Since the global financial crisis of 2007-2008, the corporate finance markets have been dramatically transformed. Most notable has been the rise of non-traditional providers of debt finance such as private credit funds, which now aggressively compete with traditional finance providers like commercial banks. In a new paper, I argue that this and other debt-related developments have significantly affected the dynamics among directors, debtholders, shareholders, and other corporate constituencies, changed the relationship between debt and equity, and given debtholders more ways and incentives to influence a company and its governance.

One of the major shifts in corporate finance is the significant rise of private capital financing (e.g., private credit, private equity, venture capital). Private credit is the fastest growing asset class among all alternative investments. It is not really new, having existed even before the financial crisis. Yet, the rise of the power, experience, and investment appetite of private credit funds has fueled a striking revival, with such funds comprising a market currently estimated at $2.1 trillion[1] and projected to grow to $2.3 trillion by 2027.[2] The gradual and continuous migration from public to private markets has also been driven by banking regulation in the aftermath of the financial crisis (e.g., The Dodd-Frank Act 2010, The Basel Framework). Low interest rates over the past two decades have also played an important role in the growth of private capital.

The evolving dynamics among traditional and non-traditional finance providers is another major development. There has been increased competition between traditional finance providers and shadow bankers (e.g., private credit funds), where the latter are not subject to the same type of regulation and scrutiny as banks are.[3] Such competition increased during 2023 and, especially, after the 2023 banking crisis, given the downtick in the syndicated loan markets, opening the way for private credit funds to increase their share in the market. Banks have also started to partner with private credit funds to provide corporate financing. More generally, ongoing liquidity issues have also affected how private equity and private credit funds but also banks work together to inject capital where needed.

Finally, the continuing macroeconomic environment highlights the significance of debt capital as a lifeblood of business and, importantly, its inter-relationship with equity capital in general, but, especially, in private companies. All of these developments are also important for corporate governance, as a firm’s capital structure influences its governance framework.

In my paper, I propose a modern conceptualization of debt governance by developing a taxonomy of modern debt governance mechanisms, comparing the influence of banks and private credit funds when investing debt capital in a firm. I rely on the term “debt governance” to denote (i) the influence of debtholders on the firm when it is not in financial distress (e.g., cost of finance, directors’ incentives, the firm’s flexibility to operate, etc.) (“the domain of debt influence”), (ii) how debtholders through their decisions influence the firm (“the mechanisms of debt influence”), and (iii) the impact that these debt governance actions have beyond the firm (e.g., general availability and cost of funding, society) (“the boundaries of debt influence”).

When comparing banks with private credit funds, the taxonomy relies on different features that are important for debt governance. They include incentives to engage with the borrower, scope and opportunity for engaging in relational finance, debt investor return, risk exposure, pricing, firm’s flexibility to operate and transaction costs, board representation, control rights, number of lenders, valuation of the firm by the secondary debt markets, and others. The taxonomy reveals both similarities and differences in how banks and private credit funds engage with their borrower-firms.

Overall, debt has come to play an important role in the firm not only during but also outside of periods of financial distress, and the mechanisms of debt governance are evolving. As their power, investment appetite, and objectives have changed, modern debt investors have become more interested in non-default governance (governance when the firm is not in financial distress) to, for instance, generate high return on their debt investment and achieve the investment strategy (for private credit funds), or to be able to successfully market debt to the secondary loan market (for banks). Modern debt investors also bargain for equity-like returns and occasionally for a substantial equity upside. Despite their investment being more similar to equity than it used to be, debt investors are still repaid ahead of equity. Compared with banks, there is more scope for relational finance by private credit funds, as they typically make a long-term illiquid investment; they also negotiate for more bespoke control rights (e.g., financial maintenance covenants rather than the incurrence-based covenants that have been prevalent in bank lending over recent years (the covenant-lite trend)). Private credit funds also seek board representation, which, on the one hand, helps them to achieve their investment strategy, and, on the other hand, gives them a dynamic) view of the firm’s valuations and insights on how to influence the firm. For banks, which are dominating in the practice of originating loans and then distributing them to the secondary market, it is in the original debt investor’s interest to monitor the firm and invest in the relationship with the firm. Otherwise, they might not be able to market this debt to the secondary market or, alternatively, be able to market it but only at a substantial discount to its original price, meaning that they will incur losses.

With the evolution of corporate finance and in a world of more sophisticated debtholders, outside financial distress, equity and debt have become even more intertwined. Moreover, the lines between equity and debt have become more blurred over the years, especially in the private capital domain. The changes in the corporate finance markets are key in the discourse of the interplay between corporate finance and corporate governance, and, more specifically, how corporate finance influences corporate control.

ENDNOTES

[1] The International Monetary Fund, ‘The Rise and Risks of Private Credit’ (2024) Ch 2 of the April 2024 Global Financial Stability Report.

[2] Preqin, ‘Preqin Global Report 2023: Private Debt’ (2023).

[3] The Council of the European Union adopted new rules for private debt funds (AIFMD II). These new rules introduce leverage limits of 175% for open-ended and 300% for closed-ended funds.

This post comes to us from Narine Lalafaryan, assistant professor of corporate law at the University of Cambridge, Faculty of Law and a fellow at the Cambridge Endowment for Research in Finance. It is based on her new paper, “Private Credit: A Renaissance in Corporate Finance,” forthcoming in the Journal of Corporate Law Studies and available here.