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