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

26:30What does that mean for our economy if we are suddenly just very illiquid 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 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 there 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?

27:06Congress and regulators can look at those signals and say, OK, 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 owned that asset. I'm going to go make that board an offer.

27:40And 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 when 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 them after bankruptcy to figure out, okay, is the bankruptcy system doing a good job reorganizing these companies?

28:20If 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 the little bit we can't 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.

29:05Certainly 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 they're venture capital funded or they're 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 are a bit of a hybrid, or syndicated loans that at least have those trading prices.

29:40If 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? 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 does private credit versus tradable instruments, how do you anticipate it or how is it already changing how a bankruptcy process might look?

30:30Sure. 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 were struggling pre-bankruptcy and then they continue 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.

31:06Well, 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?

31:40A 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 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 as 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.

32:13It should be liquidated. It 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 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?

32:43And 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.

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34:18pages of market research into five insights with a click? Do that with Acrobat. Need templates for a sales proposal that'll close that deal? Do that with Acrobat. Need an AI specialist to tailor the tone of your market report to sound real smart in real time? Do that with the all-new Adobe Acrobat Studio. Learn more at adobe.com slash do that with Acrobat. 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 public market, maybe there's greater potential for working out your issues if you get into trouble.

35:09So 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 course is cut. The one thing that's clear cuts that's important is we're losing the claims trading market.

35:48That'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 as to the question of, well, aren't these private credit lenders smarter, more versatile, more nimble, able to commit capital, and won't that be good for companies? In 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.

36:22You 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, let's pull the plug on these things earlier.

36:59So something that I've heard from lawyers working in this space is that when private credit lenders replace 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.

37:31So it's really hard to tell, but I'm certainly a bit skeptical. 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 salty over the collapse of Red Lobster, which you mentioned in your paper.

38:09So 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 liquidations after stalling for a very long time. Red Lobster is really interesting. Red Lobster have been struggling for a little while. and then 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, other lenders would have been a lot more cautious about doing that because 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.

39:04And 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 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.

39:41Jared, 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.

40:21Securitization, syndicated 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, 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.

40:59I 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 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.

41:41And 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 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.

42:18The 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, health of the company and whether it was already heading for insolvency for various reasons.

43:02Can you talk a little bit more about this idea, this notion that you just talked about, which is that the incentives from the private credit fund standpoint to extend and pretend. I could imagine, for example, that a private credit fund, just for reputational purposes, would not want a high profile or any profile bankruptcy among their investments to the point where 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.

43:41And 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 your first point, you absolutely worry in the world of 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.

44:15Another recent example, Sears, which filed for bankruptcy maybe eight years ago or something like that. Sears limped 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 shopped at Sears recently, but I remember coming 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 shorted 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.

44:56And 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. There are all these ways in which it's bad. And so, like you said, the worry is that private credit companies are going, or private credit-backed firms, because their lenders will want to be more agreeable, they may wait longer to reorganize than they would have otherwise.

45:32Whether or not that's true, 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 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 then created private credit. He needed loans from investment funds in order for the world to be a more perfect place. Those people are right, too, some of the time. The question is, well, what does it look like when we're not all right?

46:03And 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 this 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?

46:38As a social scientist, that's always the question you want to know is if you hear about this one story, you hear about the Pluralsight example that I mentioned earlier, where you have a private credit backed company where the lenders are doing liability management stuff. You have these aggressive debt market transactions. So 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.

47:14And 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. 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.

47:56But 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? What 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.

48:29They 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'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?

49:18Are 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.

50:00Private credit funds, if they really are a private investment fund, that's sort of a very different model. That is pooled capital from a bank 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, right? Every investment fund manager is going to say, no, no, we're subject to all this regulation.

50:38Sure, 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 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.

51:26That'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 difference is 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.

51:59It's you get all the upside, you bear none of the downsides. 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, 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 All Thoughts' unofficial tagline, which is incentives matter. So we kind of came full circle on that conversation.

52:36That 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. Thank you very much.

53:02Joe, 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. Yeah, for sure. Right. You know, regulatory capital rules were 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.

53:44Right. 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 investor's 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.

54:29Totally. 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.

55:17So 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 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.

56:03But 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, wow, you could really get serious 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, OK, 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.

56:48That 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 empty Sears of the world now just have a really like depressing retail experience. 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 Wiesenthal. 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.

57:25Follow our producers, Carmen Rodriguez at Carmen Armin, Dashiell Bennett at Dashbot, and Kale Brooks at Kale Brooks. And thank you to our producer, Moses Andam. 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.gg slash outlaws. And if you enjoy Outlaws, if you like it, when we dive deep into the implications of the rise of private credit, then please leave us a positive review on your favorite podcast platform. And remember, if you're a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free.

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