Odd Lots - The Black Hole of Private Credit That's Swallowing the Economy

Episode Date: September 2, 2024

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 CreditPrivate Credit Pushes Deeper Into Risk That Wall Street Is FleeingOnly Bloomberg.com subscribers can get the Odd Lots newsletter in their inbox each week, plus unlimited access to the site and app. Subscribe at bloomberg.com/subscriptions/oddlotsSee omnystudio.com/listener for privacy information.

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Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg television, radio, and wherever you get your podcasts. Bloomberg Audio Studios. Podcasts, Radio, News. Hello and welcome to another episode of the Odd Thoughts podcast. I'm Tracy Alloway. And I'm Joe Wisenthall. Joe, do you remember reading headlines like the incredible shrinking stock market?

Yes, I forgot about that whole period. A lot in the 2010s 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, when Microsoft and Apple and all those went public and it was like no one knew anything about them when they first came out. 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 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 not necessarily in terms of absolute available shares. And this has been a sort of ongoing trend and discussion. 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 market side, you know, it's almost like opting to go the public route is almost like a red flag. Oh, that's a terrible thought, but you're right. But there seems to be something to that, right? That's what we've seen in the last several years. 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?

We've obviously talked about private credit a fair 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 one day. 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 we're going. relatively recently. We had a lot of companies that were issuing bonds, so selling those to investors, or they were taking out loans from banks, or they were taking out loans that would be intermediated by banks and then sold onto more investors. Those are called leverage loans. And this was kind of what we had seen in the stock market in like the 80s, the 90s, maybe the early 2000s, lots of companies coming to the public market via debt. But now, with the rise of 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. Right. And we've sort of talked to a lot about the why. of private credit and various advantages and, you know, certain types of companies in the industries that maybe banks don't service directly or maybe some flexibility. We ever 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? Yeah. And this is the thing I find really

interesting because there's so much hand-wringing 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 guest. We are going to be speaking with the 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 Lots 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 Scotty Collins Professor of Law at Harvard Law School and his co-author Elizabeth Defontanate. 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 odd lots. Thank you so much. So first of all, how did this get on your radar as law professors? How did this become something that you were both interested in doing research on? 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 debt, right? There's constant innovation in debt, and that shows up in innovation in bankruptcy. And something that I kept hearing from market participants was increasingly important was private credit, private credit, private credit, private credit. And that made me want to learn about

it. And what you do in the member of a faculty and you want to learn about something is you try to find a way to write about it. 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 of it that was changing really rapidly was the private credit funds. So these, you know, the big private equity funds, you know, the Baines and TPGs and others, they had these private credit arms that were appearing and getting bigger and bigger and bigger, and they started

becoming more of the story. And that to me was very interesting because private-a-what-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. 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, you know, corporate finance has done over the past 10 years. Like when I started to hear from people about private credit, I realized I'm out of date.

Something new is going on and I need to get smart on it. 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 long-time credit reporter kind of blows my mind that that's the case. But 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 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. 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 it is,

what's going on with all these loans. So there are some way. ways, indirect ways of trying to access what's happening, but there's no centralized database that you can 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 them all 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 decades. And there's, 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 80s, but more so and really got going in the 90s, and especially in the early 2000s, which was the syndicated loan market. So there, 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 creditors. 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 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, 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 the entire debt piece of your capital structure. 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, not subject to any of the usual things that we're seeing in the

debt market. 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 syndicated debt meant that bank loans could be much bigger.

the risk is 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, becoming bigger than any kind of loan that any bank could have ever made on their own. So it's a total revolution in the way that we think about debt. And, you know, 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. Well, 10 years ago, we didn't think that was the right thing to do at all, and now all of a sudden we do. Canadian women are looking for more.

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Follow leaders with Francine Lacroix wherever you get your podcasts. You spell out this evolution of the debt markets and the historical things you're taught in law school about the dangers 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 to people, what problems does the private credit market solve for them?

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, you know, primarily been constrained because of regulation and sort of regulation designed to discourage them from making risky loans and from, you know, to have diversification 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 retreated from particularly the lower middle market, 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 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, are multi-year loans. And that's just a fundamental mismatch that 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 securities 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 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 multi-year. So in some sense, it's actually a better fit than banks for financing this type of loan. 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 Jared can tell. Yeah. So when you talk to people in this business and we did a lot of, we had a lot of conversations of people in the process of working on this paper, one of the things you hear over and over is the private credit is 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. 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 around looking for investors. Instead, we've got the money. it's sitting in our bank accounts, we're ready to give it to you. And that better user experience kind of also applies to the life cycle of the loan, where 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've got this problem, you know, we help, and the private credit lender is helpful. And the thinking there is that private credit lenders are in the business of originating loans, 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 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 take your loan,

chop it into 15 pieces and sell it to 15 really nasty hedge funds will then become impossible for you to negotiate with. So you have this kind of user experience feature to private credit that, you know, everyone in the business, and obviously they have their own selfish motivations for saying this, so we should be a sense of a little skeptical, but they say, you know, basically, you know, you want to come to us. We're like the Apple store for credit. You know, those other guys like Bank of America, you know, that's like going to buy something

of a 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 trying to compete on service. 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 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 or recent strategies around bankruptcy and 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 in the payment or bankruptcy waterfall as they possibly can be. Yeah. So when we went into this research project, I think Elizabeth and I were kind of hoping that we can tell the following story. And the story would be something like this. Over the 2010s, 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, 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. Like the story of debtor creditor law today, to a very large extent, is really smart people looking for problems and documents so they can, and 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 10 years ago. That's a story today. 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 to say that it would really go too far. I think it's a story of private credit is you have this response to what one hedge fund manager described to me as, I can't afford anymore to invest in a 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 litigious to invest in debt. Poof, 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. The private credit asset manager isn't going to do bad things to some of its fund investors to the debt. detriment of other fund investors. And so all of a sudden, many of those tricks allegedly go away. Now the caveat to this is recently we did see a company do some sort of hardball debt maneuver,

which we weren't expecting to see, but we saw. And some of the reporting around it suggested that there's been others too. It's hard to tell because this space, like we've said, is private. We don't know what goes on. So it does seem like the market is a lot. learned how to do this kind of aggressive reading of debt documents and to look for ways to borrow incremental money without 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 not being

kept up at night nearly as much by shenanigans in the debt markets as you are if you invest in like broadly syndicated debt. It sounds pretty good to me. Okay, so less legal fees, less creditor un-creditor violence, liability asset matching, the better user experience. So what's the catch? I don't see any problems. One potential problem is, of course, these are, in some cases, absolutely massive loans. And so you do lose diversification benefits. 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 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 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 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. Joe's being facetious, by the way. He says he doesn't troll, but he trolls all the time. No, I'm saying it. I'm saying there's like a whole, you know, you just check, go down the list.

It all sounds good. 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 D-D-I-S, you see the distribution of its bonds maturing. That's all based on public info. Right. If everything becomes private, then we don't have as much information. about how levered or indebted companies actually are. Sure.

Is that right? That is the 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. They might be largely overstated.

there's really no way to know until you exit that investment. And that's exactly how it is on the private equity side, that 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 a question is, can we have that 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? Yeah, and so something to think about is the broadly syndicated debt world and the high yield world of debt incur this, created this benefit for all of us. And that benefit was we could follow the trading prices of debt in real time and get a sense of where are their problems in our economy, what sectors are in trouble? Like, think about COVID-19. So COVID-19 hits.

We're all watching, like, what are the debt prices of the big hotel companies telling us about the likelihood 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 going on regulators. Look what's going on Congress.

Our debt is trading down 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 an offer. And so all of those price signals just disappear from the allocation of capital from policymaking. And I think it poses a real challenge to what are a really 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 to the other. And so you actually can't follow them after bankruptcy to figure out, okay, is the bankruptcy system doing a good job reorganizing these companies? If there are policy buttons to push and 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 the little bit we can see. And I think our worry is that that's what a lot of policymaking in the debt space is going to turn into where we're just going to guess, oh, yeah, that whole industry is funded by private credit. How's it doing? We have no 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 too without that debt knowledge? 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 is sort of the opposite where you have a lot of privately owned companies.

So either their venture capital funded or their private equity owned, but they still have today a public debt piece. either fully public in terms of 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 really all information about this company that is used to be visible to investors, to regulators, to the broader public. You know, I'd never really thought about the question of like, how are we measuring the efficacy of existing bankruptcy law? 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 does private credit versus tradable instruments, how do you think about assessing the success of the existing bankruptcy regime? And then how does private credit versus tradable instruments, how do you anticipate it or how is it already changing how a bankruptcy process might look?

Sure. So bankruptcy success is somewhat hard to measure. There's not one way to do it. The definition I think 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. to struggle after bankruptcy. So there's a real bias in the system towards reorganization, which always makes you worry that the system isn't liquidating 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 you want is a bankruptcy system that reallocates assets efficiently. And the worry is that the bankruptcy system doesn't always do that, 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, we're 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 are in trouble or are in chapter, after 11. 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 weren't just smart and capable, at least this is the theory. And so when the banks stand up and say, hey, judge, here's how we think this company should be organized. It should be sold. It should be liquidated. It should be organized, whatever it is. The judge says, okay, like you're 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 the lead up to bankruptcy. Right. So you're just going to have 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 adapt to. Canadian women are looking for more. More to themselves, their businesses, their elected leaders, and the world are at them. And that's why we're thrilled to introduce the Honest Talk podcast. I'm Jennifer Stewart.

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Coast, listen as soon as you wake up. That's the Bloomberg Surveillance Podcast with Tom Keene, Paul Sweeney, and me, Alexis Christophorus. today wherever you get your podcasts. Bloomberg Surveillance, Essential Listening, each and every business day. Just to play devil's advocate for 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 group than you would have in the private company.

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 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? 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 forces cut.

The one thing that's clear cuts that's important is we're losing, you know, the claims trading markets. Like that's just going to look a lot different, like the active market and the claims of Chapter 11 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? You know, at the end, it depends. So something you worry about is, 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 been. Had they filed for bankruptcy in like 2005 versus 2009 when their business had already, eroded 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, we make loans

to sponsor-backed companies, and if the sponsor wants 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 $30 million loan that might have been done by 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 than that bank might have been. But the world could 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 of the idea that all of this is unidirectional, 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. 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 mentioned in your paper. So could you talk a little bit about that one and what it tells us about private credit?

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 liquidation. after stalling for a very long time. Red Lobster is really interesting. Red Lobster had been struggling for a little while. And then its Fortress Investment Group, which was its private credit lender, came in and took over the company and basically just owned the asset very quickly. And something that is so interesting about that is that traditionally, you know, other lenders would have been a lot more cautious about doing that. Because all Other lenders are very cognizant of what we call lender liability.

And this line of law that suggests that you shouldn't, if you're a lender, play too much of a role in business decisions of companies that you lend to. And like, there's an example of like a private credit lender just behaving in this really aggressive way, which, you know, is interesting. Like, 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, at your corner bank in 1925, who's going to work with you on your farm? You know, the answer is maybe some of the time that's the story, but other than 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. 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 there a possibility that in the future, you could see bankruptcy law start to change to take into account more of these new players and the way the market actually works now? I do think that will happen. I think bankruptcy judges are very sophisticated and they've proven very worthy over time of adapting to lots of changes in credit markets. Securitizations.

indicated lending, claims trading, like you sort of name it. It's like the law eventually adapts. So here, you know, one 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, it's mindful of the fact that there isn't claims trading. So those are all ways in 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. I should add that, you know, there's a couple 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 debt and so on with your creditor. So it could be the case that we have a lot fewer bankruptcies, more out-of-court restructurings. But it could also be that once you do reach bankruptcy, if you go the 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 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, I think people are well aware that 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 illegal 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. That's just sort of corporate finance 101. 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. 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-2000s, 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 about this idea, this notion that you just talked about,

which is that, you know, the incentives 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 they make purposefully bad bets. Yes, extending this loan is going to. 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 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? So to start with their first point. Yeah. So you absolutely worry in the world of, you know, corporations that it could be as simple as vanity on the part of the CEO. They just don't want to file for bankruptcy. They don't want to restructure. Another recent example, Sears, which filed for bankruptcy maybe eight years ago or something like that. Sears lived along for many years, you know, one of the great American retailers selling store after store, and it became this miserable experience. I don't know if you shocked at Sears recently, but like I remember

the lead up to bankruptcy. My dad always used to park by Sears because he always said that's where it was empty and there were available parking spots. That was always his strategy. I hope you're short of them when you heard that. So, but if you went to a Sears, like in the lead up to bankruptcy, what you would have discovered was empty shelves. like it was a bad experience. 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 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 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.

You know, whether or not that's true, who knows? 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, tell you how great it is. And like, you know, when God stopped on the seventh day after creating the world, he'd then created private credit. because we need it loans from investment funds in order for the world to be a more perfect place. Those people are right to some of the time.

The question is, well, what does it look like when we're not all right? 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 that are needed. You do hear in this space that there is flexibility and that lenders are helpful

and 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, 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 have like a private credit-backed company where the lenders are doing liability, management stuff. You have this very aggressive, these aggressive debt market transactions. So, you know, is that representative of something? 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, we didn't have any confidence. that we were capturing something real. Like, you know if you follow the trajectory 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.

You anticipated my next question, which is the number you cite in the paper is $1.5 trillion. So how did you end up with that specific number in the end? I think actually what we did was choose the most conservative one. Wow. 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. Yeah. And again, a big challenge here is that if you talk to people in this business, a lot of them

will tell 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, does that mean? These sort of basic definitional questions, there's not agreement on. Like, 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. And like all of that, that's a thing in the financial markets. 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 they'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 want exposure to this asset class. But apart from that, it's really hard to tell. 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 something like that. Are there specific concerns depending on the type of lender that is involved in these deals? 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 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. Private credit funds, if they really are a private investment fund, that's sort of a very different model that is pooled capital from a big of typically large institutional investors. And they are usually closed-end funds. So the capital is locked in for at least 10 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 is relatively speaking, incredibly light. 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 extreme in terms of what 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 fundraise for their next fund, just as you mentioned earlier, they are really not going 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 headlines and so on. That's one potential worry. Another is when you're reaching the end of the fund's life. And so there, 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. You have a management 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, many academic studies looking at, again, 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. All right, Elizabeth, I love that you mentioned A Thoughts'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. It was great. Thank you. Thank you so much. Joe, 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 post 2008, right? You know, regulatory capital rules were anything. engineered for this specific outcome, getting risky loans off of bank balance sheets, pushing them on 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 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 a very large investors balance sheet and they end up owning the entire capital stack of a company, basically, the equity and the debt, that could be problematic. And then the second thing is, I cannot imagine that when bank regulators were making some of these rules post 2008, that they were necessarily thinking of the bankruptcy implications or like the informational disadvantages of not having a claims trading process. Totally. 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 of the borrower, you go to the 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 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 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 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. But that strikes me as something where, while you could really get serious, like, degradation of the quality of assets that come into bankruptcy. Yeah. And I thought the Sears example was both harsh and powerful. Yeah, totally.

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 its 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. 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 MTCers of the world now, just have a really depressing retail experience. Totally. 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. And I'm Jill Weizenthal. 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 research. Follow our producers, Carmen Rodriguez, at Carmen Arman, Dashel Bennett at Dashbot and Kel Brooks at Kel Brooks. And thank you to our producer, Moses, Ondom. For more Oddlots content, go to Bloomberg.com slash oddlots, where we have transcripts, a blog, and a newsletter. And you can chat about all of these topics 24-7 in our Discord, discord.g.g slash oddlots. And if you enjoy Oddlots, if you like it when we dive deep into the implications of the rise

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