CLS Blue Sky Blog

How Private Credit Funds Are Making Debt Look a Lot Like Equity

Over recent decades, and especially since the 2007-2008 global financial crisis (GFC), the corporate finance markets have changed considerably. First, there is more corporate debt now than ever. The 2023 banking crisis, and the ongoing macroeconomic conditions, further highlight the significance of debt capital as a lifeblood of business.

Second, fuelled by post-GFC banking regulation (e.g., The Dodd-Frank Act 2010, Basel III), competition between banks and private credit funds has increased, with the latter not being regulated in the same way as banks. The power, appetite, and experience of private credit funds have all skyrocketed. Those funds include firms like Ares, Apollo, Blackstone, and Oaktree Capital, and they provide financing directly to companies through lending, asset-based finance, mezzanine financing, and distressed and opportunistic debt.

Third, debt currently offers very attractive nominal returns because of higher interest rates. Originally viewed as a Wall Street competitor, private credit has gradually conquered the UK and the rest of Europe as well. The attractive returns on debt (12 percent, senior secured, or 20 percent for opportunistic and distressed debt), due to higher interest rates, have also helped the industry grow rapidly in Asia-Pacific and the Middle East. 2023 has recorded the two biggest private credit deals to date: $4.8 billion financing for Finastra and €4.5 billion financing for Adevinta ASA. The private credit market has reached $1.6 trillion and is estimated to reach $2.3 trillion by 2027, according to the data provider Preqin.

From offering multi-billion-dollar unitranche club financing to providing net-asset-value (NAV) loans and payment-in-kind (PIK) loans, the more experienced private credit funds have arguably led to what I describe as a quantum leap in corporate finance. What is more, they have started providing finance to multinational public companies, such as Wolfspeed Inc., AT&T, and Air France.

In light of this quantum leap, in a new paper I examine the evolution of corporate finance markets after the GFC with respect to private debt. I argue that the role of debt and its relationship with equity in the firm, due to recent significant developments in the corporate finance markets after the GFC, has been transformed. To the best of my knowledge, this is the first legally focused academic paper to look at private credit funds and compare their business model with that of banks from a corporate governance perspective.

In my paper, I show that modern debt providers participate in capital growth and work toward maximizing a firm’s profits. I also show that there is not always a conflict between the interests of equity and the providers of debt and that corporate loan financing agreements are often expected to be renegotiated (repriced). Based on developments in the corporate finance markets, I argue that, aside from during periods of financial distress, debt and equity can rarely exist apart. The reliance of private credit funds on private (contractual) bargaining can also improve economic efficiency.

In my paper, I build on the developments in corporate finance markets and develop a taxonomy of modern debt governance mechanisms. The taxonomy reveals several similarities, but from a corporate governance point of view, also stark differences between the role of banks and private credit funds when lending to and engaging with corporate borrowers:

  1. By seeking board representation on a borrower’s board and getting full access to its management, private credit funds equip themselves with a dynamic view of the firm’s valuation, which helps private credit funds achieve their investment strategy. It also shows how the funds play a corporate governance role in contrast to traditional bank financing.
  2. Private credit funds lend to companies with long-term horizons (five-seven years) and are skilled at operating in an illiquid market, while typically also charging an illiquidity premium. Working with companies long term and without the involvement of multiple lenders typically lays a foundation for trust and cooperation between the firm and its debt investors. Relational finance is back!
  3. By bargaining for a minimum return (akin to quasi-equity) on their debt investment and a carry, debt investors are interested in value-maximization. They also bargain for an equity upside and are often lead investors in the deal. Unlike traditional lenders that are interested merely in maintaining the value of a firm, private credit investors are interested in capital growth and profit-maximization so they can not only be paid the debt and interest but also earn a return on their debt investment. These new debt investors are interested in ‘non-default governance’ issues (i.e., governance outside their borrowers’ financial distress) because their investment is like equity.
  4. Private credit funds provide financing based on a floating-price mechanism (floating interest re-priced every 30-90 days), in addition to bargaining for stricter covenants (including financial maintenance covenants) than bank lenders do. Pricing and re-pricing debt so frequently strengthens debtholders’ control of a firm, enabling them to (i) continuously influence and engage with the firm before any financial distress occurs, (ii) have a dynamic view of the firm’s valuation, which often corresponds to the interest rates, and (iii) consequently, develop an evergreen financing structure.
  5. Re-pricing debt has further implications for understanding debt financing and, in particular, loan financing: Loan agreements are expected to be breached, then repriced.

Because of the quantum leap in corporate finance, modern debt shares significant characteristics with equity. This prompts a need to re-evaluate the role of debt in the firm and what it means for traditional legal and economic frameworks. Rather than “debt” or “equity,” maybe it should be called just capital.

This post comes to us from Narine Lalafaryan, an assistant professor of corporate law in the Faculty of Law at the University of Cambridge. It is based on her recent paper, “Private Credit: The Evolution of Corporate Finance and The Firm,” available here. A version of this post appeared on the Oxford Business Law Blog and the ECGI Blog.

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