if a company is just kind of limping along because
it's big creditor doesn't want to have to take a loss,
or it doesn't want to have to issue a press
release saying one of its portfolio companies has gone bankrupt,
(52:23):
that has real world implications for the people who work
at the company or at Sears who can't get a
promotion and are just working in a gosh, I'm just
imagining walking through the emptcerieses of the world now just
have a really like depressing retail experience.
Speaker 3 (52:38):
Totally.
Speaker 2 (52:39):
All right, shall we leave it there, Let's leave it there.
This has been another episode of the All Thoughts podcast.
I'm Tracy Alloway. You can follow me at Tracy Alloway.
Speaker 3 (52:47):
And I'm Jill Wisenth though you can follow me at
the Stalwart. Follow our guests Jared Elias, He's at Jared Elias.
It doesn't appear that Elizabeth is on Twitter, so that's
wise for her, but go check out her recent Follow
our producers Carmen Rodriguez at carman Erman dash Ol Bennett
at Dashbot and Kilbrooks at Kilbrooks. And thank you to
(53:07):
our producer Moses Ondem. For more Oddlots content, go to
Bloomberg dot com slash odd Lots, where we have transcripts
of blog and a newsletter and you can chat about
all of these topics twenty four to seven in our
discord Discord dot gg slash Outlots.
Speaker 2 (53:22):
And if you enjoy Odd Lots, if you like it
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(53:44):
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Speaker 4 (54:06):
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