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

[Music] Bloomberg audio Studios podcasts radio [Music] news hello and welcome to another episode of the OD Lots podcast I'm Tracy Alaway and I'm Joe weisenthal 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 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 spack 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 uh 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 I 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 uh 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 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 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 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 a lot about uh

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 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 the credit Market goes private like this yeah and this is the thing find really Interesting because there's so much hand ringing 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 odd Lots newsletter which you should all subscribe to and we're going to be diving into it in some more detail now so we are speaking to Jared Elias he is the Scott C Collins professor of law at Harvard Law School and his co-author

Elizabeth defon 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 thoughts 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

um and that shows up in innovation in bankruptcy and something that I kept hearing from AR participants was increasingly important Was Private credit private credit private credit and that made me want to learn about it and what you do when you're the member of a faculty and you want to learn about something is you try to find 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 Banes 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 Equity 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 longtime 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 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 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 is evolving in stages and so the the sort of original granddaddy of them allall was kind of the classic bank loan uh where you have a really tight intense Relationship between a company and its relationship bank and 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 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 in 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 uh 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 uh from 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 you know 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 file that funds your entire 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 uh 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 we shouldn't understate just what a radical change this is in debt so the way that we teach Corporate Finance in 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 the bank loads could be much bigger the risk is dispersed over many people um everybody wins right and all of a sudden retreated from that Vision to a totally different Vision um where they spread risk over people by making them investors in a fund um 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 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 [Music] do you spell out this evolution of the debt market 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 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 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 uh 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 shortterm liability which is customer deposits and very long-term assets so some of these loans of course Are 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 that 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 typee of loan we'll talk about some of the issues With that and and open ended funds and so on and I think the last part of the story is one that 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 with people in the process of working on this paper One of the things you hear over and over is that 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 account were ready to give it to you 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 um to have a covenant default excused you 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 you help and the private credit lender 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

um when times are bad and then When times get really bad and need to look at some sort of restructuring um the private credit lender is there to be helpful um 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 fon 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 their own selfish motivations for saying this so we should be 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 at the used car dealership you don't want that right you want the Apple Store and There really is something to this idea 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 cuz 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 both kind of hoping that we could 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 um 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 De or creditor law like the story of debt or creditor law today to a very large Extent is really smart people looking for problems and documents so they can take advantage of other investors in the de like that is very much the story at the moment and it's very strange that wasn't the story 10 years a 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 that would if you

were to say that it would really go too far I think it's a story of pred for 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 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 detriment of other fund investors and so all of a sudden many of those tricks allegedly go away now um the caveat to this is recently we did see a company do some sort of um you know Hardball um debt maneuver which we weren't expecting to see but we saw um and some of the Reporting around it suggested that were'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 what goes on 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 the consent 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 debt

it sounds pretty good to me uh okay so there's less legal fees less uh creditor unred or 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 benefit these are these are very risky Investments I 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 uh 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 was 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 uh 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 factious by the way he he says he doesn't troll but he trolls all time I'm saying all the 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 ddis you see the distribution of its bonds maturing M 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 uh and That 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 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 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 that to think about is the broadly syndicated debt world and the high yield world of debt um 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 the problem s 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 these de 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 going on Congress our debt is trading down you know to zero like please we need special

treatment investors looking for a deal can say hm the debt of this company is 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 you know 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 if there are policy buttons to push in the way the system is run which 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 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 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 the one that worries us more is sort of the opposite where you you have a lot of privately owned compan So either they're 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 had 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 uh private credit versus uh Tradable instruments how do you anticipate it or how is it already uh changing what a 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 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 right 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 if 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 in is a bankruptcy system that reallocates assets efficiently and the worry is that you know 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 where we' 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 or the debt 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 it should be liquidated it should be organized whatever it is um the judge says okay like you probably know you're 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 um 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 has 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 [Music] to 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 um 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 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 clearcuts 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 D when that deor 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 um because private credit lenders have their own incentives and maybe their incentives are to say look you know we we make Loans to sponsor back companies and if the sponsor wants to continue we're going to keep doing at 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 a company and to own the asset um than that bank might have been but the world could look very different for larger companies

where private credit lenders might be easier um for companies to do workouts with so it's really hard to tell um but I'm certainly a bit skeptical of the idea that all 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 mention in your paper so could you talk a little bit about that one and what it tells us about private credit sure so um 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 um Red Lobster is really interesting Red Lobster been struggling For a little while um and then

it it Fortress Investment Group which was its private credit lender came in and took over the company and basically just owns 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 um 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 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 lenders is just like the banker and you know it's 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 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 bank bcy 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 laws 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 very worthy over Time of adapting to lots of changes in credit markets securization syndicated Lending claims trading like you should of name it 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 um 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 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 you could it could be the case that we have a lot fewer bankruptcies more adequate 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

and you could in fact have a wave of zombie companies by the time that they enter into bankruptcy and 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 in the 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 uh 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 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

call back to GM which I had you know so long ago i' had 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 uh 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 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 uh 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 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 right um another recent example um Sears which filed for bankruptcy maybe eight years ago or

something like that 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 shoed at Sears recently but like I remember 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 so that was always his strategy I hope you shorted them when you heard that so but if if you went to a Sears like in the leadup 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 um 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 they 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 companies are going or private

credit backed firms um because their lenders will want to be more agreeable they may wait longer to reorganized 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 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 when God stopped on the seventh day after creating the world

he then created private credit because 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 and 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 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 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 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 um 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 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 went 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 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 site in the paper is $1.5 trillion dollar 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 uh but again could be significantly bigger than that yeah and 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 they run this similar process for these broadly syndicated loans and like all of that 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 that 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 wants 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 you think of sort of a bank that is uh 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 you know 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 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 uh 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 fund raise 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 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 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 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 aot's unofficial Tagline which is incentives matter so we kind of came full circle on that conversation that was a fantastic overview of yeah 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 very much [Music] Joe I thought that conversation was fascinating and I know we've said this On it on a number of episodes by now but to some extent the rise of private credit is what Regulators wanted 2008 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 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 like 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 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 uh 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 uh 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 uh loans are not in the hands of you know entities that also have people's uh uh safe deposits that being said you Know one of the things that I the argument you know there's obviously the lack of information and the lack of clarity and that's interesting from multiples perspectives but also this idea of like well the sort of zombie company

phenomenon which is that if you sort of declare bankruptcy in the at the right time there's still some sort of potentially turnaround 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 degradation of the quality of assets that come into bankruptcy yeah

and I thought the Sear's example was both harsh and Powerful 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 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 seies of the world now just have a really like depressing retail experience totally all right shall we leave it there let's leave it there this has been another episode of the ath thoughts podcast I'm Tracy Alay you can follow me at Tracy Alaway and I'm Jill wisenthal you can follow me at the stwart 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

Carman arm- Bennett at dashbot and K Brooks at K Brooks and thank you to our producer Moses andam for more oddlot content go to bloomberg.com odlot 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 g/ lots and if you enjoy OD Lots 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

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