Private credit: a renaissance in corporate finance

ABSTRACT

The thesis of this paper is 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 global financial crisis of 2007-2008, has been transformed. The relatively new, but already very experienced private credit funds, are competing with banks in a dynamic market which is full of unforeseen and large-scale risks. The paper examines private credit funds and compares their business model to bank financing from a corporate governance perspective. The paper shows that modern debt providers (i) are interested in the firm's profit maximisation, (ii) are dynamically involved in the governance of the firm also outside financial distress, and that (iii) corporate loan financing agreements are often expected to be renegotiated (repriced). The paper argues that outside financial distress, debt and equity have become even more overlapping and intertwined than they used to be.

KEYWORDS:

• Corporate finance
• private credit
• private capital
• debt governance
• equity and debt
• direct lending

1. A renaissance in corporate finance

Over the past 25 years the corporate finance landscape and, especially the corporate debt finance environment, has changed significantly.¹ The rise in innovative trends and techniques in corporate finance enhanced the essential role of debt in the firm.² Fuelled by the post-GFC banking regulation,³ there has been an increased competition among the traditional finance providers, such as banks, and the non-traditional finance providers,⁴ in particular, private credit funds.⁵ This competition has been one of the main factors shaping the global debt financing markets in the past years.⁶ More recently, the competition has become more intense, as sophisticated institutional investors (e.g. sovereign wealth funds) started to compete with banks and private credit funds by directly providing financing to companies.⁷

With the development of the primary and secondary markets for corporate loans, debtholders found innovative ways to minimise their risk exposure. Innovative legal tools to diversify risk, and to price it adequately and on a dynamic basis incentivise debtholders to think of alternative strategies and financing options for engaging with their borrowers. The growing interconnectedness of financial risks also influenced the development of debt markets and the incentives of debtholders.⁸ The changes driven by the urgent need for sustainable finance further enhanced the essential role of debt in the firm’s life cycle.⁹ Other factors, influencing and reshaping the role of debt in the firm, include the advancement of digital lending and FinTech lending,¹⁰ as well as the blurring lines between private and public capital markets.¹¹

Lately, inflation has caused a surge in the interest rates worldwide.¹² Higher interest rates result in a lower demand in risky leveraged loans, which might negatively affect firms’ refinancing chances.¹³ On top of that, the global corporate indebtedness reached unprecedented levels caused by the COVID-19-crisis.¹⁴ In this period, the debt of private non-financial sector reached its all-time high (approximately 170% of world GDP).¹⁵ In 2022/2023, the global corporate debt has reached its new record peak with $456 billions of net new corporate debt incurred.¹⁶ Finally, the 2023 collapse of several banks in the United States and Europe – providers of $ billions of debt capital – is a strong reminder of debt’s prominent role in supporting economic activity and of its significant role in the firm.¹⁷

These developments in corporate finance are very important also for corporate governance: a firm’s capital structure influences its governance framework. Unlike equity, debt has not yet been in the spotlight of corporate governance. The notion of ‘debt governance’ is an emerging and evolving one. The earlier influential literature highlighted the role of debt in interactive corporate governance¹⁸ and stressed that debt is the ‘missing lever’¹⁹ of corporate governance. It also examined, to a certain extent, the increasing potential of debt to influence the firm’s performance.²⁰

Recently, there have also been several important contributions advocating for the significance of debt in corporate governance. Examples include investigating the role of debt stewardship in the context of ESG and The UK Stewardship Code,²¹ examining debt governance effects of material adverse change/effect clauses in corporate debt financing agreements,²² studying the role of negative debt covenants in credit agreements,²³ analysing the governance role of debt in the U.S.-based dual class ownership structures,²⁴ and proposing a theory of governance in the context of credit derivatives trading.²⁵

Yet, the role of debt in corporate governance²⁶ has predominantly been addressed in the context of debt covenants²⁷ and, in the majority of cases, with respect to the traditional bank financing.²⁸ The earlier scholarship has not addressed the increasing significance of private credit funds and of the modern debt governance mechanisms, including the debtholder control tools requested by the private credit market.

These developments have important implications for the firm, as they materially impact the dynamics between the different corporate constituencies (e.g. directors, debtholders, shareholders), giving debtholders more control mechanisms to influence the firm also outside financial distress: to cope with the dynamic nature of corporate debt markets, which are full of unforeseen and large-scale risks.²⁹

In these areas of corporate finance and corporate governance foundational legal questions require re-examination. The urgency of addressing these issues is reinforced by the important changes in corporate finance markets over the past twenty-five years, including the increasing popularity of the private capital industry, specifically of private credit (that has recently been outperforming even the high-yield bonds and the syndicated loan markets),³⁰ and by the need to better understand the dynamic role of debt in the firm and its modern-day relationship with equity.

In light of this, the focus of this paper is the evolution of the role of corporate debt finance outside financial distress: how debt investment has influenced and could influence the firm in this timeframe.³¹

The paper proposes a modern conceptualisation of debt governance (‘modern debt governance’). It does so by developing a taxonomy of modern debt governance, comparing the influence of banks and private credit funds when investing debt capital in a firm.³² The term ‘debt governance’ in this paper denotes (i) the influence of debtholders on the firm outside financial distress (e.g. cost of finance, directors’ incentives, decisions of the board, the firm’s flexibility to operate, relationship between debtholders and shareholders) (‘the domain of debt influence’), and (ii) how debtholders through their decisions influence the firm (‘the mechanisms of debt influence’), and (iii) the impact that such debt governance decisions have also beyond the firm (i.e. externalities) (e.g. the society, other market participants, general availability of funding) (‘the boundaries of debt influence’).³³

Due to market changes, debt finance has come to play an important role in the firm also outside financial distress: the mechanisms of debt governance are and will be evolving, and the impact of debt on the firm’s performance is of a dynamic nature. Both traditional, but also more modern mechanisms of debt governance are a result of a market driven approach that aims to address the evolving nature of debt finance.

Private credit funds invest on a long-term basis and operate in an illiquid market, charging an illiquidity premium for this. Such a long-term and typically illiquid investment that is usually carried out on a bilateral basis (i.e. between a single debt investor and a borrower) lays a foundation for more cooperation and trust building between the firm and its debt investors. Relational finance is back!

Floating price in private credit (i.e. floating interest re-priced every 30–90 days), as opposed to relying only on debt covenants, is a modern form of debtholders’ influence. It also drives the debtholders’ control of the firm, enabling them (i) to influence and engage with the firm on an ongoing basis and prior to its financial distress, (ii) to have a dynamic view of the firm’s valuation (which often corresponds to the interest rates), and (iii) consequently, to develop an evergreen financing structure. As interest rates go up (as has been the case lately), the servicing of debt becomes more difficult for the borrower-firms (i.e. cost of debt servicing is becoming high). This modern form of debt governance has significant implications on the incentives of the firm’s directors to take into account the interests of debtholders also outside financial distress.³⁴ In modern markets, debtholders are increasingly interested in ex-ante accurately pricing and ex-post dynamically repricing their investments, as opposed to focusing only on their ex-post credit ranking. In a bank-originated debt market, repricing is also driven by the liquidity in the secondary loan markets.

The strong reliance of private credit funds on contractual creditor protection through bespoke debt covenants, in particular, financial maintenance covenants, as opposed to incurrence-based covenants, that have been predominant in bank lending (covenant-lite trend), provides private credit funds with more scope for control and intervention. Such a control is, moreover, of a long-lasting and relational nature.

By seeking board representation and getting access to the borrower-firm’s management team, private credit funds have a dynamic view on the firm’s valuation and influence the firm. Board representation also helps private credit funds to achieve their investment strategy. This management aspect speaks directly to the corporate governance role of debt.

They also bargain for an equity upside and are often lead investors in the deal. These debt investors are interested in ‘non-default governance’ issues (i.e. governance outside financial distress) because their investment is like equity. More recently, debt investment also generates higher returns than equity, because of the rise in the interest rates. While this type of investment is akin to equity, debt investors are still repaid ahead of equity.

The modern debt governance approach of repricing debt has further implications on the understanding of the nature of loan financing. It challenges the traditional position that loan financing deals are not expected to be renegotiated: they are expected to be continued and not ended. Yet, sometimes, they are expected to be ex-post repriced due to the dynamic nature of debt finance.

The contractual return provisions in the private credit market, entitling debt providers to a minimum return (akin to quasi-equity) and carried interest on their debt investment, directly challenge the traditional conception of debt in corporate finance and corporate governance.³⁵ The conventional approach is that debt providers are interested in value-maintaining activities of the firm, whereas shareholders are interested in value-maximisation. Private creditors invest for a long-term. These investors are interested in the firm’s success and its capital growth in order to be paid back not only the main debt sum, the interest rate, but also a return on their debt investment and participate in profit sharing on the fund level.

Private credit funds, as they continue to compete with banks, are likely to play a key role in the evolving nature of corporate finance – reshaping and revolutionising private debt markets, by filling in the gaps in financing needs and helping to stabilise financial markets.

In the modern market environment of sophisticated debtholders, outside financial distress, equity and debt have become even more intertwined than they used to be. This paper does not claim that debt governance is always in the interests of equity. Instead, it argues that the significant changes to debt markets affect modern-day debt capital’s relationship with equity, making the two more interconnected and overlapping, even more so in private firms.³⁶ Modern-day debt investors are interested in the success of their investments also outside the firm’s financial distress, for instance, to generate high return on their debt investment and to achieve the investment strategy (for private credit funds), or to be able to successfully market debt to the secondary loan market (for banks).³⁷ Effective debt governance not only within, but also outside financial distress further minimises ‘the firm’s total competence and conflict costs’.³⁸

This paper also aims to show that often debtholders through these modern debt governance mechanisms of private ordering (contractual bargaining) achieve and could achieve a degree of control also outside financial distress. By addressing this, the paper aims to show how the reliance of private credit funds on private bargaining can also improve the economic efficiency (i.e. the link between contractual bargaining (private law) and economic efficiency.)³⁹

The remainder of this paper is organised as follows: Section 2 studies the important changes in corporate finance markets with respect to private debt. It further presents a taxonomy of the key features of private debt (loan) financing deals, comparing banks with private credit funds (Table 1). Section 3 considers the implications of the market changes, discussed in Section 2, from a debt governance perspective. It develops a taxonomy of modern debt governance mechanisms, analysing and contrasting bank financing and private credit financing (Table 2). Section 4 then examines the connection between ‘equity’ and ‘debt’ in the firm in the world of sophisticated debtholders. It examines the general benefits of the interlinked equity-debt governance system outside financial distress, and also the advantages of symbiotic equity-debt governance for the firms with private credit financing. Section 5 concludes.

Table 1. Taxonomy of private debt (loan) financing based on the type of the debtholder.

Taxonomy of loan financing based on the type of the debtholder Part I
Important features of a loan financing deal	Deal execution	Uncertainty about market volatility (between terms sheet and closing)	Typical business model	Risk exposure	Market type
Bank lending (including syndicated)	Slow underwriting, long due diligence	High: price might be subject to change by the time of underwriting (state of market)	‘originate- to-distribute’ (short-term)	Low	Liquid secondary loan market*
					*Although in the recent economic turmoil the availability of liquidity has been tested.
Private credit (direct lending)	Speedy underwriting, short due diligence	Low: no uncertainty about market volatility, price predictable	Typically ‘originate-to-suit and fit’ (self-originating) (long-term)	High	Illiquid market*.
			Sometimes also buying loans from banks.		*illiquidity premium charged by the debt investor

Taxonomy of loan financing based on the type of the debtholder Part II
Important features of a loan financing deal	Numbers of lenders	Type of relationship	Credit rating	Transparency/confidentiality	Investor return
Bank lending (including syndicated)	Bilateral loan: one lender but subject to change (transfer).	Typically non-relational finance (but with smaller and micro-firms relational finance might still exist).	Credit rating required. Predominantly investment grade borrowers	More transparency about deal, less confidential (e.g. involvement of credit rating agencies)	Typically fixed interest rate
	Syndicated loan: a group of several lenders typically larger than a club deal	Borrower might not know well and/or trust the holder of its debt, especially post-transfer of its debt
Private credit (direct lending)	Typically a bilateral loan: one lender stays till maturity.	Relational finance:	Unrated/credit rating not required.	Less transparency, highly confidential	Inherently floating interest rate (re-priced 30–90 days).
	Club deals, including unitranche, for larger deals: several lenders, not as many as in a syndicated loan (less information asymmetry)	- stability;	Leveraged market predominantly, but recently also investment grade borrowers
		- safety;
		- borrower knows and trusts who owns their debt. But potential hold-up problem			Higher return, risk-adjusted return, return typically 10-12%, could be as high as 20%

Taxonomy of loan financing based on the type of the debtholder Part III
Important features of a loan financing deal	Borrower base	Contractual creditor protection (in particular, covenants)	Proprietary creditor protection (rights in rem)	Regulation	Funding model
Bank lending (including syndicated)	For bilateral lending: 200 mln and below	Cov-lite*.	Depends on the type of the borrower-firm, but not always asset-backed financing	Highly regulated (e.g. Basel III – capital adequacy rules)	Reliance on deposits – demand for liquidity
	For syndicated lending: 200mln – 5bln of EBITDA	*might be subject to change due to 2023 banking crisis
	Bigger companies, investment grade firms
Private credit (direct lending)	20mln – 5bln of EBITDA, recently also larger	Tighter covenants:	Predominantly asset-based credit (tangible collateral)	Subject to a certain regulatory framework as asset managers, but not subject to banking regulation	Capital model raised – long term funding
	Typically middle market firms	- financial maintenance covenants
	Recently also large unitranche or privately placed financing	- stronger protection - higher call premiums

Taxonomy of loan financing based on the type of the debtholder Part IV
Important features of a loan financing deal	Information speed on the borrower	Cost of capital	Board representation	Business environment and risks	Mismatch between assets and liabilities of debt provider
Bank lending (including syndicated)	Typically quarterly	Lower than private credit	No ex-ante board representation (outside financial distress)*. *Lender might negotiate/gain board representation ex-post during severe financial distress	Macro-environment	High
Private credit (direct lending)	Within weeks	More expensive than bank financing	Actively seeking ex-ante board representation also outside financial distress. Active involvement during financing distress	Typically micro-environment connected to the specific borrower-firm	Low: debt capital is locked in

Taxonomy of loan financing based on the type of the debtholder Part V
Important features of a loan financing deal	Lender incentives	Transaction costs	Deal documentation	Dealing with incompleteness of information
Bank lending including (syndicated)	Incentivised as long as its helps with ‘originate-to-sell’	Typically: search costs, monitoring costs, drafting costs, renegotiation costs, debt transfer costs, costs arising from inability to transfer debt	Standard market documentation (LMA, LSTA) with some flexibility to amend	Fixed interest rate – valuation fixed (fixed-term income)
	Monitoring the borrower	Lower costs < than private credit due to higher standardisation of terms	Low transaction costs	There is a link between the credit rating of the firm and the interest rate it is charged.
Private credit (direct lending)	Highly incentivised private credit managers (return directly linked to performance; ‘originate-to-suit and fit’)	Typically: search costs, monitoring costs, information costs, drafting costs, investment costs (adding value, know how), enforcement costs, evergreen valuation costs, renegotiation/restructuring costs	Privately negotiated documentation (business-tailored and deal specific): structural flexibility, scope for creativity and innovation	Dynamic valuation (evergreen), valuation of assets often corresponding to the interest rate
	Not only monitoring the borrower, but also adding value through expertise	Higher costs > than bank lending	High transaction costs

Table 2. Taxonomy of Modern Debt Governance based on the type of the debtholder.

Taxonomy of Modern Debt Governance based on the type of the debtholder Part I
Important features of debt governance	Incentives (engagement with borrower)	Scope for relational finance	Effect of dynamic valuation	Debt investor return
Bank	‘originate-to-distribute’	Low unless this a micro and small firm	N/A	Fixed interest rate.
	Short-term influence on the borrower; liquid secondary loan market	- exit to distribute (cannot keep on balance sheet) [exit connected to market efficiency?]		Interested in the borrower-firm’s value maintenance
	Interest in maintaining borrower’s value to be able to market the product to the secondary loan market	- borrower might not know/trust the subsequent owner of its debt
Private credit (direct lending)	‘originate to suit and fit’	High	High – dynamic valuation of the borrower	Inherently floating interest rate (re-priced every 30–90 days). Minimum return on investment:
	Long-term influence on the borrower; illiquid market	- no exit (locked in)		-8-12% (in the past months)
	Interest in adding value, maximising borrower’s value	- relational finance		-as high as 20% in better economic conditions
		- borrower knows and trusts the owner of its debt		Directly participating in capital growth, actively interested in the borrower-firm’s success and wealth maximisation.

Taxonomy of Modern Debt Governance based on the type of the debtholder Part II
Important features of debt governance	Board representation	Incentives to renegotiate/restructure	Risk exposure	Pricing
Bank	No	Low	Low	Mostly ex-ante
	Only during financial distress – when debtholders take control of the firm	- exit to distribute (cannot keep on balance sheet)	-liquidity*
		- but might have to renegotiate to be able to exit later	*recent developments in the markets show that it has become more difficult to market the product to the secondary loan market (i.e. risk exposure increased)
		- borrower might not know/trust the subsequent owner of its debt
Private credit (direct lending)	Yes.	High	High	Ex-ante and ex-post
	Also outside financial distress. Debtholders are seeking board representation from Day 1 (outside financial distress). Board observer rights (active or passive involvement, depending on the situation of the firm)	- no exit (locked in)	-illiquidity (locked in)	Continuously renegotiating (floating pricing)
		- relational finance
		-borrower knows and trusts the owner of this debt

Taxonomy of Modern Debt Governance based on the type of the debtholder Part III
Important features of debt governance	Control rights	Covenants	Parallel equity ownership	Cost of finance
Bank	Mostly ex-ante, and for a short-term for traded debt	Covenant-lite	No	Low
	contractual control rights (covenants, mostly covenant-lite in the past years)	Covenant-loose	- Only when the borrower defaults and the financing agreement contains conversion rights (debt converts into shares or if debt/equity swap as a result of restructuring)
			- Typically conflict of interest between equity and debt investors
Private credit (direct lending)	Strong and dynamic control (re-pricing every 30–90 days)	Covenants generally	Yes	High
	- contractual control rights (strong covenant protection)	financial covenants, including financial maintenance covenants	- private credit capital providers often also provide the equity capital (private equity and private credit)	Higher % rate than in bank financing
	-proprietary control rights (asset-backed finance is increasingly predominant in direct lending)	agreeing to operate within restrictions or not is governance	-no conflict of interest between equity and debt investors if both equity and debt are provided by the same provider	Illiquidity premium
	-board representation			Higher pressure on the borrower to service debt than in bank financing

Taxonomy of Modern Debt Governance based on the type of the debtholder Part IV
Important features of debt governance	Effect on directors’ incentives	Advantages/costs of debt governance on the firm	Positive/negative externalities
Bank	shareholders – value maximisation vs debtholders – value maintenance	Advantages:	Positive:
	Directors have to deal with this	- signalling to the market that the firm obtained bank financing (went through costly underwriting, due diligence, etc.).	- liquidity, many firms get financing
	Directors have to deal with this	-skilled debt finance provider	Negative:
		Costs:	- if not successfully traded to the secondary market, this blocks the other firms in need of finance
	Agency costs > than in private credit	N/A, or in certain cases a hold-up problem	-macro-risks to the economy
Private credit (direct lending)	Outside financial distress reduced agency costs: shareholders and debtholders interested in value maximisation (aligned interests, profit maximisation).	Advantages:	Positive:
	Directors have a united front from the firm’s capital (equity and debt) providers. Directors invested in debt origination and keeping it until its maturity or repayment (also charging an illiquidity premium for this), and also in better debtholder protection. Often as shareholders and debtholders are the same no costs arising from profit-sharing issues	-flexibility	-small and medium-sized companies getting access to financing (middle-market companies)
	Reduced or no agency costs	-certainty	-debtholders adding value to the firm through their skill and knowledge
		-trust	Negative:
		-adding value and expertise to help the firm grow	-lack of transparency on the quality of borrower-firms (traditionally used to be unrated firms) and financing conditions
		-no conflict or minimised conflict between shareholders and creditors outside financial distress	-locked in a relationship
		-borrowers knows who owns its debt
		Costs:
		-higher cost of capital than bank financing
		-locked in relationship (scope for a hold-up problem)

Taxonomy of Modern Debt Governance based on the type of the debtholder Part V
Important features for debt governance	Number of lenders	Firm’s flexibility to operate and transaction costs	Effect of competition in private debt lending market	Valuation of the firm by the secondary debt markets
Bank	1 lender in a bi-lateral loan. Many lenders in syndicated financing, collective action problem:	Less flexibility as the agreement is based on a standard documentation (LMA, LSTA), also debt is transferred. Low transaction costs	Increases bank’s monitoring of debt to be able to sell it	Typically yes. Originate-to-distribute
	-coordination costs.
	-information asymmetry.
	-conflict costs
Private credit (direct lending)	1 lender in a bi-lateral loan	Flexible as the financing terms are specifically tailored to the firm’s business and the project in question (business-tailored financing documentation)	Ongoing monitoring to be able to add value to the borrower-firm and to attract more clientele	Sometimes yes: when bought from banks
	Recently for bigger loan financing deals – club deals, unitranche – no conflict. Club deals – several lenders, not as many as in syndicated financing	High transaction costs		Predominantly self-originating debt

2. Modern private debt: how did we get here?

This section addresses the first theme of this paper: the evolution of corporate finance, in particular, of corporate debt finance. It examines the significant patterns of change in the corporate debt finance markets over the past twenty-five years with respect to private debt. In doing so, this section also investigates the key features of modern debt: dynamic, parallel, adaptable, and market driven.⁴⁰

The proceeding analysis establishes the framework on which Sections 3 and 4 rely on (i) to analyse and, where relevant, also to propose modern mechanisms of debt governance, and (ii) to investigate how debtholders influence or could influence the firm outside financial distress. Before doing this, sub-section ‘A’ offers an overview of the origins of the role of ‘debt’ in corporate governance.

A. ‘Debt’ in corporate governance

The term ‘debt governance’ has not often been used in the corporate governance literature, or in the general corporate law scholarship.⁴¹ In their seminal corporate governance paper, Shleifer and Vishny argued that large debtholders have incentives to improve the firm’s performance because similarly to large shareholders, ‘[…] they want to see the returns on their investments to materialize’.⁴² It was the influential works by Triantis and Daniels (1995), and Baird and Rasmussen (2006), followed by later studies by Tung (2009), Whitehead (2009), Choi and Triantis (2013), Yadav (2014) that revolutionised the role of debt in the firm and highlighted the role of debt in corporate governance, exploring its significance in the context of the firm.⁴³

This earlier scholarship made very important contributions in advocating that debt has been a ‘missing lever’⁴⁴ of corporate governance, as argued by Baird and Rasmussen, and that debtholders are in a position to monitor and detect managerial shirking, as advocated by Triantis and Daniels.⁴⁵ Choi and Triantis further demonstrated how the debtholders’ certain decisions via signal-exchange and collaboration on penalising management have beneficial effects for the firm and its other stakeholders.⁴⁶ Economists Nini, Smith, and Sufi showed that efficient debtholder control can promote equity-focused corporate governance or even replace it.⁴⁷

Later, Gullifer and Payne argued that one should also consider the governance power given to the debtholders when they waive a breach or default by the borrower-firm.⁴⁸ Gullifer and Penn examined the role of negative covenants in credit agreements and their potential role in aligning the interests of directors with that of the firm.⁴⁹ More recently, Gomtsian offered a framework for understanding how debt holders can contribute to stewardship outside distress, exploring the role of debtholders in promoting responsible business practices through the stewardship of borrowers.⁵⁰ In the context of U.S. uptier transactions, Schloessmann proposed to treat debtholder control over debt covenants similar to the control that controlling shareholders have over corporations by imposing a waivable fiduciary duty of loyalty on controlling debtholders.⁵¹

Nevertheless, the role of debt in the firm for a long time has traditionally been limited to when the firm becomes insolvent or is bordering insolvency.⁵² Besides, by virtue of the times when the studies were made, many of them predominantly examined the role of debt covenants and mostly with respect to the traditional bank financing model. The times were different, so were the nature, complexity, and sophistication level of debt markets and of their participants. The times have changed: the firm no longer has to be insolvent for its debtholders to have a significant impact on the firm, and their influence mechanisms do not have to be limited to debt covenants (as discussed in Sections 3 and 4).

B. Two markets for private debt

The important developments in corporate finance markets over the past twenty-five years, and especially post-GFC, resulted in two markets for private debt (i.e. markets where a firm can obtain private debt financing): the traditional bank market and the private credit market. How did we get here? As the proceeding discussion explains, in these two markets, there is a difference not only in the nature and identity of the providers of debt capital, but also in the incentives and the rights that they request to influence and control the firm.⁵³

The reason for such a divergence is that in a modern market (i.e. post-GFC) banks have been mostly operating within the funding model of ‘originate-to-distribute’⁵⁴ to the secondary liquid loan market. The term ‘originate-to-distribute’ means that debt is originated and later sold to the secondary loan market. This model is also known in the finance community as the ‘moving business’.

By contrast, private credit funds have largely focused on the funding model of ‘originate-to-suit-and-fit’ the portfolio of the market that they operate in. The term ‘originate-to-suit-and-fit’ means that debt is originated and kept until its maturity or repayment. This financing framework is also called the ‘storage business’.

The distinction between these two funding models can additionally be described as ‘trading the risk’ for banks vs ‘owning the risk’ for private credit funds. The following sub-sections ‘i’–‘iv’ explore these two funding models (including their interconnectedness), the business nature of private credit funds and their future in debt markets, and the obstacles facing the banks post-GFC, preventing them from using the same business operational strategy as the private credit funds.

i. How and why did this happen?

The corporate debt financing markets were slow developing markets with a strong relational finance element attached to them: banks relied on their relationship with firms to originate and manage their portfolios.⁵⁵ In the loan markets, the banks simply knew the firms that they were dealing with: there was less information asymmetry between the providers and receivers of debt finance. As a result, there was not an urgent need to look into loan covenant packages to address borrower-opportunism and to facilitate information sharing regime, and the contractual framework (including debtholder protection provisions) was less detailed. Similarly, for the bond markets, there were covenants included in bond agreements; those, however, were a lot thinner than the covenants requested by banks in loan financing agreements.

From 1970s, when the syndicated loan market started to gather speed, not only the debtholders, but also the corporate borrowers became more sophisticated.⁵⁶ Prior to the GFC and, especially, in its aftermath, there has been a further important change in the nature of debt finance and of its providers. The traditional bank-financed debt market has withered away. In this market, there has been a gradual shift from relationship finance to a state where relational finance has become much less common.

This change happened following the various economic scandals during the GFC⁵⁷ that involved several of the global financial players, such as the Lehman Brothers, the Royal Bank of Scotland and others, causing the financial regulators worldwide to introduce stricter rules for the banks.⁵⁸ Gorton and Metrick suggest that the rise of nonbank lenders was facilitated by ‘regulatory and legal changes that gave advantages to three main institutions: money-market mutual funds (MMMFs) to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (repos) that facilitated the use of securitized bonds as money’.⁵⁹ The shift from the traditional banking model into what is commonly known as market-based finance⁶⁰ could also be attributed to developments in financing engineering, as well as the globalisation of funding and capital markets.⁶¹

Driven by these changes, markets moved on. There is still the architecture for loans, but banks are often selling or are aiming to sell loans soon after the origination to the secondary loan market.⁶² Banks also no longer retain monopolistic position of financing large-scale leveraged buyouts.⁶³ These developments in debt markets created a raft of opportunities for private credit funds,⁶⁴ changing the historic perception of private credit ‘from dinosaur to dynamic funding model’.⁶⁵ Private credit funds have come to fill in the gaps in the market where the banks could no longer contribute. Characterised as the ‘money market funding of capital market lending’,⁶⁶ private credit funds are financial intermediaries ‘[…] conduct[ing] maturity, credit, and liquidity transformation without explicit access to central bank liquidity or public sector credit guarantees’.⁶⁷

During the course of the past fifteen years and, especially, since the start of the COVID-19-crisis, the private credit market has flourished.⁶⁸ The number of private credit funds has increased dramatically, so did their power and investment appetite.⁶⁹ The private credit market includes asset manager giants, such as Apollo, Ares, Blackstone, KKR, and Oaktree Capital. Over the period of 2003–2020, the market for corporate private debt has grown four times.⁷⁰ The private credit market, specifically, expanded from $250 billion in 2010, to $1.5 trillion as of 3rd quarter of 2023,⁷¹ making it a larger market than the venture capital market (which was estimated to grow to $251.54 billion in 2023).⁷² In comparison, in 2023, the high-yield bond market has reached $1.4 trillion, the leveraged loan market $1.4 trillion, the Eurozone bank loans $5.0 trillion, the US bank loans $5.4 trillion, and the market for investment-grade bonds $8.1 trillion.⁷³ As of March 2024, the private credit market is estimated to have reached $1.8 trillion.⁷⁴

ii. Private credit – a revived and nearly new phenomenon

Described as the ‘new force in finance’,⁷⁵ private credit is becoming one of the key sources of modern debt finance. As an asset class, it existed even before the GFC. Yet, private credit is a revived and a nearly new paradigm because of its significant growth over the past years. In the past fifteen years, private credit funds thrived and are no longer seen as finance providers to only short-term, small sum, non-investment grade firms, which used to be the traditional perception of private credit.⁷⁶ Private credit is active not only in the leveraged loan market and provides enough ‘liquidity to fund larger and larger transactions, but also the flexibility to provide an array of financing structures – including unitranche and floating-rate notes’.⁷⁷

Such an advancement in the private credit market is evidenced, for instance, by the provision of $4.8 billion financing for Finastra⁷⁸ and €4.5 billion financing for Adevinta ASA: the two largest private credit deals on record at the timing of writing this paper. This trend also attests to the willingness of the private credit funds to cooperate amongst each other to finance larger (club) deals.⁷⁹

Additionally, private credit has become even more relevant in helping banks to push their liquidity, especially given the 2023 banking turmoil. A notable example of this trend is Ares Management’s acquisition of $3.5 billion lender finance portfolio from Pacific Western Bank, where this portfolio consists of high quality, senior secured, asset-backed loans.⁸⁰ Private credit’s commitment to green finance has also become more substantial. For instance, Blackstone raised $7.1 billion (The Blackstone Green Private Credit Fund III) to finance clean-energy companies.⁸¹ Another interesting development with regards to the involvement of private credit – which has traditionally been seen as a finance source for private firms – is the provision of large amounts of private credit financing to multinational public firms. An example of this is chipmaker Wolfspeed Inc. raising $1.25 billion secured note financing from private credit providers, such as Apollo and others.⁸²

From the investors’ side, a 2023 survey by Goldman Sachs shows that institutional family offices are also interested in investing in private credit.⁸³

From offering multi-billion dollar unitranche club financing to the provision of net-asset-value (NAV) loans and payment-in-kind (PIK) loans, the more experienced private credit funds, such as Ares, Apollo, Blackstone, and Oaktree Capital, have arguably led to what I describe as a quantum leap in corporate finance.⁸⁴

This dramatic rise of private credit has been described as a ‘parallel to the “privatisation” of equity markets’.⁸⁵ The data provider Preqin projects a growth for private credit between 2021 and 2027 to reach an all-time high in 2027 by reaching $2.3 trillion.⁸⁶ By contrast, the projections for bank financing are less optimistic. For instance, according to the latest EY European Bank Lending Economic Forecast, growth in bank lending to businesses across the Eurozone area is estimated to slow down with growth of only 3% in 2023 and 0.9% in 2024.⁸⁷

The ongoing competition between banks and private credit funds directly impacts borrower-firms.⁸⁸ This competition especially increased as leveraged loans and other sources of traditional capital have dried up, and buyout firms started to seek finance from private credit funds.⁸⁹ An important question, however, is whether the boom behind credit is here to stay. In the context of European deals,⁹⁰ on the one hand, in contrast to 2020, during 2021 there was an 89% increase in deals by alternative (nonbank) lenders.⁹¹ By contrast, in Q3 2022, the number of European private debt deals fell by 15.7% in comparison to the same period in 2021.⁹² On the other hand, according to the data provider Preqin, in the second quarter of 2023 alone private credit funds raised $71.2 billion globally, which is more than twice the amount compared to the first quarter of 2023, with a fundraising increase in Europe ($33.8 billion raised in Europe out of $71.2 billion globally) and with direct lending being the most dominant private credit strategy.⁹³

Besides, the surge in the interest rates to combat inflation has its costs and benefits for the providers of private credit. This is because some firms will struggle accessing public markets for finance, helping private credit providers to gain further clientele. It has been suggested that such a development may be advantageous for private credit funds, as it gives them a stronger position to bargain for more protection and favourable conditions.⁹⁴ Rising interest rates, however, also entail problems for the borrower-firms that have already incurred a lot of private debt: they now will be facing debt repayments with a higher rate and will need to continue honouring their financial obligations.⁹⁵

Despite the ongoing macroeconomic conditions, there is strong demand for private credit, ‘[…] even as dealmaking wanes’.⁹⁶ This is because private credit provides attractive returns. It could also help with hedging against rising inflation and diversifying borrowing portfolio of the firms.⁹⁷ Moody’s 2023 study on private credit and associated risks highlights that ‘[…] when managed within a robust risk framework, [it] provides opportunity for growth and can improve the portfolio’s overall risk-adjusted return’.⁹⁸

As economic conditions globally deteriorate, the private credit model is in a good position to attract even more share of a market from commercial banks, as private credit funds are experienced in operating in an illiquid market: that is their business model.⁹⁹ Finally, as mentioned earlier, while the private credit market originated as a finance provider for small and medium-sized companies, in the past years (especially post-COVID-19), the private credit industry has provided multi-billion $ finance also to investment grade private companies, and recently also public companies – a substantial improvement in the landscape of corporate borrowers which rely on private credit. Given the current strains on bank financing, the question arises whether the corporate borrowers that are unable to obtain private credit are self-screening themselves.

iii. Private credit and its business model

The magnetic success behind private credit could be attributed to its different business model from that of banks. This paper developed a taxonomy of private debt financing (Table 1) below, which aims to demonstrate the important characteristics of loan financing deals based on the type of the debtholder: bank vs private credit.

As shown in Table 1, there are several important differences in the business models of the providers of private debt. In the originate-to-distribute (bank-dominated) market, debt is being traded, and the two most important questions for the original debt investor are (i) who is going to hold these rights at a later stage, and (ii) whether it will be in a position to predictably sell the loan in the near future (e.g. three months).

For private credit funds, on the other hand, the main interest is not to originate debt in order to later distribute it; they are predominantly interested in suiting-and-fitting the portfolio of the market that they operate in and often self-originate loans by keeping them until their maturity.¹⁰⁰ Institutional and retail investors in this market invest in loans and provide capital normally to small and medium-sized companies, where capital is essentially the provision of support to the firm by investing in it.¹⁰¹ In terms of public counterparts for private credit, it has been suggested that ‘[for] private direct lending market, its public counterparts are the syndicated bank loan market and the high yield market’.¹⁰²

Unlike commercial banks, private credit funds do not have traditional depositors whose funds are covered by insurance. Instead, they raise short-term funds in the money markets,¹⁰³ including from commercial banks, relying on this type of financing to purchase assets that have a longer-term maturity.¹⁰⁴ Also differently from banks, private credit funds typically provide high-risk loans which are not liquid.¹⁰⁵ The driver for them is a long-term relationship with their borrower-firms. This leads to flexibility between the relationship of debt providers and the borrower-firm and the returns that private credit funds negotiate to satisfy their investment model: risk-adjusted returns in addition to the traditional interest charged on debt. In other words, private credit aims to provide better absolute returns to its investors in a form of a regular income (return premium and performance premium).¹⁰⁶

Compared to banks, private credit funds provide firms with access to non-amortising, bullet structures and typically offer more flexibility.¹⁰⁷ They also offer (i) a faster way of obtaining finance due to the due diligence and underwriting process being shorter than the one conducted by banks, (ii) larger hold sizes for leveraged loans, and (iii) more creative solutions to finance the growth of the firm.¹⁰⁸ Yet, private credit funds request a higher cost of credit and are not in a position to provide clearing facilities and ancillaries.¹⁰⁹ During the past years, the protective debt covenant package in bank provided financing has typically been covenant-lite, as opposed to the covenant protection package included in the direct lending deals originated by the private credit funds.¹¹⁰ The latter bargain for a stronger protection (e.g. the inclusion of financial maintenance covenants).¹¹¹

In terms of the seniority of private credit in capital structure, according to Deloitte’s 2023 Spring Private Debt Deal Tracker, from Q4 of 2021 to Q4 of 2022, from 4,290 total European deals completed by 76 private debt lenders that participated in Deloitte’s survey,¹¹² 83% of the private credit deals were first lien structured¹¹³ (senior unitranche/stretched senior, super senior RCF,¹¹⁴ super senior TL¹¹⁵). Unitranche financing¹¹⁶ in this period has been the most common structure for private debt deals, with 57% of the UK deals and 48% of the European deals structured this way.¹¹⁷ In comparison, subordinate structures represent only 17%.¹¹⁸ In sum, in the private credit market the trade-off for the firm is a higher price and more control on its business decisions by the debtholders, but more scope for relational finance with the debtholder, and innovation, creativity, and growth for the borrower-firm.

Despite their increasing numbers and growing significance, there has been little scholarly research carried out specifically on private credit funds. Notable exceptions from economics and finance are mentioned below. Buchner et al., using proprietary deal data (for the period of 1982–2015) of private-debt funds from the Centre for Private Equity Research, among other things, find that private credit deals without venture capital and private equity sponsors generate premium, and that this sponsorless premium compensates debt investors for higher risk and costs of risks mitigation.¹¹⁹ Jang uses a proprietary dataset of credit agreements to study the US market of nonbank direct lending to private equity middle market buyouts.¹²⁰ Jang’s study shows that similarly to banks, direct lenders actively rely on covenants for monitoring the borrower-firm; by contrast to bank financing, direct lending is more expensive, because private credit funds bargain for higher interest rates and request tighter debt covenants; compared to bank financing they also provide finance more against cash flow to smaller firms, offer more flexibility in ex-post distress situations, and require more involvement from private equity (‘PE’) sponsors.¹²¹ A study by Block et al., surveys the US and European investors, primarily direct lending funds, with private debt assets under management of over $300 billion.¹²² Among other things, the authors find that the US and European funds share many similarities, but that the European private credit funds are less dependent on PE sponsors and are more in a competition with banks.¹²³ Earlier, Böni and Manigart¹²⁴ collected data on 448 private debt funds (1986–2018) and examined their net-of-fees internal rate of return (‘IRR’) (private debt fund performance), finding that on average the net-of-fees IRR was 9.19% and highlighting that private credit funds offer attractive returns to their investors.¹²⁵

iv. It is a trade-off story

The costs and benefits of the nonbank financing system have been a subject of great debate. The empirical evidence suggests that nonbank financing creates value by ‘[…] provid[ing] commercial banks with sources for increased loanable funds and assumes some of the risks associated with loan origination’.¹²⁶ Chernenko et al. – who analysed hand-collected credit agreements (filed with The US Securities and Exchange Commission) for a random sample of 750 publicly traded US-based middle-market firms that appear in Compustat financial dataset at least once for the time period between 2010–2015 – find that one-third of all loans are provided by nonbank financial intermediaries.¹²⁷ This is especially true when there is less competition between the banks and nonbanks, as the latter see this as an opportunity to charge a higher interest rate.¹²⁸ Chernenko et al., also show that ‘nonbanks improve access to capital for firms that are observably risky and that are unable to borrow from banks because of bank regulations’.¹²⁹ A study by Davydiuk et al., finds that borrower-firms’ access to direct lending, in particular, funding by business development companies, stimulated economic growth and innovation.¹³⁰

According to The UK Financial Conduct Authority, this non-traditional finance model ‘offers the prospect of significant welfare gains for society – if we monitor it carefully’.¹³¹ Similarly, a study by The World Bank highlights the benefits for firms of obtaining new finance from non-traditional sources, specifically, the advantages with respect to diversification of their financing sources and improvement of resilience to financial crises.¹³² At the same time, nonbank lenders are also an important source for obtaining syndicated financing for non-financial firms.¹³³ Ivashina and Valée show that ‘a larger non-bank funding for the loan, and a smaller skin in the game of the arranging bank, are […] associated with more complex contractual terms’.¹³⁴

On the other hand, the increasing shift from the bank-dominated model to private credit has raised concerns over the transparency of the firms that are being financed by private credit funds and of their debt. The EU adopted new rules on the amount of borrowed money that private debt funds can invest.¹³⁵

C. Interconnectedness of two markets

The flourishing of private credit creates more competition in debt financing markets; competition in itself is a positive phenomenon. Although, as the previous sub-section explained, there are two markets for firms to obtain private finance (i.e. from private credit funds and from banks), the private credit model is not entirely separate from the rest of the private debt market (i.e. bank-originated debt). Why? There is an economic link between these two markets because of various intercreditor issues which often arise as banks and private credit funds both borrow from and lend to each other and generally do business with each other, including, for instance, by participating in syndicated financing.¹³⁶ This sub-section highlights the interconnectedness of risks in these two markets.¹³⁷

On the one hand, since typically the private credit capital is ‘locked in’, it is less susceptible to fluctuations in the market and, therefore, less likely to cause a systemic crisis by itself.¹³⁸ On the other hand, as private credit funds also often borrow money from banks for their business and the availability of bank capital has been limited since especially the banking turmoil of 2023,¹³⁹ such a development may also affect private credit funds. Moreover, if the borrower-firms cannot repay due to rising interest rates, this may also negatively impact the private credit industry. This is not only a problem for those lending and doing business with the providers of private credit, but also for those firms which, as a result, may not be able to borrow from them.

These propositions are in line with the Bank of England’s (‘BoE’) Financial Stability Report, highlighting that ‘Any crystallisation of risks in [private credit] markets could spill over to the UK given the role of risker credit markets in financing UK businesses, and through UK financial institutions’ exposures to affected global counterparties, including foreign banks’.¹⁴⁰

On the other hand, the same BoE report also mentions that

Private credit exposures of UK banks are limited. The closed-ended nature of funds investing in private credit, their low leverage, and extended lifespan, may help to limit fire sale risks. The [US] Federal Reserve has therefore noted that risks to US financial stability from private credit funds appear low. Nonetheless, parts of the US market use riskier fund structures with greater leverage to boost returns compared to the UK.¹⁴¹

The web of interconnected risks in these two parallel markets for private debt may, nevertheless, present systemic risks for the global economy.¹⁴² This type of risk interconnection is in addition to more general correlation of financial risks as a result of the COVID-19-crisis.¹⁴³ While this paper does not aim to discuss the macroeconomic implications of these interconnected risks, it is important to flag that the debtholder controls rights in each market have been different over the past years (covenant-lite or more aggressive).¹⁴⁴ In covenant-lite packages, the control rights inserted vary in their nature from those in non-leveraged finance.¹⁴⁵

The empirical results also confirm that in modern debt markets there is an ever-growing interconnectedness between these different types¹⁴⁶ of debtholders and the capital that they provide.¹⁴⁷ At the same time, their incentives are different. For instance, compared to bank lenders, nonbank syndicate participants have a higher likelihood of exiting the syndicate than agreeing to renegotiate the syndicated deal.¹⁴⁸

The changes in debt markets, resulting in two competitive markets for private debt, have important consequences for the relationship of debtholders and their borrower-firms. Modern-day debtholders have more mechanisms, experience, and more diverse interests to control their investments on a continuous basis, including prior to the firm’s financial distress. The implications of these changes from the perspective of the corporate governance role of debt form the discussion of Section 3.

3. Modern debt governance – why should we care?

This section addresses the second theme of this paper: the implications of the changes in debt financing markets for modern debt governance. Table 2 presents a developed taxonomy of modern debt governance mechanisms, categorising them based on the type of the debtholder (banks vs private credit funds). The taxonomy also shows how changes in private debt finance markets have shaped modern debt governance.

This section also demonstrates that these debt governance mechanisms (i) reflect the parallel nature (i.e. banks vs private credit funds) of the market reality in which debtholders and firms operate in, (ii) are driven by the competition between the providers of debt capital, (iii) and are adaptable – directed by the need to keep pace with the dynamic nature of modern debt finance. This section further explains why debtholders are interested in the governance of the firm when the firm is solvent.

A. Mechanisms

This sub-section develops a modern taxonomy – shaped by the modern market practices – which provides a summary of the modern debt governance mechanisms forming the basis of the discussion in sub-sections B–G.

B. Relational finance is back

Due to the typically bilateral and illiquid nature of private credit financing, there is more scope in private credit for relational finance. ‘Relational finance concentrates specifically on the essence of the debtor–creditor relationship. It incentivises the creditor to ensure beneficial financial coordination and control, with derived gains accumulating to all stakeholders’.¹⁴⁹

For borrower-firms the relational nature of finance has both its advantages and disadvantages. It is beneficial as relational debtholder has a better knowledge of the specifics and objectives of the borrower business and is, arguably, in a better position to help the borrower to achieve them. It also helps both borrowers and debtholders to address information asymmetry problems, minimising the social costs that are connected to financial distress.¹⁵⁰

On the other hand, the costs of relational finance for the borrower are the information monopoly obtained by its debtholder. This is especially the case with the private credit financing, where the debt investment is long-term and where the nature of financing is private. In the longer-term, this might result in a hold-up problem for the borrower.

As mentioned in Section 2, for banks relational finance has mostly withered away due to increased banking regulation.¹⁵¹ The increased competition – as a result of change to the landscape of debt providers and predominantly driven by banking regulation, which creates a capitally inefficient framework for banks – continues to impact banks’ ability to provide long-term relational finance and above a certain size.¹⁵²

C. Board representation – dynamic view of valuation

In addition to the relational nature of private credit financing, private credit funds also make nominations for their representatives to sit on the board of directors of their portfolio companies.¹⁵³ This management aspect (representation on the board) speaks directly to the corporate governance role of debt. It also helps to establish a more informed relationship between the debtholders and the firm, giving debtholders a dynamic view of the firm’s valuation.

Debtholders’ involvement on the borrower-firm’s board in this way adds value to the firm, contributes and helps private credit funds to achieve their investment strategy.¹⁵⁴ It is also beneficial for the firm in terms of knowing and trusting who owns the risk of its debt. Debtholders in this way also have enhanced information rights.¹⁵⁵ These debt investors have formal and informal meetings with the board of their portfolio (i.e. borrower) firms.

Driven by the relational nature of finance provided in this market, private creditors participate in the running of the firm and provide sophisticated monitoring. They get access to the management team, scrutinising what the managers of the borrower-firm do. Such access also helps to establish relational finance. This type of involvement channels a continuous flow of information, enabling private credit funds to do firm valuations on a dynamic basis – valuations that reflect the true value of the firm at the time.

This development has lately been studied empirically. An empirical study on private credit funds by Block et al., surveys the degree of board representation when private credit funds sit on the board of their borrower-firms.¹⁵⁶ The survey finds that outside financial distress, private credit funds do seek board representation both in the US and in Europe, where only 41% and 22% participants of their survey responded to remaining as passive participants.¹⁵⁷ The authors also find that during financial distress, there is more active participation on the borrower-firm’s board.¹⁵⁸ Their results are in line with the empirical findings by Jang (2022),¹⁵⁹ suggesting, among other things, that private credit funds have a strong influence on the board (actively seeking board observation rights) during renegotiation process post-covenant violation.¹⁶⁰ As shown in Table 2, compared to private credit, in modern-day bank financing, there is less opportunity for relational finance, the debtholders have less enhanced information, and there is less scope for dynamic valuation of the firm.

D. Equity upside, being lead investor, participation in capital growth

One of the interesting features of loan financing provided by private credit funds is the direct participation of debt investors in capital growth of the private credit funds in which they inject debt capital.¹⁶¹ Such a participation in capital growth and profit sharing is achieved through a contractual mechanism stipulating for an internal rate of return (‘IRR’).¹⁶²

The return consists of two components. The first one known as ‘“preferred return” (also hurdle rate) [is] a minimum annual return that the limited partners are entitled to claim before the fund manager starts receiving carried interest’.¹⁶³ In this regard, compared to private equity, where investors should not expect a return on capital or distributions for typically several years, in private credit, investors are entitled to receive this part of their income quickly. The second one ‘“carried interest” [is] the amount (profits) which is above the preferred return rate that the fund manager receives as compensation which is based on the performance of the investment’.¹⁶⁴

It is a contractual entitlement to a return on their debt investment: return not in the form of a traditional interest rate, as it is in bank financing, but in addition to this. Depending on the private credit strategy (senior debt, subordinated capital, credit opportunities/distressed debt, specialty finance) the IRR is different, with senior debt having the lowest (but still a higher IRR than investment grade bonds or higher yield bonds) and distressed debt having the highest IRR.¹⁶⁵

This development shows that private credit challenges the traditional conception of debt investment in corporate finance and corporate governance. The established position is that debt providers are interested in value-maintaining activities of the firm, whereas shareholders are interested in value-maximisation. The conventional approach for loan finance (as opposed to, for instance, convertible debt) is that there is no capital growth for debt providers.¹⁶⁶ Yet, in private credit, debt investors’ participation in profit (i.e. through a return on their debt investment) disqualifies the orthodox position.

In private credit, debt investment is typically for a long-term (these debt investors, are locked in a relationship for a long time), and the investors in this market are interested in the firm’s successful performance: to be paid back not only the main sum, the interest, but also a return on their investment.

In addition to participation in profit sharing via return on debt investment on a fund level, as discussed above, private credit investors participate in control and upside risk through equity stakes and warrants. When they do so, they benefit in their capacity as shareholders and not debtholders, but it is their bargaining for these rights contractually as debtholders that later allows this level of control.

In this regard, Buchner et al., find that

the average deal in [their] sample [deals between 1982–2015] comprises an equity stake (Direct Equity) of almost 7% upon conclusion of the deal. Through their exercise of warrants included in the deal, debt investors acquire a further equity stake, averaging 4% upon warrant exercise. ([…] Postdeal Equity).¹⁶⁷

Buchner et al., further find that in approximately 63% of the private debt deals in their sample, private credit funds reported to act as lead investors in the given deal, with private credit funds in sponsor-less deals (i.e. without venture capital, private equity) more likely to act as lead investors in their portfolio (borrower) companies than in the sponsored (i.e. venture capital, private equity) deals.¹⁶⁸

E. Bespoke debt covenants

Unlike in bank financing, where the design of debt covenants is often ex-ante informed by the later chance and cost of syndication of the loan, in private credit, including for unitranche loan facilities,¹⁶⁹ debt covenants can be more bespoke. Private credit funds also bargain for stricter financial maintenance covenants. Examples of maintenance covenants are a borrower maintaining a (i) maximum leverage ratio (specified ratio of debt to EBITDA,¹⁷⁰ or some other cash flow measure), or maximum interest coverage ratio (specified ratio of EBITDA or some other cash flow measure to interest expense), or minimum fixed charge coverage ratio (specified ratio of EBITDA, or some other measure).

These leverage covenants are key and will require the borrower to deleverage over time. Especially for senior debt facilities, breach of a financial covenant will be an Event of Default under the financing agreement, allowing the debtholder to accelerate the debt. In bank financing, since 2017–2018 onwards there has been the trend of covenant-lite financing. By contrast to financial maintenance covenants, incurrence covenants that are more common in high-yield bonds and covenant-lite loans ‘[…] only require compliance with a financial ratio if the borrower does a particular action (for example, issues more debt or takes on a further loan)’.¹⁷¹ In addition, to more bespoke financial covenants, private credit funds also bargain for heavy information rights to monitor the borrower.

Unlike bank financing, where standardised (e.g. LMA-based)¹⁷² documentation is very common and serves as a basis for negotiations, for private credit financing, because of its nature, often the loan documentation specifically reflects the objectives of the borrower–lender relationship and is bilaterally negotiated between the parties. This also gives debtholders more scope for ex-ante bargaining for control and monitoring rights.

Finally, it is important to note that there is a difference between debt governance via debt covenants (covenant-lite) in bank financing and debt governance via bespoke debt (including financial maintenance) covenants in a relational finance environment on a long-term basis that is provided by private credit funds.

F. Dynamic control through floating pricing

This sub-section focuses on the repricing trend in private credit. Floating price phenomenon in private credit is a way of debtholder influence – driving debtholders’ control of the firm. This type of control enables debtholders to have a significant impact on the firm: to influence the firm not only in a more traditional sense, when the firm is in financial distress, but also beyond this timeframe. It is also different from more traditional debt governance through debt covenants.¹⁷³

i. Pricing and barriers to accurate pricing

This sub-section explores the important aspects to an accurate calculation of credit risk and pricing of debt, and the typical barriers to their accurate completion. Many notions, including that of credit risk and pricing of debt, are a response to imperfect markets and market failures.¹⁷⁴

From the debtholders’ perspective, credit risk has been defined as ‘the possibility of losing money due to the inability, unwillingness, or nontimeliness of a counterparty to honor a financial obligation’.¹⁷⁵ It has been suggested that main issues with respect to risk are the non-guaranteed nature that the event will materialise, the latter’s impact on the firm’s value, and that there are both positive and negative implications that could be caused by the materialisation of the event.¹⁷⁶

Debtholders price risk in different ways, such as through interest rate, contractual creditor protection, and through proprietary creditor protection. When pricing risk, they also rely on borrower’s past financial statements. Financial statements, however, rely on historical data, and, therefore, their usefulness is limited to a certain extent. Contractual representations and warranties are also not useful in the longer term. This is due to the fact that except for a few repeating (evergreen) representations,¹⁷⁷ the majority of contractual representations and warranties in loan financing are given by the firm at the time of entering into the agreement. Risk is also priced by relying on various risk-diversification (debt decoupling) mechanisms (e.g. loan transfers). Risk exposure becomes a bigger concern for debtholders when the provided finance is medium or long-term. This is especially the case in private credit, where in addition to the long-term nature of financing the market is illiquid.¹⁷⁸ There are several reasons for debtholders’ concern in long-term financings.

First, the longer the time-period of exposure, the higher the chances that the borrower-firm might not be able or willing to pay. In other words, time is a risk.¹⁷⁹ Debt investors look for optimal mechanisms to quantify types of risks, including credit risk. Yet, quantification of credit risk is a complicated and not an exact science. Relying heavily on a single number or a fixed criterion might not necessarily be useful. Several barometers of risks have been suggested in the literature, such as the credit exposure, the probability of default, the recovery rate in case of default, and the tenor of the provided loan.¹⁸⁰

Second, the predictability or precise calculation based on one or only several figures (e.g. by relying on financial covenants: debt/equity ratio, EBITDA,¹⁸¹ etc.) is often impractical. This is because specifically quantified numbers mainly account for borrower-opportunism (e.g. endogenous events/idiosyncratic risks), whereas external events (e.g. exogenous risks/risk externalities, such as inflation, market crash, or COVID-19) can also significantly influence a borrower-firm’s behaviour.

Third, an exact quantification of the debtholder’s exposure is typically calculated at ‘Day 1’. This is one of the main issues for bank-originated loan financing (e.g. term loans, revolving loans, syndicated loans) and is also true for bonds. When the firm enters into the agreement with the debtholder, the firm makes representations and warranties about its business. Except for very few repeating representations, however, the rest of representation and warranties are typically made at ‘Day 1’ of entering into the transaction. Setting the price at ‘Day 1’ typically does not reflect what might happen, for instance, in a year. Such a quantification of risk is thus often not up to date; it does not necessarily consider the long-term nature of finance and unpredictable future.¹⁸² There are also other types of risks relevant for credit pricing, such as liquidity risk, market risk, operation risk, that should ultimately be reflected in the pricing of corporate debt. In private credit, these issues are addressed through a floating interest, which is repriced every 30–90 days.

In the past years, another new debt pricing component has been the factoring of ESG requirements in the price of corporate debt (e.g. sustainability-linked loans, social loans, green loans).¹⁸³ The inclusion of ESG-based criteria in sustainability-linked loans, green loans, social loans, is an example of the ex-post incentive alignment (reward) legal strategy.¹⁸⁴ In the private credit market, this is achieved through ESG-linked margin ratchets.¹⁸⁵ The loan interest margins are reduced when the borrower-firm achieves certain predefined sustainability targets.

In the context of the calculation of credit price, a firm’s credit rating often provides certain guidance to its debt investors. In the private credit market, however, borrower-firms used to be and many of them still are typically unrated firms. In bank financing, a firm’s credit rating is determined by credit rating agencies based on historical data, and it is often the borrower-firm that initiates a dialogue with a credit rating agency to appraise its credit rating. At times a part of the undetected risk could be attributed to the willingness of credit rating agencies to ‘over-rate’ borrower-firms. It has been argued that this was the case during the 2008 sub-prime crisis.¹⁸⁶ One explanation for this could be that there is not enough competition among the credit rating agencies. This sub-section will not discuss the credit rating issue further. For the purposes of the following analysis, it is sufficient to note that credit rating in private credit is not a requirement and in bank financing it represents a backwards-looking approach that does not necessarily and accurately reflect what will happen to the firm. This is especially concerning for long-term revolving loans. This position is in line with the proposition that ‘the probability of default with the potential for credit ratings to migrate over time adds a dynamic element to credit risk estimation’.¹⁸⁷

Credit risk is further influenced by the decisions of the firm’s directors. Directors, as fiduciaries of the company,¹⁸⁸ are the ones to make most decisions. Their decisions also impact the firm’s debt financing decisions and its credit risk profile. According to Merton, three variables plus a discount factor are used to determine the likelihood of default. Those are ‘the time to maturity (lessens the likelihood), the volatility of the company’s operations (increases the likelihood), and the existing distance between the assets and debt (lessens the likelihood)’.¹⁸⁹

The empirical evidence in the context of bank financing suggests that renegotiated debt agreements following a violation of covenants have interesting pricing implications. For instance, Nini et al., find that such debt agreements ‘provide less fundings, have a shorter maturity, and carry a higher interest rate spread compared with the contracts prior to the violation’.¹⁹⁰ Roberts shows that the typical loan provided by a commercial bank reprices corporate loans five times or every nine months.¹⁹¹ Gârleanu and Zweibel find that the median covenant violation occurs one year from the inception of the loan.¹⁹² Repricing of corporate debt is sometimes caused not necessarily by a violation of the terms by the borrower-firm, but as a consequence of an exogenous risk affecting the financial relationship or because the firm wishes to have more flexibility in its operations.

ii. Dynamic element to pricing

This sub-section argues that floating pricing in private credit is a form of debt governance, directly impacting the firm and addressing the dynamic nature of debt. Often pricing and repricing of debt has nothing to do with the low quality of the borrower-firm. Rather, it is driven by the firm’s wishes to be more flexible in its day-to-day operations, especially in the context of bigger deals.

As the following discussion explains, the capital providers in the private credit market are not looking to a control in the traditional sense, and they still acquire information often because of the relational nature of finance. These debt investors charge a floating rate spread above the reference rate. The floating interest provides private credit investors with the opportunity to reflect the current market cost of lending in their long-term relationship with the firm.

In the past twenty-five years, there has been a shift in the corporate debt market from escalating and exiting a financial relationship to ex-post repricing it. For banks, it is important for their debt investment to reflect the current cost of lending and the up-to-date position of the borrower-firm: to be able to sell this debt to the liquid secondary loan market. Unlike banks, private credit funds typically operate in an illiquid market: they price their illiquidity, including by charging an illiquidity premium.¹⁹³ Dynamic pricing has become an essential part of private credit financing, as it allows private credit funds to price their illiquidity more adequately and to keep up with the market changes (e.g. the rise in the interest rates to combat inflation) affecting the cost of finance.

Firms are normally provided with financing based on debtholders’ ex-ante calculation of (i) the profitability of the project and (ii) the overall credit risk of the borrower-firm.¹⁹⁴ Consequently, pricing is the flipside of the expected profit from the loan. Debtholders typically calculate the risk of a firm’s default in advance and price debt accordingly. Such a pricing strategy is beneficial for them as it allows to offset the risk of potential default on the part of the firm. Generally, they are also careful about terminating financing because a wrongful acceleration might result in payment of a substantial amount of damages and might also negatively affect their business reputation.

Pricing/repricing debt is useful not only for countering the renowned information asymmetry problem and the inter-connected ‘market for lemons’¹⁹⁵ issue embedded in debt financing markets; arguably, it is equally important for addressing the problem of lending to the borrower-firm when the debtholders have made a ‘pricing mistake’. In this context, the term ‘pricing mistake’ means that the price (i.e. the margin) does not reflect the risk or the market cost of lending. In other words, it is no longer profitable for the lender to lend to the firm on such price as agreed previously. The COVID-19-crisis is a practical example of such a situation where debtholders were forced to reconsider the price of corporate debt. This proposition is in line with the earlier empirical evidence, which suggests that many long-term debt contracts are renegotiated prior to their stated maturity.¹⁹⁶

From the borrower-firms perspective there are two main reasons why the borrowers agree on floating interest rate. First, in the context of private credit lending, the borrower is looking for specialised lenders who can help the company to achieve its business strategy, and, in return, the borrower agrees on floating interest rate. Second, in the past years since the beginning of 2023, there were serious liquidity issues, affecting significantly syndicate loan markets. This meant that borrowers did not have many alternatives, but many of companies needed urgent financing.

Repricing results in changes to the amount, maturity and other terms of financing, and sometimes these changes are caused not necessarily by financial distress of the firm.¹⁹⁷ This allows debtholders to directly and significantly influence the firm and is a new form of debt governance, which is different from the traditional influence of debtholders via breach of debt covenants. It drives the debtholders’ control of the firm. Floating price enables debtholder to influence and engage with the firm on an ongoing basis and to be in a good position to dynamically value the firm. As interest rates go up, the servicing of debt becomes more difficult for the borrower-firms (i.e. cost of debt servicing is becoming high). This new form of debt governance has significant implications on the incentives of the firm’s directors and puts pressure on them to consider the interests of the debtholders also outside financial distress.

G. Liquidity affecting governance

Since the GFC, there has been a further development in the secondary loan markets. There is more liquidity in the secondary loan market, and banks no longer hold on to loans until their maturity. This sub-section focuses on the changes in the secondary markets for corporate loans, and the impact of the liquidity in the secondary loan markets on debt investors’ incentives to divest and transfer risk. It argues that such a change has its implications on their behaviour and engagement with borrower-firms from a debt governance perspective.

i. Evolution, but revolution?

When making financing decisions, debt investors provisionally calculate the riskiness of the firm in their cost of finance. These investors that are interested in minimising their risk exposure from the default of an individual borrower-firm might look for techniques to transfer their loans and diversify their risk. This is especially typical for syndicated loans.¹⁹⁸

There are different reasons for loan transfers, which include, but are not limited to risk diversification, subsequent syndication, and the defaulting nature of the loan. For banks, this could also be the result of capital adequacy rules imposed by banking regulation.¹⁹⁹ When banks offset risk because there is a problem with the borrower-firm, they may write down a loan or transfer it, or enter into a credit default swap, or a repo transaction.

In debt finance, there used to be a distinction between a tradable debt and other type of debt.²⁰⁰ However, these other types of debts that used to be non-tradable, for instance, syndicated loans, have now come to be transferred on a frequent basis. This creates liquidity for the secondary markets for loans. The buyers used to be banks, but nowadays the buyers of transferred loans can also be specialised distressed debt traders and vulture funds. For loans that are not syndicated, the interest in a loan can also be sold to the secondary market. Alternative means of creating liquidity also involve collateralised loan obligations and credit default swaps. As a result, there is a shift from ‘assets that are held to creation of assets that are tradable similar to securities’.²⁰¹ The strict distinction between these two classes of debt is no longer as important as it used to be.

Although this paper focuses on private debt, it is worth mentioning that, in relation to the bond markets, bondholders also used to hold on to debt until the maturity of the bonds, relying on payments on the principal amount and interest. In the past years, bondholders typically sell their bonds prior to their maturity.²⁰² Schwarcz argues that this makes bondholders similar to equity investors, as they are now more interested in pricing their debt as opposed to securing a priority in the creditor rank.²⁰³

For bank financing, historically banks sold their participations in loans, but that they also kept most of their loans until maturity and, by negotiating a loan, used to protect their assets.²⁰⁴ Nowadays, banks typically originate loans to sale those to the secondary loan market, and they buy and sell credit risk in order to manage their risk exposure more efficiently.²⁰⁵ In this regard, the maturity of loan has been argued to also affect corporate governance.²⁰⁶

The secondary market for loans consists of the primary (syndicated) loan market, where portions of a loan are placed with several banks, and the secondary category for the seasoned or secondary loans, where it is a single bank selling off an existing loan or a part of it.²⁰⁷ These secondary loan markets have grown in their size and act as an important channel for managing credit risk.²⁰⁸ As a result, there is more liquidity not only in the context of public, but also private debt markets. Such a development in secondary trading has been argued to possibly even overtake the important role of debt covenants, including financial covenants, and monitoring in corporate governance.²⁰⁹

At the same time, in the past years corporate borrowers started to restrict the use of sub-participation for lenders, and this development has had an immediate impact on the liquidity in the secondary loan market.²¹⁰ Penn argues that the reason for this is because borrowers no longer view sub-participation as a mechanism of transferring economic risk. Rather, they see it as a ‘[…] method of transfer which potentially impacts rights and obligations under the underlying loan and also its relationship with the [l]ender’.²¹¹

ii. Liquidity and transferred debt

The liquidity in the secondary loan market, some might argue, weakens the incentives of the original debt investors to actively monitor the firm. Along these lines, some argue that the traditional mechanisms of engaging with the firm (e.g. debt covenants), thus, might be less relevant.²¹² This sub-section argues that since in the past years there has been a lot of competition in the secondary loan markets, it is in the original debt investors’ interests to monitor the original loan package and invest in the relationship with the firm. Otherwise, the original debt investor (typically a commercial bank) might not be able to successfully market this debt to the secondary loan market or be able to market it but only with a substantial discount to its original price, meaning that it will incur losses.²¹³

Despite the changes in the market from originate-to-hold to originate-to-distribute,²¹⁴ first, the original banks will not be in a strong position to distribute the debt if it does not reflect the true position of the borrower-firm at the time.

Second, the lead arranger/manager in syndicated facilities often hold on to debt, even if the other members of the consortium market it to the secondary debt market. On the one hand, an information asymmetry exists between the original and the new debtholder. On the other hand, these new investors can benefit from the involvement of the original banks and the information that they hold on the firm.

Third, the borrowers sometimes successfully manage to restrict some types of transfer, for instance, sub-participation.²¹⁵ Moreover, the empirical evidence in the context of bank loan financing suggests that there are negative stock returns for the firm on the loan sale announcement.²¹⁶

The liquidity in the secondary loan markets, and the option to market the debt to the secondary market is also profitable for the firm. This is because, especially in times of recession and as shown by the Twitter deal, the investors in the secondary market will not be willing to buy an overpriced debt, or will buy it, but at a huge discount to the original price. By making either decision, the secondary debt investors, also contribute to debt governance (‘lender governance’).²¹⁷ Moreover, the longer the original debt investors are forced to hold their debt and are not able to sell it, the longer the loan market will be frozen, causing further negative externalities. At the time of submitting this paper, the banks were not yet able to offload or refinance Twitter debt.²¹⁸

Such a risk diversification strategy could affect debtholders’ incentives and the extent of their involvement in monitoring the borrower.²¹⁹ This additionally raises the question of socially optimal renegotiation of the financing agreement and the debt investor’s incentives to transfer the loan. It also touches upon an important tension between ‘the right of the borrower to prevent or limit the transfer of the debt and the right of a lender to alienate its own property, namely the debt or the proceeds’.²²⁰

It is also possible for debt investors to provide finance to firms, with an option for the former to transfer the loan at any point in time.²²¹ This typically happens especially with high-risk (non-investment grade) firms. Depending on the type of a loan transfer (e.g. novation, assignment, sub-participation),²²² the original debt investor will either cease its relationship with the firm or will continue to be involved in a limited way. While one might argue that the liquidity in the secondary loan markets might dis-incentivise debt investors, including syndicate lenders, to monitor and enforce the firm’s compliance,²²³ the empirical evidence suggests the contrary.²²⁴ Additionally, the original debt investors will be concerned about the restrictiveness of the initial financing terms. This is because they may otherwise be concerned that they will not be able, for instance, to transfer the loans in the secondary loan market without appropriate debtholder protection mechanisms.²²⁵

4. The equity-debt story in a world of sophisticated debtholders

This section addresses the third theme of this paper: the implications of the evolution of corporate debt finance for the modern-day relationship between equity and debt. What happens to the equity-debt story in a world of sophisticated debtholders? Due to the changes in corporate finance markets and the increased importance of the role of debt financing, equity and debt governance have become even more intertwined and overlapping than they used to be.²²⁶ This section does not claim that debt governance is always in the interests of equity. Instead, it argues that the significant changes to debt markets affect modern-day debt capital’s relationship with equity, making the two more interconnected and overlapping.

i. Why should there be more interest?

The preceding discussion showed the evolution of the role of debt in the firm. The way that debt operates today implies that the firm’s directors are often incentivised and influenced to take into account the debtholders’ interests also outside financial distress. Depending on the type of debt financing (bank or private credit), the influence mechanisms may differ (Table 2). Before exploring the benefits of symbiotic equity-debt governance, one should consider why there should be more interest in the relationship between modern-day equity and debt. Three inter-connected justifications are presented below.

First, according to the data provided by the UK Companies House, private limited companies (with a share capital) accounted for over 92.7% (↑4,929,778) of all corporate bodies on the total register at the end of March 2023²²⁷ – up from 2022 (4,713,538)²²⁸ and from 2021 (4,539, 191).²²⁹ By contrast, the number of public limited companies in the UK in 2021–2022 in the same time period was ↓5,951 (0.1% of all corporate bodies registered in the UK):²³⁰ down from 2020–2021 (6,103).²³¹ For 2022–2023, unlike for the previous years, there is no separate number provided for public limited companies; the UK Companies House only mentions that ‘public limited companies have been declining in number since 2008. They now make up only 0.1% of the register’.²³² Second, Ellias and de Fontenay, referring to a study by Kaplan and Strömberg, note that a significant number of the US firms are owned by private equity funds, rather than public shareholders.²³³ Ellias and de Fontenay also note that even in public companies in the US the modern shareholder base is ‘increasingly concentrated, institutional, and activist’.²³⁴ Third, in private companies, that are increasing in their numbers, there is a significant increase in debt capital (driven also by the post-GFC lower interest rates policy until recently and the COVID-19 pandemic).²³⁵ As mentioned earlier, in 2022/23, the global corporate debt reached a record high: $456 billions of net new debt.²³⁶

B. Advantages of symbiotic governance

How do developments in corporate debt finance markets affect the relationship of equity and debt? This section argues that equity and debt governance have become even more overlapping and intertwined than they used to be, including because of the changes in the debt markets, such as the developments of liquid secondary loan markets.

The idea that equity and debt complement each other goes back to the seminal paper by Modigliani and Miller.²³⁷ There are general advantages of symbiotic governance both in private and in public firms. The differences between equity and debt governance do not mean that they are or should be exclusive. The opposite: they complement each other. Debt governance is exercised to the extent and in relation to those aspects of the firm’s business for which the debtholders have more control rights to influence the firm and to impact change, and for which they are more competent to do it. The firm’s existing shareholders and its prospective equity investors benefit to a certain extent from debtholders’ competence and effective debt governance.²³⁸ The firm benefits when its equity and debt capital providers are involved and that such symbiotic governance minimises the firm’s ‘total competence and conflict costs’.²³⁹

One example of this is when a firm pays dividends to shareholders out of retained earnings and then raises debt capital.²⁴⁰ Debt not only has a disciplining (incentivising) effect on the firm’s directors, therefore also controlling how much the directors shirk; arguably, debt investors – by scrutinising the firm and pricing debt accordingly – also effect positive externalities on others. For instance, debtholders’ power to intervene or to price and ex-post also to reprice the risk and, accordingly, to signal to the market the firm’s idiosyncratic risks and characteristics, has a disciplining effect on the borrower-firm. This disciplining effect of debt governance is applied against directors and for the benefit of all the stakeholders, including the firm’s employees, customers, and the society in general (positive externality). Effective debt governance provides an information sharing regime.

Another example is when in private credit deals, the availability of debt capital provides more flexibility to the firm, including a breathing space to undertake risky ventures and to maximise shareholders’ wealth. Existing shareholders, the prospective equity investors, and other stakeholders, moreover, benefit from the signalling function of the firm’s and its debtholders’ hedging prices. These corporate constituencies, including the firm’s employees and the society, also benefit from the existence of ESG-priced debt finance, such as sustainability-linked bonds and loans. In this vein this paper agrees with Lund, who argues that ‘[…] the insight that the individuals with the strongest interest in seeing corporations act responsibly are not always the company’s shareholders has consequences for corporate law and corporate governance’.²⁴¹

This paper’s argument of the beneficial effects of debt governance is also directly connected to Michael Jensen’s original idea that there are ‘[…] benefits of debt in motivating managers and their organization to be efficient’, which Jensen calls the ‘control hypothesis for debt creation’.²⁴² It is because of these various effects of debt governance, some of which have been caused by the evolution of debt markets, that this paper argues that the firm’s effective corporate governance is a combination of equity and debt governance, where one type of governance complements the other, creating an information sharing regime for all its stakeholders and a disciplining regime against the potential shirking of its directors.

In modern-day private firms, but also recently in public firms, the interests of capital providers are often very interlinked and overlapping. For instance, if the firm does not perform well, its original debt providers (typically banks) in a syndicated financing may not be able to sell the debt to the secondary loan market, where the investors in this secondary market are nowadays in a position to choose to buy this debt or to buy it at a huge discount. This will also create negative externalities for those firms that are waiting to receive financing from these debt providers. These debt investors want the firm to be successful to be able to market the original debt. In private credit, debt investors are interested in the firm’s success to be paid back the debt sum, interest and return on their debt investment.

Prior to the changes in debt markets, in particular, with respect to the added experience and appetite of private credit funds, and the developments in the banking regulation, it used to be the case that exiting a financial relationship was predominantly seen as a negative sign for the market, because it meant that the borrower-firm was in trouble. This, is, however, not always the case in the modern debt market, where sometimes the banks transfer debt because of the capital adequacy rules (and not necessarily because there is a problem in the firm), or where the successful marketing of debt to the secondary market is also a signal of the secondary investors’ confidence in the borrower-firm.

In the traditional debt market (originate to hold) there might have also been more conflict of interests between equity and debt capital providers (value maximisation vs value maintenance). Nowadays, this does not necessarily always have to be the case. As mentioned, in private credit, the most important reason for shared interests between equity and debt capital providers, is the interest of private credit funds in profit maximisation. In bank financing, the original debt providers also want the firm to do well in order to market the product to the liquid secondary loan market.

The modern secondary loan market also has a direct influence on the debt governance of the firm, as its decision to buy the firm’s debt or not, or to buy it at a discount, also affects the firm. In principle, the original debtholders could transfer this debt to the secondary market, but the price of debt will reflect the borrower-firm’s position (i.e. there will be a discount, and the original debtholders may incur losses). In some firms, debt capital providers also buy equity stake in the firm, making them also interested in the firm as its shareholders.

The competition, appetite, and expertise of debt investors in the secondary loan market acts as a strong incentive for the primary market to monitor and engage with the firm. The option for the debt investors in the secondary loan market to choose to accept or reject the product is a debt governance mechanism: the secondary loan market contributes to the debt governance of the firm (‘lender governance’) (Figure 1). In its turn, the original debtholders are especially incentivised to engage in debt governance to be able to market the product to the secondary market. The decision of the secondary debt investor to accept or reject the offer from the original debtholders, moreover, entails information sharing regime to the market about the firm and its prospective.

Figure 1. Steps in debt governance.

In sum, as shown in Figure 1 below, these developments allow for three steps of debt governance for ‘originate-to-distribute’ type of debt: original debt governance when pricing debt, (Step 1), and secondary debt governance when the secondary market buys the debt (Step 2). But there could also be another step between Step 1 and Step 2, which this paper calls ‘Fix the Firm’ step, where the secondary loan market rejects to buy the debt of the original holders (e.g. as was the case in the Twitter deal). This phenomenon is only possible due to the development of the secondary loan markets and the increased competition between various debt capital providers (i.e. traditional and non-traditional). It impacts the incentives of the original debtholders to monitor the firm and engage in effective debt governance, which includes, where relevant, also the selling of debt. Effective debt governance, arguably, also increases the value of equity. For instance, if the original debt providers do not effectively engage with the firm in order to be able to sell its debt to the secondary loan market, the unsuccessful debt transfer will not only affect the debtholders (i.e. they will lose money), but it will also impact the borrower-firm’s share price (or also potentially of its interconnected entities’ share price) in the market, as it may be seen as a sign of no confidence from the secondary debt investors.

C. Symbiotic governance with private credit funding

What are the advantages of symbiotic governance with private credit funding? There are several advantages of symbiotic governance, where debt is provided via private credit. First, in the private credit market, debt looks a lot like equity when it comes to the requested control rights (e.g. participation in capital growth, influence on the board), although what remains different is debt’s ranking in the firm’s capital structure. Both groups of capital providers often have a similar agenda: maximising the firm’s profits. Second, the interests of shareholders and debtholders are aligned (i.e. no conflict of interest) when debt providers simultaneously own an equity stake in the same portfolio borrower-firm, or when the private credit fund and the deal sponsor (venture capital, private equity) are affiliated.²⁴³ On the other hand, there still may be scope for misalignment with other shareholders. Third, private credit provides for better incentive alignment for fund managers. Why? This is because they typically do not look for syndication of debt; instead, they are invested in debt origination and keeping it until its maturity or repayment (also charging an illiquidity premium for this). They are also more focused on stronger debtholder protection. In this regard, Buchner et al., note that the borrower-firms with private credit financing in a sponsored (venture capital, private equity) deal, ‘may expect reputable [venture capital, private equity] sponsors to reduce the conflicts of interests between shareholders and debt holders’.²⁴⁴ They also point out that in sponsored private credit deals, equity sponsors could be expected to act in the interests of debtholders, such as through monitoring and involvement in corporate decision making.²⁴⁵

Although not in the context of private credit funds and loan financing, Keswani et al., studying the US-based mutual funds, find that two out of five fund families hold corporate bonds of the firms in which they also injected equity capital, and that the rise in debt investment in a fund that a family holds increases the likelihood of investors of the firms during shareholder meetings to vote in the interests of themselves as debtholders, even if this is against the recommendation of Institutional Shareholders Services (ISS).²⁴⁶ They mention that ‘voting has direct policy consequences as firms that receive more votes in favour of creditors make corporate decision more in line with the interests of debtholders’.²⁴⁷ Keswani et al., further note that,

[i]intuitively, there is limited conflict between debt and equity when a firm is far from financial distress: what is the interests of creditors is likely also to be in the interests of shareholders and changes in firm policy have a very small effect on the value of debtholders’ stakes. However, we would expect this conflict to be magnified close to financial distress, when corporate policies are likely to have a larger effect on the market value of debt.²⁴⁸

In the context of private credit funds, specifically, the advantage when private credit funds also own equity stake in the borrower-firms is that largely the interests of shareholders and debtholders in these companies are aligned – both interested in value maximisation. Shareholders are interested in wealth maximisation, whereas investors of private credit in these cases are also interested in the borrower-firm doing well to be able to generate return on their debt investment, as discussed previously. As a result, there is not always a conflict of interest between the interests of shareholders and debt providers in these types of firms. Such an alignment in interests also minimises incentive alignment costs for directors. It could be argued that such an alignment in interests of equity and debtholders de-risks the firm in the interest of debt with the result that the firm is less innovative. On the other hand, private credit is typically provided on terms and conditions (firm-specific, project-specific) that are designed to foster innovation and growth.

There are two additional points that should be highlighted. First, as mentioned above, in the context of debt capital provided by private credit funds, it shares several characteristics of equity. From the legal point of view, nevertheless, this investment is characterised as debt. Ellias and de Fontenay note that the protection offered to equity investors in the United States (‘US’) is dealt through the lens of fiduciary duties – doctrines embedded in equity.²⁴⁹ This position is similar in the United Kingdom (‘UK’).²⁵⁰ Ellias and de Fontenay further emphasise that by contrast to equity investors, debt investors in the US often protect themselves contractually, and in case of disputes judges rely on contractual interpretation of legal terms, which are derived from law, as opposed to equity.²⁵¹ This general approach to the treatment of equity and debt investors is similar in the UK. As Lord Reed noted in Sequana, outside financial distress, the traditional approach to the treatment of debt providers regards them as guardians of their own interests.²⁵² Ellias and de Fontenay argue that this distinction of the legal protection of equity and debt providers is outdated and predominantly based on ‘[…] an antiquated paradigm of a single bank lender and dispersed shareholders and incorrect assumptions about the risk tolerance of creditors versus shareholders’.²⁵³ This paper agrees with their position and further argues that the conventional position does not take into account the evolution of corporate finance: the rise of debt finance, development of private credit, liquidity in the secondary loan markets, the increased control rights that debtholders bargain for also outside financial distress of the firm, and the blurring lines between ‘equity’ and ‘debt’ capital in terms of their characteristics.²⁵⁴ Second, and connected to the first point, is the question of if debt in these types of private credit financings looks a lot like equity, then are the capital providers and borrower-firms interested in characterising it as debt for tax purposes?²⁵⁵ These two points merit a separate discussion and are a subject of future research.²⁵⁶

5. Conclusion

This paper provided new insights into the role of modern debt (credit) capital in the firm, its relationship with equity (share) capital, and the implications of advances in debt markets with regards to private credit (as an asset class) and its competition with banks for corporate finance and corporate governance. 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.

This paper developed a taxonomy of modern debt governance mechanisms, comparing and contrasting the influence of private credit funds and banks when lending to corporations from a corporate governance perspective. It also showed that (i) modern debt providers are often interested in the firm’s profit maximisation, (ii) equity and debt have become even more intertwined and overlapping in a world of sophisticated debtholders, and (iii) corporate loan financing agreements are often expected to be renegotiated.²⁵⁷

Debt has changed significantly over the years, and because of the quantum leap in corporate finance, modern debt shares similar characteristics to equity. It is clear that the significant changes in corporate finance markets over the past twenty-five years mean that there is an urgent need to re-evaluate foundational legal questions in this area to ensure that the legal framework (i) reflects the market reality, (ii) helps to improve it, and (iii) is fit to counter harmful practices.

Acknowledgements

I am very grateful to Felix Steffek, Eilís Ferran, Marc Moore, Graham Penn, Suren Gomtsian, Jonathan Chan, Assaf Hamdani (discussant), Gordon Smith (discussant), Simon Deakin, Carsten Gerner-Beuerle, Brian Cheffins, Louise Gullifer, Iris Chiu, Casimiro Nigro, Bart Lambrecht, Sarah Paterson, Francesca Farrington, Thomas Varouchakis, Jo Braithwaite, Clara Martins Pereira, Dominic de Cogan, Vasile Rotaru, Javier Paz Valbuena, Ilya Kokorin, Ioannis Bazinas, Andrew McLean, Karen Nokes, Eloise Scotford, Mujtaba Ghaus, Jonathan Hardman, Kobi Kastiel, Eleanore Hickman, Dionysia Katelouzou, Alperen Gözlügöl, Eva Micheler, Holger Spamann, Tobias Tröger, Vusi Mashinini, and two anonymous reviewers for excellent comments and suggestions on the earlier versions of this paper. I would also like to thank the participants of research presentations at the Columbia Law School-DFG LawFin Center's 4th Biannual Interdisciplinary Workshop on ‘Corporations, Contracts, and Corporate Law' 2024; LSE-BYU-EW-ECGI Corporate Law Roundtable 2023; University of Cambridge, Faculty of Law 2023; UCL Faculty of Laws 2023; 2nd Financial Law and Regulation Conference 2023 (LSE); SLS Annual Conference 2023 (Oxford), SLS Company Law Conference “The Future of Company Law” 2023 (Edinburgh); Droit et Croissance Law and Economics Workshop 2023; UCL Laws Corporate and Financial Law Lunchtime Seminar 2023. I have also benefitted from a stimulating dialogue with Andrew Jennings about private credit on the Business Scholarship Podcast. I am also very grateful to the editors of the European Corporate Governance Institute's Blog, the Oxford Business Law Blog, and the Columbia Law School’s CLS Blue Sky Blog for their helpful comments on the blog posts regarding this paper. I would also like to thank Preqin for the permission to use the relevant data on private credit markets for my research project. All the views expressed here are mine alone and are not an investment advice. The usual disclaimers apply. All hyperlinks were last accessed on 15 March 2024. Email: [email protected].

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No potential conflict of interest was reported by the author(s).

Additional information

Notes on contributors

Narine Lalafaryan

Narine Lalafaryan is an Assistant Professor of Corporate Law, Faculty of Law, University of Cambridge; Fellow of Pembroke College, University of Cambridge; Fellow of the Cambridge Endowment for Research in Finance. Narine has particular research interests in Corporate Finance, Law and Economics, International Finance, Economics of Deals, and Corporate Law.

Notes

1 For an outline of the evolution of the legal framework for corporate finance, see Eilís Ferran, Elizabeth Howell and Felix Steffek, Principles of Corporate Finance Law (3rd edn, OUP 2023), Ch. 1. See also, Robert C. Merton, ‘A Functional Perspective of Financial Intermediation’ (1995) 24 Financial Management 23 (offering a functional perspective for analysing the dynamics of institutional changes in financial intermediation). For an overview of the global issues on corporate debt, see The Bank for International Settlements (BIS), ‘Corporate Debt: Post-GFC Through the Pandemic’ (June 2021) BIS Quarterly Review <https://www.bis.org/publ/qtrpdf/r_qt2106b.pdf>; The World Bank, ‘Growth of Global Corporate Debt’ (2020) Policy Research Working Paper 9394 <https://documents1.worldbank.org/curated/en/570381599749598347/pdf/Growth-of-Global-Corporate-Debt-Main-Facts-and-Policy-Challenges.pdf> (noting that between 2008 and 2018, the global nonfinancial corporate debt increased from 56% to 96% of gross domestic product in emerging economies). For the European perspective, see PWC, ‘Debt Watch Europe Annual Review 2023’ (2024) <https://www.pwc.co.uk/risk/assets/pdf/debt/debt-watch-europe-q4-2023.pdf>.

2 Some scholarship treats the terms ‘firm’ and ‘corporation’ as synonyms. These terms are also often used interchangeably in legal practice. However, the term ‘firm’ is broader in its scope than the term ‘corporation’. On a discussion of the difference of these terms, see Simon Deakin, David Gindis and Geoffrey M. Hodgson, ‘What is a Firm? A Reply to Jean-Philippe Robé’ (2021) 17 Journal of Institutional Economics 861; Jonathan Hardman, ‘Fixing the Misalignment of the Concession of Corporate Legal Personality’ (2023) 43 Legal Studies 443.

3 The term ‘GFC’ stands for the global financial crisis of 2007–2008. These post-GFC regulations (e.g. Basel III, The Dodd-Frank Act 2010, more recently: Basel III Endgame) aim to restrict banks’ operational scope and ability by prescribing capital adequacy rules for them. A detailed analysis of the banking regulation is beyond the scope of this paper.

4 They are also known as shadow bankers. See The Financial Conduct Authority, ‘Shadow Banking – The Potential Risks and Rewards’ (2017) <https://www.fca.org.uk/insight/shadow-banking-potential-risks-and-rewards>; Zoltar Pozsar, Tobias Adrian, Adam Ashcraft and Hayley Boesky, ‘Shadow Banking’ (2013), FRBNY Economic Policy Review <https://www.newyorkfed.org/medialibrary/media/research/epr/2013/0713adri.pdf>.

5 See Section 2. See The US Federal Reserve System, ‘Private Credit: Characteristics and Risks’ (February 2024) <https://www.federalreserve.gov/econres/notes/feds-notes/private-credit-characteristics-and-risks-20240223.html> (noting that ‘private credit or private debt investments are debt-like, non-publicly traded instruments provided by non-bank entities, such as private credit funds or business development companies (BDCs), to fund private businesses’); The Bank of England, ‘Financial Stability Report’ (July 2023), 81 <https://www.bankofengland.co.uk/-/media/boe/files/financial-stability-report/2023/financial-stability-report-july-2023.pdf> (defining private credit as ‘lending bilaterally negotiated between borrower and lenders and typically arranged by non-banks’).

6 See also, The Alternative Credit Council, ‘Financing the Economy 2022’ (2022) <https://acc.aima.org/compass/insights/private-credit/financing-the-economy-2022.html>; The World Bank and the Cambridge Centre for Alternative Finance, ‘Regulating Alternative Finance: Results from a Global Regulator Survey’ (2019) <https://openknowledge.worldbank.org/bitstream/handle/10986/32592/142764.pdf?sequence=1&isAllowed=y>.

7 This means that private credit funds are not only competing with banks (the ‘dual track’ process), they are now also starting to watch out for a competition coming directly from institutional investors, such as large sovereign wealth funds and pension funds (the ‘triple track’ process).

8 See Section 2. See also, The Financial Stability Board, ‘Global Monitoring Report on Non-Bank Financial Intermediation’ (2021), at 17–25 <https://www.fsb.org/wp-content/uploads/P161221.pdf>.

9 A market-led approach to sustainable debt finance has been an important factor in the debtholders’ willingness to rely on additional mechanisms for price and risk adjustment, creating a new pool of debt financing products, such as sustainability-linked bonds or loans, social loans, green loans, and others. See, The European Leveraged Finance Association, ‘The Evolution of Sustainability Provisions in the Private Debt Market’ (2023), Issue No. 36 <https://elfainvestors.com/wp-content/uploads/2023/02/ELFA-Insights-36-The-Evolution-of-Sustainability-Provisions-in-the-Private-Debt-Market.pdf> see also The Association for Financial Markets in Europe, ‘ESG Finance Report Q2 2023’ (2023) <https://www.afme.eu/Portals/0/DispatchFeaturedImages/AFME%20Sustainable%20Finance%20Report%20-%20Q2%202023-1.pdf>.

10 The term ‘FinTech’ stands for the application of digital technology to financial services. See The World Bank, ‘Fintech and the Future of Finance’ (2022) <https://www.worldbank.org/en/publication/fintech-and-the-future-of-finance>; see also, The British Business Bank, ‘SME Finance Survey’ (March 2022) <https://www.british-business-bank.co.uk/wp-content/uploads/2022/02/SME-Finance-Survey-2021-Report.pdf>.

11 See The Bank of England, ‘How has Net Financing for UK Businesses Changed During the Pandemic’ (2021) <https://www.bankofengland.co.uk/bank-overground/2021/how-has-net-financing-for-uk-businesses-changed-during-the-pandemic>.

12 The Bank of England, ‘Monetary Policy Report May 2024’ (the interest rate maintained at 5.25%), <https://www.bankofengland.co.uk/monetary-policy-report/2024/may-2024>.

13 The Bank of England, ‘Financial Policy Summary and Record – July 2023’ (2023) <https://www.bankofengland.co.uk/financial-policy-summary-and-record/2023/july-2023>.

14 The Parliament of The United Kingdom, House of Lords Library, ‘UK Corporate Debt After Covid-19: What might the Impact Be?’ (2022) <https://lordslibrary.parliament.uk/uk-corporate-debt-after-covid-19-what-might-the-impact-be/>; The World Bank, ‘International Debt Statistics’ (2022) <https://openknowledge.worldbank.org/bitstream/handle/10986/36289/9781464818004.pdf>.

15 The Bank for International Settlements, ‘Private Sector Debt and Financial Stability’ (May 2022) CGFS Papers No 67 <https://www.bis.org/publ/cgfs67.htm>.

16 Reuters, ‘Corporate Net Debt Hit Record in 2022-2023, But Borrowing Appetite to Decline, Janus Henderson Says’ (2023) <https://www.reuters.com/business/corporate-net-debt-hit-record-202223-borrowing-appetite-decline-janus-henderson-2023-07-11/#:~:text=LONDON%2C%20July%2012%20(Reuters),a%20report%20published%20on%20Wednesday> (referring to a report by Janus Henderson).

17 The New York Times, ‘Yes, You Should be Worried About a Potential Bank Crisis. Here’s Why’ (2023) <https://www.nytimes.com/2023/05/04/opinion/silicon-valley-bank-first-republic-financial-crisis.html>.

18 George G. Triantis and Ronald J. Daniels, ‘The Role of Debt in Interactive Corporate Governance’ (1995) 83 (4) California Law Review 1073–1113.

19 Douglas G. Baird and Robert K. Rasmussen, ‘Private Debt and the Missing Lever of Corporate Governance’ (2006) 154 University of Pennsylvania Law Review 1209–1251.

20 See Frederick Tung, ‘Leverage in the Board Room: The Unsung Influence of Private Lenders in Corporate Governance’ (2009) 57 University of California Law Review 117; John Armour, Brian Cheffins and David Skeel, ‘Corporate Ownership Structure and the Evolution of Bankruptcy Law: Lessons from the United Kingdom’ (2003) 55 Vanderbilt Law Review 1699; Greg Nini, David C. Smith and Amir Sufi, ‘Creditor Control Rights, Corporate Governance and Firm Value’ (2012) 25 Review of Financial Studies 1713; Albert Choi and George Triantis, ‘Market Conditions and Contract Design: Variations in Debt Contracting’ (2013) 88 New York University Law Review 52; Yesha Yadav, ‘The Case for a Market in Debt Governance’ (2014) 67 Vanderbilt Law Review 771; John Armour and others, ‘How Do Creditor Rights Matter for Debt Finance? A Review of Empirical Evidence’ in Frederique Dahan (ed.), The Research Handbook on Secured Financing in Commercial Transactions (2015); Charles Whitehead, ‘Debt and Corporate Governance’ in Jeffrey N. Gordon and Wolf-Georg Ringe (eds) The Oxford Handbook of Corporate Law and Governance (2015), 470–488; Sudheer Chava and others, ‘Debt Governance and Corporate Governance’ (2019) 11 Annual Review of Financial Economics 197; Judy Day and Peter Taylor, ‘The Role of Debt Contracts in UK Corporate Governance’ (1998) 2 Journal of Management and Governance 171; Ioannis Spyridopoulos, ‘Tough Love: The Effect of Debt Contract Design on firms’ Performance’ (2020) 44 Review of Corporate Finance Studies 47. For further details, see Section 4.

21 Suren Gomtsian, ‘Debtholder Stewardship’ (2023) 86 The Modern Law Review 395. The term ‘ESG’ stands for Environmental, Social, and Governance.

22 Narine Lalafaryan, ‘Orchestrating Finance with Material Adverse Changes?’ (2022) 42 Legal Studies 1. Narine Lalafaryan, ‘Material Adverse Change Uncertainty: Costing a Fortune if Not Corporate Lives’ (2021) 21 Journal of Corporate Law Studies 39.

23 Louise Gullifer and Graham Penn, ‘The Boundaries of a Borrower’s Freedom to Act: Negative Covenants in Loan Agreements’, in P. Davies and M. Raczynska (eds) Contents of Commercial Contracts: Terms Affecting Freedom (Hart Publishing 2020), at 139–162. See also Louise Gullifer and Jennifer Payne, ‘Corporate Finance Law: Principles and Policy’ (3rd edn, Hart Publishing 2020), at 87–97.

24 Aiyesha Dey, Valeri Nikolaev and Xue Wang, ‘Disproportional Control Rights and the Governance Role of Debt’ (2016) 62 Management Science 2581.

25 Yadav (n 20).

26 Andrei Shleifer and Robert Vishny define the term ‘corporate governance’ as ‘the ways in which suppliers of finance to corporations assure themselves of getting a return on their investment’. (See Andrei Shleifer and Robert Vishny, ‘A Survey of Corporate Governance’ (1997) 52 The Journal of Finance 737). Marc T. Moore, Corporate Governance in the Shadow of the State (Hart Publishing 2013), at 13 notes that ‘corporate governance – analysed from a distinctly legal perspective – is first and foremost an enquiry into the causes and consequences of the allocation of power within large economic organisations’. Moore further notes at 14 that ‘[…] corporate governance can be defined as the social problem of holding powerful decision-makers in large economic organisation accountable for their actions, in order to legitimate their continuing possession and exercise of power’. Brian Cheffins, in line with the UK Cadbury Report, defines the term ‘corporate governance’ as ‘concerned with the systems by which companies are directed and controlled’. (See Brian Cheffins, Corporate Ownership and Control: British Business Transformed (Oxford University Press 2008), in Ch.1, ‘Setting the Scene’, at 4, referring to The Cadbury Report (1992)). See also The UK Corporate Governance Code (2018), at 1.

27 Sudheer Chava and others, ‘Debt Covenants and Corporate Governance’ (2019) 11 Annual Review of Financial Economics 197; Gullifer and Penn (n 23), at 139–162; Adam B. Badawi, ‘Debt Contract Terms and Creditor Control’ (2019) 4 Journal of Law, Finance, and Accounting 1; Nicolae Gârleanu and Jeffrey Zweibel, ‘Design and Renegotiation of Debt Covenants’ (2009) 22 The Review of Financial Studies 749.

28 One of the pioneering works in this area is Clifford Smith and Jerold Warner, ‘On Financial Contracting: An Analysis of Bond Covenants’ (1979) 7 Journal of Financial Economics 117. See also, Victoria Ivashina and others, ‘Bank Debt and Corporate Governance’ (2009) 22 Review of Financial Studies 41; Eugene Fama, ‘What is Different About Banks?’ (1985) 15 Journal of Monetary Economics 29; Christopher James, ‘Some Evidence on the Uniqueness of Bank Loans’ (1987) 19 Journal of Financial Economics 217; Marcel Kahan and David Yermack, ‘Investment Opportunities and the Design of Debt Securities’ (1998) 14 Journal of Law, Economics, & Organization 136; William W. Bratton, ‘Bond and Loan Covenants, Theory and Practice’ (2016) 11 Capital Markets Law Journal 461; Raghuram G. Rajan, ‘Insiders and Outsiders: The Choice between Informed and Arm’s-Length Debt’ (1992) 47 The Journal of Finance 1367; Gary Gorton and James Kahn, ‘The Design of Bank Loan Contracts’ (2000) 13 The Review of Financial Studies 331; Hideki Kanda, ‘Debtholders and Equityholders’ (1992) 21 The Journal of Legal Studies 431; Loretta Mester, Leonard Nakamura and Micheline Renault, ‘Transactions Accounts and Loan Monitoring’ (2007) 20 The Review of Financial Studies 529; Michael Roberts and Michael Schwert, ‘Interest Rates and the Design of Financial Contracts’ (2022) NBER Working Paper 27195. But see the recent working paper by Victoria Ivashina and Boris Vallée, ‘Complexity in Loan Contracts’ (2022) <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3218631> (who also look at non-bank financing and use novel data on 1,240 credit agreements from the leveraged loan market. The authors find at 1 that ‘sophisticated borrowers, and larger non-bank funding of a loan, are associated with more complex contractual terms’).

29 See Sections 3 and 4.

30 Narine Lalafaryan, ‘Private Credit: Debt Looking a Lot Like Equity' (2024) The European Corporate Governance Institute's Blog, <https://www.ecgi.global/publications/blog/private-credit-debt-looking-a-lot-like-equity>; Narine Lalafaryan, ‘How Private Credit Funds Are Making Debt Look a Lot Like Equity' (2024), The CLS Blue Sky Blog, <https://clsbluesky.law.columbia.edu/2024/02/05/how-private-credit-funds-are-making-debt-look-a-lot-like-equity/>; Narine Lalafaryan, ‘Private Credit: Debt Investment Akin to Equity’ (2023) The Oxford Business Law Blog, <https://blogs.law.ox.ac.uk/oblb/blog-post/2023/12/private-credit-debt-investment-akin-equity>; Bloomberg, ‘Private Credit’s Dancing in the Streets Gets Wilder’ (2023), <https://www.bloomberg.com/opinion/articles/2023-07-18/private-credit-the-wild-ride-is-not-yet-over?in_source=embedded-checkout-banner> (referring to Morgan Stanley).

31 At the same time, it is important to acknowledge that insolvency/bankruptcy law has a direct impact on the governance of solvent firms. Debtholders via various control measures ex-ante protect themselves from ex-post costs of insolvency; therefore, the insolvency/bankruptcy regime informs the bargaining and incentives of debtholders, including debtholders' rights in contract and in rem. For examples of influential scholarship in this area see David A. Skeel Jr, ‘An Evolutionary Theory of Corporate Law and Corporate Bankruptcy’ (1998) 51 Vanderbilt Law Review 1323; Triantis and Daniels (n 18) 1073; Lucian A. Bebchuk, ‘The Ex Ante Costs of Violating the Absolute Priority Rule’ (2002) 57 The Journal of Finance 445; Michelle White, ‘The Corporate Bankruptcy Decision’ (1989) 3 Journal of Financial Perspectives 129; Oliver Hart, ‘Different Approaches to Bankruptcy’ (2000) NBER Working Paper 7921, <https://www.nber.org/system/files/working_papers/w7921/w7921.pdf>.

32 See Section 3 “A” Table 2. Private credit strategies include direct lending, mezzanine, special situations, distressed lending, venture debt, real estate debt, and infrastructure debt. The paper focuses on direct lending, as it is the dominant private credit strategy.

33 This paper considers the evolution of corporate finance with respect to private credit and bank financing. Private credit shares similarities with private equity, and venture capital, especially in the context of fund level arrangements. An analysis of various features of private equity and venture capital and their connection to private credit is outside the scope of this paper. An interesting research angle for future work might be to investigate the economic implications of private credit (e.g. financial stability concerns). For examples, see Simon Witney, Corporate Governance and Responsible Investment in Private Equity (Cambridge University Press 2020); Casimiro A. Nigro and Jörg R. Stahl, ‘Venture Capital-Backed Firms, Unavoidable Value Destroying Trade Sales, and Fair Value Protections’ (2021) 22 European Business Organization Law Review 39; Elizabeth Pollman, ‘Startup Governance’ (2019) 168 University of Pennsylvania Law Review 155; Douglas Cumming and Sofia Johan, Venture Capital and Private Equity Contract: An International Perspective (2nd edn, Elsevier 2014); Allen Berger and Gregory Udell, ‘The Economics of Small Business Finance: The Roles of Private Equity and Debt Markets in the Financial Growth Cycle’ (1998) 22 Journal of Banking and Finance 613. These issues are highlighted in Section 2 ‘C’, but can be explored in more detail in the future.

34 See Section 3.

35 See Section 3.

36 See Section 4.

37 See Sections 4 and 5.

38 Zohar Goshen and Richard Squire, ‘Principal Costs: A New Theory for Corporate Law and Governance’ (2017) 177 Columbia Law Review 767.

39 Ronald Coase, ‘The Problem of Social Cost’ (1960) 3 The Journal of Law & Economics 1. The paper does not oppose regulation (i.e. whether private credit funds should or should not be regulated, and to what extent). The question addressed in this paper is how debtholders protect themselves. In the context of regulation, on 26 February 2024, the European Union adopted new rules for private credit funds, with the introduction of leverage limited of 175% for open-ended and 300% for closed-ended funds (amending Directives 2011/61/EU and 2009/65/EC) <https://data.consilium.europa.eu/doc/document/PE-67-2023-INIT/en/pdf>.

40 The term ‘dynamic’ means that debt is evolving and changing. The term ‘adaptable’ means that debt has the capacity and ability to change. On an interesting discussion of the history and key drivers of debt textualism, see Eric L. Talley and Sneha Pandya, ‘Debt Textualism and Creditor-On-Creditor Violence: A Modest Plea to Keep the Faith’ (2023) 171 University of Pennsylvania Law Review 1976. 

41 A search on the Google Scholar platform of the term ‘debt governance’ brings 1,170 results, out of which most of the results do not relate to corporate debt governance but are in the context of sovereign debt. The search of the term ‘creditor governance’ brings 223 results, whereas the search of ‘lender governance’ only 77 results.

42 Shleifer and Vishny (n 26).

43 See Triantis and Daniels (n 18); George G. Triantis, ‘Debt Financing and Motivation’ (1997) 31 University of Richmond Law Review 1323; Baird and Rasmussen (n 19); Tung (n 20); Yadav (n 20).

44 Baird and Rasmussen (n 19); Yadav (n 20).

45 Triantis and Daniels (n 18).

46 See also, Choi and Triantis (n 20).

47 Nini, Smith and Sufi (n 20).

48 See Gullifer and Payne (n 23) 92, 139–162; Day and Taylor (n 20).

49 Gullifer and Penn (n 23), 139–162.

50 Gomtsian (n 21).

51 Ryan Schloessmann, ‘Covenant Control: The Case for Treating Uptier Transactions as a Form of Corporate Control’ (2023) 90 The University of Chicago Law Review 1198, also referencing the decision of Delaware bankruptcy court in In re TPC Group 2022 WL 2498751 (Bankr. D. Del. July 6, 2022).

52 In the United Kingdom, this position was developed through common law. See West Mercia Safetywear v Dodd [1988] 4 BCC 30 (CA). See also, BTI v Sequana [2022] UKSC 25, per Lord Reed at para 8.1. The Supreme Court in Sequana [2022] held that real risk of insolvency is insufficient (‘I am satisfied that the rule in West Mercia does not apply merely because the company is at a real and not remote risk of insolvency at some point in the future.’ (para 14, per Lord Reed, emphasis added)). See also, Sequana [2022] para 83, per Lord Reed; para 199, per Lord Briggs with whom Lord Kitchin agreed; para 306, per Lady Arden. The majority in Sequana [2022] also found that the ‘creditor duty’ is engaged when the directors know, or ought to know, that the company is insolvent or bordering on insolvency, or that an insolvent liquidation or administration is probable. See para 203, per Lord Briggs with whom Lord Kitchin agrees; para 231, per Lord Hodge. Both Lord Reed and Lady Arden left open the question of whether it is essential that the directors know or ought to know that this is the case (see para 90 and 281). As mentioned earlier, the insolvency/bankruptcy regime directly influence the ex-ante governance of solvent firms, as advocated by White (n 31), Triantis and Daniels (n 18), Skeel (n 31), Hart (n 31), Bebchuk (n 31).

53 For a discussion on the interconnectedness of risks in these two markets, see Section 2 ‘C’ below.

54 See also sub-section ‘ii’ below. On the development of the originate-to-distribute model in the banking industry, see Vitaly M. Bord and João A. C. Santos, ‘The Rise of the Originate-to-Distribute Model and the Role of Banks in Financial Intermediation’ (2012) 18 Economic Policy Review 21.

55 See The Bank for International Settlements, ‘Structure Changes in Banking After the Crisis’ (2018) CGFS Papers No 60 <https://www.bis.org/publ/cgfs60.pdf>; Edward P.M. Gardener, ‘The Future of “Traditional Banking”’ in The Recent Evolution of Financial Systems (Palgrave Macmillan 1997), 33–56. See also, James Crotty, ‘Structural Causes of the Global Financial Crisis: A Critical Assessment of the “New Financial Architecture”’ (2009) 33 Cambridge Journal of Economics 563.

56 The Bank for International Settlements, ‘The Syndicated Loan Market: Structure, Development and Implications’ (2004) The BIS Quarterly Review, 75–89 <https://www.bis.org/publ/qtrpdf/r_qt0412g.pdf>.

57 For an overview, see Edward J. Schoen, ‘The 2007–2009 Financial Crisis: An Erosion of Ethics: A Case Study’ (2017) 146 Journal of Business Ethics 805.

58 E.g. Basel 3 and Basel 3.5 regulatory framework for banks in Europe; The Dodd-Frank Act in the United States. See also Stephen M. Bainbridge, Corporate Governance After the Financial Crisis (OUP 2012), 13.

59 Gary Gorton and Andrew Metrick, ‘Regulating the Shadow Banking System’ (2010) Brookings Paper on Economic Activity, 261 <https://www.brookings.edu/wp-content/uploads/2010/09/2010b_bpea_gorton.pdf>

60 Ross Levine, ‘Bank-Based or Market-Based Financial Systems: Which is Better?’ (2022) 11 Journal of Financial Intermediation 398.

61 The Financial Conduct Authority, ‘Market-Based Finance: Its Contributions and Emerging Issues’ (2016) <https://www.fca.org.uk/publications/occasional-papers/occasional-paper-no-18-market-based-finance-its-contributions-and>.

62 For more details on loan transfers, including mechanisms of transfer and reasons for transfers, see Section 3, sub-section ‘E’.

63 Financial Times, ‘LBO Finance: Buyout Groups Push into Lucrative Private Credit’ (2022) <https://www.ft.com/content/29f6cf4b-72ac-486d-a7cc-d772e92f5569>.

64 See Deloitte, ‘Private Debt Deal Tracker’ (Autumn 2022) <https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/corporate-finance/deloitte-uk-pddt-autumn-2022.pdf>. See also, Stephen L. Nesbitt, Private Debt: Yield, Safety and the Emergence of Alternative Lending (Wiley 2023); Stephen L. Nesbitt, ‘Credit as a Separate Asset Class’ in Private Debt: Opportunities in Direct Lending (Wiley 2019).

65 Fidelity International, ‘Private Debt: From Dinosaur to Dynamic Funding Model’ (2022), <https://www.fidelityinternational.com/editorial/article/private-debt-from-dinosaur-to-dynamic-funding-model-6b44ea-en5/>.

66 Perry Mehrling and others, ‘Bagehot was a Shadow Banker: Shadow Banking, Central Banking, and the Future of Global Finance’ (2013) New York: Institute for New Economic Thinking <https://www.ceu.edu/sites/default/files/attachment/event/6574/nov05-perry-mehrling.pdf>.

67 The Federal Reserve Bank of New York, ‘Shadow Banking’ (2013) 19 Economic Policy Review, at 1.

68 Preqin, Preqin Global Report 2023: Private Debt (2023).

69 Yale Insights, ‘Can We Reduce Risk from the Shadow Banking System?’ (2022) interview of Prof. Janet L. Yellen <https://insights.som.yale.edu/insights/can-we-reduce-risk-from-the-shadow-banking-system>.

70 S&P Global, ‘Private Debt: A Lesser-Known Corner of Finance Finds the Spotlight’ (2021) <https://www.spglobal.com/en/research-insights/featured/private-debt>. The European Central Bank, ‘The Rise of Non-bank Finance and Its Implications for Monetary Policy Transmission’ (2021) <https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp210824~9ab47b501b.en.html>.

71 Preqin Preqin Global Report 2023(n 69).

72 Research and Markets, ‘Venture Capital Investment Global Market Report 2023’ (May 2023) (noting that the size of the global venture capital market was $207.74 billion in 2022, with projections to growth to $251.54 billion in 2023).

73 Bloomberg (n 30) (referring to Morgan Stanley).

74 This is an estimate provided by various data providers.

75 Financial Times, ‘The Real Risk of Private Credit Does Not Lie in Misbehaviour on Wall Street’ (2023) <https://www.ft.com/content/06bb4967-7d38-46f1-9078-f8761814c8af>; Bloomberg, ‘Private Credit’s Quiet, Unstoppable Rise Comes with Unknown Risk’ (2023) <https://www.bloomberg.com/news/articles/2023-06-16/wall-street-s-hot-new-thing-is-private-credit-a-cousin-of-private-equity?leadSource=uverify%20wall>.

76 See Vitaly M. Bord, Victoria Ivashina and Ryan D. Taliaferro, ‘Large Banks and Small Firm Lending’ (2021) 48 Journal of Financial Intermediation 100924. See also, Financial Times, ‘Private Credit Finds Its Next Big Target: Investment-grade Debt’ (2023) <https://www.ft.com/content/271be286-ac12-449e-96f0-0d3ff9b4d6ee>.

77 S&P Global, ‘Global Credit Outlook 2023: No Easy Way Out’ (2022), 26.

78 Bloomberg, ‘Record $4.8 Billion Private Loan Refinances Vista’s Finastra’ (2023) <https://www.bloomberg.com/news/articles/2023-08-14/vista-nears-record-4-8-billion-private-loan-for-finastra-refi?leadSource=uverify%20wall>; Bloomberg, ‘Adevinta Private Credit Deal Oversubscribed by Over $2.7 Billion’ (2023) <https://www.bloomberg.com/news/articles/2023-12-18/adevinta-private-credit-deal-oversubscribed-by-over-2-7-billion?leadSource=uverify%20wall>.

79 On the other hand, a single private credit fund is also in a position to provide a large-scale financing. For example, Softbank obtained $5.1 billion direct corporate credit facility from Apollo. See, Bloomberg, ‘Apollo Increases SoftBank Loan to $5.1 Billion from $4 Billion’ (2023) <https://www.bloomberg.com/news/articles/2022-03-24/apollo-increases-softbank-loan-to-5-1-billion-from-4-billion#xj4y7vzkg>.

80 Ares Management, ‘Ares Management Acquires $3.5 Billion Lender Finance Portfolio from Pacific Western Bank’ (2023) <https://ir.aresmgmt.com/news/ares-management-acquires-3-5-billion-lender-finance-portfolio-from-pacific-western-bank/8d2916c8-6669-4cbd-b1f7-60f976ea7cb0/>.

81 Blackstone, ‘Blackstone Closes Record Energy Transition Private Credit Fund at Over $7 Billion’ (2023) <https://www.blackstone.com/news/press/blackstone-closes-record-energy-transition-private-credit-fund-at-over-7-billion/>.

82 Wolfspeed Inc. raised $ 1.25 billion from Apollo and other managers. See CNBC, ‘New Trend Sees Public Borrowers Turning to Private Credit for Capital’ (2023) <https://www.cnbc.com/video/2023/06/26/new-trend-sees-public-borrowers-turning-to-private-credit-for-capital.html>. Other examples of obtaining private credit financing by large public companies include the multinational telecom company AT&T, the airline company Air France-KLM, and multinational real-estate company Vonovia. See, Financial Times, ‘Apollo Chief Warns Private Equity Industry “in Retreat” as Rates Rise’ (2023) <https://www.ft.com/content/7d24db29-9046-42d3-a221-efb9e54db702>. See also, Sergey Chernenko, Isil Erel and Robert Prilmeier, ‘Why Do Firms Borrow Directly from Nonbanks?’ (2022) The Review of Financial Studies 1-46. An earlier example is Hertz Holding Inc. obtaining $4 billion fleet financing from Apollo.

83 Goldman Sachs, ‘Eyes on the Horizon’ (2023) <https://www.gsam.com/content/dam/pwm/direct-links/us/en/PDF/onegs_familyoffice_eyesonthehorizon.pdf?sa=n&rd=n> (surveying 166 institutional family offices, where a big number of family offices (30%) announced planning to increase their allocations to private credit).

84 Narine Lalafaryan, ‘How Private Credit Funds Are Making Debt Look a Lot Like Equity’ (2024) CLS Blue Sky Blog <https://clsbluesky.law.columbia.edu/2024/02/05/how-private-credit-funds-are-making-debt-look-a-lot-like-equity>; Narine Lalafaryan, ‘Private Credit: Debt Investment Akin to Equity’ (2023) Oxford Business Law Blog <https://blogs.law.ox.ac.uk/oblb/blog-post/2023/12/private-credit-debt-investment-akin-equity>.

85 Financial Times, ‘The New LBO Market: It’s Gone Private’ (2023) <https://www.ft.com/content/0758d47f-ed50-47b5-bea1-20946271bc6a>.

86 Preqin Preqin Global Report 2023 (n 69) 5.

87 Ernst & Young, ‘Eurozone Bank Lending Growth Forecast to Fall This Year and Next, as Rising Interest Rates Drive a Drop in Loan Demand’ (2023) <https://www.ey.com/en_ro/news/2023/06/eurozone-bank-lending-growth-forecast-to-fall-this-year-and-next>.

88 The Financial Stability Board (n 9).

89 Heather Waters Borthwick, Tomasz Kulawik and Andrew Mavers, ‘Rise of the Jumbo Unitranche: A Continued Trend in 2022?’ (2022) Journal of International Banking and Financial Law <https://www.shearman.com/-/media/files/perspectives/2022/03/rise-of-the-jumbo-unitranche-a-continuing-trend-in-2022.pdf>.

90 Including the private debt deals in the UK.

91 Deloitte, ‘Alternative Lender Deal Tracker’ (2022) <https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/corporate-finance/deloitte-uk-aldt-spring-2022.pdf>.

92 Deloitte, ‘Private Debt Deal Tracker: Q3 2022 Key Findings’ (2023) <https://www2.deloitte.com/uk/en/pages/financial-advisory/articles/private-debt-deal-tracker.html>.

93 Preqin, ‘Private Debt Q2 2023: Preqin Quarterly Update’ (2023) <https://www.preqin.com/insights/research/quarterly-updates/q2-2023-private-debt>.

94 PitchBook, ‘Private-debt Market Braces for Stormy Seas’ (2023) <https://pitchbook.com/news/articles/private-debt-market-downturn-weekend-analysis>.

95 PitchBook (n 96).

96 Bloomberg, ‘Private Credit Funds Get Pickier as Downturn Fears Intensify’ (2023) <https://www.bloomberg.com/news/articles/2023-01-05/private-credit-funds-get-pickier-as-fears-of-recession-intensify?leadSource=uverify%20wall>, see also, Financial Times, ‘The Private Credit “Golden Moment”’ (2023) <https://www.ft.com/content/42297b43-7918-4734-b6d5-623c6d6fa00f>.

97 Moody’s Analytics, ‘Private Credit: How Much is Too Much in a Credit Portfolio?’ (2023) <https://www.moodysanalytics.com/articles/2023/private-debt-how-much-is-too-much-in-a-credit-portfolio>.

98 Moody’s Analytics (n 99).

99 S&P Global, ‘When Rates Rise: Risks to Global Banks Could Emerge from the Shadows’ (2023) <https://www.spglobal.com/_assets/documents/ratings/research/101572746.pdf> (referring to Prequin’s December 14 2023 Outlook Report). See also, Goldman Sachs, ‘Private Credit may Outperform Public Bonds as Defaults Rise’ (11 May 2023) <https://www.goldmansachs.com/intelligence/pages/private-credit-may-outperform-public-bonds-as-defaults-rise.html> Deloitte, ‘Private Debt Deal Tracker’ (Spring 2023) <https://www2.deloitte.com/content/dam/Deloitte/uk/Documents/corporate-finance/deloitte-uk-pddt-spring-2023.pdf>.

100 See also, Victoria Ivashina and Anna Kovner, ‘The Private Equity Advantage: Leveraged Buyout Firms and Relationship Banking’ (2011) 24 The Review of Financial Studies 2462.

101 This has been the case for the past 15 years; more recently private credit funds also started provided financing to investment grade firms.

102 Jeffrey Kramer, Texas Private Equity Conference 2022, ‘The Role of Private Equity and Debt in Reshaping the Ownership, Valuation, and Governance of Private Companies’ (2022) 43 Journal of Applied Corporate Finance, 66.

103 An example is Ares Management Corporation raising about $1.5 billion for its new fund for high-net-worth clients. See Ares, ‘Ares Strategic Income Fund Launches with 1.5 Billion of Investible Capital’ (2023) <https://ir.aresmgmt.com/news/ares-strategic-income-fund-launches-with-1-5-billion-of-investible-capital/74a01fc8-505f-4bf0-ac0f-c966a0511c05/>.

104 The International Monetary Fund, ‘What is Shadow Banking?’ (2013) 50 Finance and Development.

105 See also, the Alternative Credit Council in partnership with Allen & Overy LLP, ‘Financing the Economy 2022’ (2022) <https://acc.aima.org/compass/insights/private-credit/financing-the-economy-2022.html>.

106 For a further discussion, see Section 3.

107 Deloitte, ‘Alternative Lender Deal Tracker’ (n 93) 1–71.

108 Deloitte (2022).

109 Deloitte (2022).

110 Oaktree Capital Management, ‘Direct Lending: Benefits, Risks and Opportunities’ (May 2021) <https://www.oaktreecapital.com/docs/default-source/default-document-library/direct-lending.pdf?sfvrsn=347d7e66_4#:~:text=These%20include%20maintenance%2Dbased%20covenants,EBITDA%20below%20a%20specific%20level>.

111 For a further discussion, see Section 3 ‘E’.

112 Deloitte, ‘Private Debt Deal Tracker’ (Spring 2023), at 25 (also noting that from 4,290 total deals, 1,472 deals were completed in the UK, whereas 2,818 were completed in the rest of Europe).

113 First lien debt means that the holders of the first lien debt are entitled to be paid back prior to all other debtholders.

114 ‘RCF’ stands for a revolving credit facility.

115 ‘TL’ stands for a term loan.

116 Eilís Ferran, Elizabeth Howell and Felix Steffek, Principles of Corporate Finance Law (3rd edn, OUP 2023), at 342 (noting that ‘Unitranche facilities have become more popular in the last decade as an alternative to syndicated loans and complex lending structures. A unitranche facility is a term loan consisting of a single tranche and documented in a single loan agreement with a blended senior/junior interest rate’).

117 Deloitte, ‘Private Debt Deal Tracker’ (Spring 2023), 25.

118 From the unitranche deals (> euro 300 million) reported since the inception of Deloitte’s Deal Tracker, the largest private credit deal (unitranche financing) in the amount of £3,5 billion was to the borrower Access Group in the UK in June 2022. It was provided by a private club of lenders (Park Square, Bain, SMBC, Blackstone Credit, Apollo, HPS, Arcmont), see Deloitte, ‘Private Debt Deal Tracker’ (Spring 2023), at 30.

119 Axel Buchner et al., ‘Private Debt and the Role of Venture Capital and Private Equity Sponsors’ (2023) Management Science 1–24.

120 Young Soo Jang, ‘Are Direct Lenders More Like Banks or Arm’s-Length Investors?’ (2024) working paper <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4529656>.

121 Jang, ‘Are Direct Lenders’ (n 122).

122 © Joern Block and others, ‘A Survey of Private Debt Funds’ (2023 January) NBER working paper 30868 <https://www.nber.org/papers/w30868>

123 © Block et al., ‘A Survey of Private Debt Funds’ (n 124).

124 Pascal Böni and Sophie Manigart, ‘Private Debt Fund Returns, Persistence, and Market Conditions’ (2022) 78 Financial Analysts Journal 121.

125 For an earlier work on the performance of private credit funds, see Shawn Munday and others, ‘Performance of Private Credit Funds: A First Look’ (2018) The Institute for Private Capital 1–36 (Munday et al., study absolute and relative performance of private credit funds by relying on a private database of institutional quality private credit funds).

126 Ridoy Nath and Mohammad Chowdhury, ‘Shadow Banking: A Bibliometric and Content Analysis’ (2021) 68 Financial Innovation, referring to CL Culp and AM Neves, ‘Shadow Banking, Risk Transfer, and Financial Stability’ (2017) 29 Journal of Applied Corporate Finance 45.

127 Chernenko et al. (n 84) at 1 (finding that ‘Firms with negative EBITDA and debt/EBITDA greater than six are 32% and 15% more likely to borrow from nonbanks. These firms pay significantly higher interest rates, especially following the 2013 leveraged loan guidance revisions. Nonbank borrowers also receive different nonprice terms compared to firms borrowing from banks’). The firms in Chernenko et al.’s (n 84) study are middle-market firms, which are defined as firms with sales between $10 million and $1billion.

128 Chernenko et al. (n 84) at 1-46.

129 Chernenko et al. (n 84) at 1.

130 Tetiana Davydiuk, Tatyana Marchuk and Samuel Rosen, ‘Direct Lenders in the U.S. Middle Market’ (2024) working paper <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3568718>. See also, Böni and Manigart (n 126).

131 The Financial Conduct Authority, ‘Shadow Banking – The Potential Risks and Rewards’ (2017) <https://www.fca.org.uk/insight/shadow-banking-potential-risks-and-rewards>.

132 The World Bank, ‘Growth of Global Corporate Debt: Main Facts and Policy Challenges’ (2021), 2 <https://openknowledge.worldbank.org/handle/10986/34480>.

133 The Bank for International Settlements, ‘Non-bank Lenders in the Syndicated Loan Market’ (2022) The BIS Quarterly Review, 1–29 <https://www.bis.org/publ/qtrpdf/r_qt2203c.pdf>.

134 Victoria Ivashina and Boris Vallée (n 28) (working paper), 4.

135 Financial Times, ‘EU Tightens Rules on Leverage for Private Credit Funds’ (2023) <https://www.ft.com/content/2ab74817-5b14-4110-9815-a7549621b521>.

136 See Financial Times, ‘Marc Rowan’s ‘Great Times’ Private Credit Speech’ (2023) <https://www.ft.com/content/aa982bca-5696-45f2-9141-b07194b3f972>.

137 As mentioned in Section 1, a detailed discussion of macro-economic risks of private credit, including financial stability concerns, is beyond the scope of this paper.

138 Cambridge Associates LLC, ‘Private Credit Strategies: An Introduction’ (2017) <https://www.cambridgeassociates.com/insight/private-credit-strategies-introduction/>.

139 Greg Feldberg and Carey Mott, ‘The 2023 Banking Crisis: Lessons about Bail-in’ (2023) Yale School of Management <https://som.yale.edu/story/2023/2023-banking-crisis-lessons-about-bail>.

140 The Bank of England, ‘Financial Stability Report’ (July 2023), 81 (also noting at 9, that ‘Riskier corporate borrowing in financial markets – such as private credit and leveraged lending – appears particularly vulnerable […]’).

141 The Bank of England (n 142) 81, referring to The Federal Reserve’s ‘Financial Stability Report’ (May 2023) <https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf>.

142 The Financial Stability Board (n 9) 17–25.

143 The World Bank, ‘Finance for an Equitable Recovery: World Development Report’ (2022), 3 <https://documents1.worldbank.org/curated/en/408661644986413472/pdf/World-Development-Report-2022-Finance-for-an-Equitable-Recovery.pdf>.

144 For a further discussion of debtholders’ rights in these two markets, see Section 3, including Table 2.

145 Sarah Paterson, ‘The Rise of Covenant-lite Lending and Implications for the UK’s Corporate Insolvency Law Toolbox’ (2019) 39 Oxford Journal of Legal Studies 654.

146 There is also the difference between the level of regulation of these two groups. Banks are highly regulated. Private credit funds are not subject to the banking regulation. They, however, are regulated as asset managers.

147 Isil Erel and Eduard Inozemtsev, ‘Evolution of Debt Financing Toward Less Regulated Financial Intermediaries’ (2024) NBER Working Paper No. w32114 <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4716678>. See also, Calebe de Roure, Loriana Pelizzon and Anjan Thakor, ‘P2P Lenders versus Banks: Cream Skimming or Bottom Fishing?’ (2022) 11 The Review of Corporate Finance Studies 213; Rustom M. Irani and others, ‘The Rise of Shadow Banking: Evidence from Capital Regulation’ (2021) 34 The Review of Financial Studies 2181; Mitchell Berlin, Greg Nini and Edison G. Yu, ‘Concentration of Control Rights in Leveraged Loan Syndicates’ (2020) 137 Journal of Financial Economics 249.

148 Mehdi Beyahaghi, Ca Nguyen and John K. Walk, ‘Institutional Investors and Loan Dynamics: Evidence from Loan Renegotiations’ (2019) 56 (C) Journal of Corporate Finance 482.

149 Lalafaryan (n 22) 18.

150 Jan Keil, ‘Lending Relationships when Creditors are in Control’ forthcoming Journal of Corporate Finance 30.

151 Basel III endgame.

152 Although this paper does not focus on the banking regulation and supervision, it is worth mentioning that The United States Federal Reserve, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation proposed a new framework which would apply to banks with more than $100 billion in assets and which could erase almost all of the $118 billion in excess capital that banks put aside. According to this new proposal, banks will have to hold 16% more capital and will have time until the start of 2028 to comply with the new rules.

153 Block et al. ‘A Survey of Private Debt Funds’ (n 124), and Jang, ‘Are Direct Lenders’ (n 122).

154 This is in line with the proposition by Peter Huang and Michael Knoll, ‘Corporate Finance, Corporate Law and Finance Theory’ (2000) 74 Southern California Law Review 175 (noting that the connecting theme in various topics and aspects of corporate finance is the notion that capital structure can create value).

155 Typically, these directors are less active compared to the directors nominated by the private equity firm, where, for instance, in the context of a buyout transaction private equity firms will nominate two directors on the board.

156 © Joern Block and others, ‘A Survey of Private Debt Funds’ (January 2023) University of Chicago, Working Paper No. 2023-10, at 18 <https://bfi.uchicago.edu/wp-content/uploads/2023/01/BFI_WP_2023-10.pdf>.

157 © Block et al., ‘A Survey of Private Debt Funds’ (n 160), 19.

158 © Block et al., ‘A Survey of Private Debt Funds’ (n 160), 19.

159 Jang (2023).

160 © Block et al., ‘A Survey of Private Debt Funds’ (n 160), 19 referring to Jang, ‘Are Direct Lenders’ (n 122).

161 Participation of investors (LPs) in the profits of the private credit fund.

162 Corporate Finance Institute <https://corporatefinanceinstitute.com/resources/valuation/internal-rate-return-irr/> (‘IRR is the expected compound annual rate of return that will be earned on a project or investment’).

163 Deloitte, ‘Private Debt Deal Tracker’ (2023), 55.

164 Deloitte, (2023), 55.

165 Cambridge Associates LLC <https://publishedresearch.cambridgeassociates.com/wp-content/uploads/2017/09/201709_PrivateCreditIntro_3.png> (IRR ranging from minimum 6% to maximum 20% depending on the private credit strategy).

166 The traditional approach in corporate finance theory is that debt providers are entitled to receive the main debt sum and an interest on top of their debt investment, but unlike shareholders, who participate in profit sharing, if the borrower-firm does well creditors will not benefit from this (i.e. no entitlement to share in firm profits).

167 Axel Buchner et al. (n 121).

168 Buchner et al. (n 121) 16–17.

169 Eilís Ferran, Elizabeth Howell, Felix Steffek, Principles of Corporate Finance Law (3rd edn, OUP 2023), 342–343.

170 ‘EBITDA’ stands for Earnings before Interest, Taxes, Depreciation, and Amortization.

171 Gullifer and Payne (n 23) 220.

172 ‘LMA’ stands for the Loan Market Association.

173 Gullifer and Payne (n 23), Gullifer and Penn  (n 23).

174 Eugene F. Fama, ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (1970) 25 The Journal of Finance 383; Eugene F. Fama, ‘Efficient Capital Markets II’ (1991) 46 The Journal of Finance 1575.

175 Sylvain Bouteillé and Diane Coogan-Pushner, ‘Fundamentals of Credit Risk’ in The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures (Wiley 2013), 3.

176 Mark Laycock, ‘Risk Oversight’ in The Risk Management at the Top: A Guide to Risk and its Governance in Financial Institutions (Wiley, 2014), 11–13.

177 Repeating representations will be expressed to be by reference to the facts and circumstances prevailing at the time of the repetition.

178 Bouteillé and Coogan-Pushner (n 179) 4.

179 Bouteillé and Coogan-Pushner (n 179) 4.

180 The term ‘credit exposure of a loan’ denotes the notional amount of the loan.

181 The term ‘EBITDA’ stands for earnings before interest, tax, depreciation, and amortisation.

182 Gârleanu and Zweibel (n 27) 749–781 (finding that, ‘[…] 15%-20% (depending on the type of covenant) of outstanding loans are in violation during a typical quarter, and conditional on violating a covenant, a loan is delinquent about 40% of the time’).

183 The Loan Market Association (‘LMA’) and The Loan Syndications and Trading Association (‘LSTA), ‘Sustainability Linked Loan Principles’ (February 2023), ‘Guidance on Sustainability Linked Loan Principles’ (February 2023); ‘Social Loan Principles’ (February 2023), ‘Guidance on Social Loan Principles’ (February 2023); ‘Green Loan Principles’ (February 2023), ‘Guidance on Green Loan Principles’ (February 2023), <https://www.lsta.org/app/uploads/2023/02/LSTA-Sustainable-Lending-Library-Feb-2023.pdf>.

184 John Armour, Henry Hansmann and Reiner Kraakman, ‘Agency Problems and Legal Strategies’ Ch. 2 in The Anatomy of Corporate Law (3rd edn, Oxford University Press 2017). At the same, there is also the risk of greenwashing. See John Armour, Luca Enriques and Thom Wetzer, ‘Mandatory Corporate Climate Disclosures: Now, but How?’ (2022) 2021 (3) Columbia Business Law Review. See also, Sehoon Kim and others, ‘ESG Lending’ (2023) ECGI Working Paper No 817/2022 <https://papers.ssrn.com/sol3/Papers.cfm?abstract_id=3865147>.

185 The European Leveraged Finance Association (n 9).

186 Claire Hill, ‘Why Did Rating Agencies Do Such a Bad Job Rating Subprime Securities?’ (2010) 71 University of Pittsburgh Law Review 585.

187 Laycock (n 180) 13 [emphasis added].

188 In the UK, this position was affirmed in BTI 2014 LLC v Sequana SA and others [2022] UKSC 25.

189 See Robert C. Merton, ‘On the Pricing of Corporate Debt: The Risk Structure of Interest Rates’ (1974) 29 The Journal of Finance 449.

190 Greg Nini, David C. Smith and Amir Sufi, ‘Creditor Control Rights, Corporate Governance, and Firm Value’ (2012) 25 The Review of Financial Studies 1713.

191 Michael R. Roberts, ‘The Role of Dynamic Renegotiation and Asymmetric Information in Financial Contracting’ (2015) 116 Journal of Financial Economics 61–81 (noting at 61, that ‘The pricing, maturity, amount, and covenants are all significantly modified during each renegotiation, whose timing is governed by the financial health of the contracting parties and uncertainty regarding the borrowers’ credit quality’).

192 Gârleanu and Zweibel (n 27). See also, Sudheer Chava and Michael R. Roberts, ‘How Does Financing Impact Investment? The Role of Debt Covenants’ (2008) 63 The Journal of Finance 2085.

193 As liquidity has become a bigger issue recently, similarly to the private equity industry, there is a rise in what is known as ‘continuation funds’ in private credit. A discussion of continuation funds is beyond the scope of this paper. On a discussion of private equity continuation funds, see Kobi Kastiel and Yaron Nili, ‘The Rise of Continuation Funds’ (2024) University of Pennsylvania Law Review.

194 The credit risk of the firm may also be influenced by macro and micro-environment.

195 George A. Akerlof, ‘The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanism’ (1970) 84 Quarterly Journal of Economics 488.

196 Garleanû and Zweibel (n 27); ini et al. (n 194). See also the sub-section on debt covenants and empirical evidence in Section 3. 

197 Michael R. Roberts and Amir Sufi, ‘Renegotiation of Financial Contracts: Evidence from Private Credit Agreements’ (2009) 93 Journal of Financial Economics 159 (noting at 159 that, ‘Using a large sample of private credit agreements between U.S. publicly traded firms and financial institutions, [the authors] show that over 90% of long-term debt contracts are renegotiated prior to their stated maturity’).

198 Rasmussen and Baird (n 19) 1209–1251 (noting at 1244 that, ‘Most large loans are arranged by a lead bank, but financed by a syndicate of banks. This allows banks to spread their risk. The lead bank does not typically sell its interest. There is, however, a secondary market for those portions of the loan held by other members of the syndicate. The possibility of creditor control may matter as much as whether it is actually exercised, and even more than the threat of a hostile takeover. Any new lender has to worry about the private information held by the existing lender. The existing lender may want to withdraw for reasons that are not yet plain to outsiders. Any new lender is in any event bound to insist upon its own control rights to protect itself’).

199 E.g. Basel 3 regulation.

200 Gullifer and Payne (n 23) 435–438.

201 Gullifer and Payne (n 23) 435.

202 Steven L. Schwarcz, ‘Rethinking Corporate Governance for a Bondholder Financed, Systematically Risky World’ (2017) 58 William and Mary Law Review 1335.

203 Schwarcz, ‘Rethinking Corporate Governance’ (n 206) 1344–1345. See also, Steven L. Schwarcz, ‘Rethinking a Corporation’s Obligations to Creditors’ (1996) 17 Cardozo Law Review 647.

204 Phillip Wood, ‘Bondholders and Banks—Why the Difference in Protections?’ (2011) 6 Capital Markets Law Journal 188.

205 Loan selling by banks, however, is becoming more difficult given the macroeconomic conditions.

206 Charles Whitehead, ‘Debt and Corporate Governance’ in J. Gordon and G. Ringe (eds) The Oxford Handbook of Corporate Law and Governance (OUP 2018).

207 Sandeep Dahiya, Manju Puri and Anthony Saunders, ‘Bank Borrowers and Loan Sales: New Evidence on the Uniqueness of Bank Loans’ (2003) 76 The Journal of Business 563.

208 Steven Drucker and Manju Puri, ‘On Loan Sales, Loan Contracting, and Lending Relationships’ (2009) 22 The Review of Financial Studies 2835.

209 Whitehead (n 210) Ch. 18.

210 Graham Penn, ‘Promoting Liquidity in the Secondary Loan Market: Is Sub-Participation Still Fit For Purpose?’ (2022) 37 Journal of International Banking Law and Regulation 85.

211 Penn (n 214) 85.

212 Jeremy McClane, ‘Corporate Non-Governance’ (2020) 44 Delaware Journal of Corporate Law 1.

213 Recent practical examples of banks having troubles to offload debt and incurring losses as a result, include the debt deals of Twitter Inc., Nielsen Holdings Plc, and Citrix Systems Inc. See Bloomberg, ‘Banks Stuck with $42 Billion Debt Seize Chance to Offload It’ (2022) <https://www.bloomberg.com/news/articles/2022-11-29/banks-stuck-with-42-billion-debt-seize-chance-to-offload-it#xj4y7vzkg>. See also Section 4.

214 McClane (n 216).

215 Penn (n 214).

216 See Sandeep Dahiya et al. (n 211) (noting at 563 that ‘[…] a large proportion of these borrowers file for bankruptcy after the loan sale. The evidence supports the hypothesis that the news of a bank loan sale conveys negative certification, which is validated by the subsequent performance of the firms whose loans are sold’).

217 See also Section 4, sub-section A ‘i’.

218 Bloomberg, ‘Banks Stuck with X Debt Held Refinancing Talks with Elon Musk’ (March 2024) <https://www.bloomberg.com/news/articles/2024-03-04/banks-stuck-with-x-debt-held-refinancing-talks-with-elon-musk?utm_source=website&utm_medium=share&utm_campaign=copy&leadSource=uverify%20wall>.

219 Gullifer and Payne (n 23) 95. See, Patrick Bolton and Martin Oehmke, ‘Credit Default Swaps and the Empty Creditor Problem’ (2011) 24 The Review of Financial Studies 2617.

220 Gullifer and Payne (n 23) 486; Penn (n 214).

221 Gullifer and Payne (n 23) 220 (noting that ‘Where loans are transferable, however, the ability to transfer the loan for a good price may be more important to the lender than the absolute credit risk, since the lender may have little intention of keeping the loan until it is due to be repaid’).

222 Some of the loan transfer mechanisms (e.g., assignment or novation), but not all (e.g., sub-participation) enable lenders to cease their relationship with the borrower. For further details, see Gullifer and Payne (n 23) 437–438 and 478. See also, Rafal Zakrzewski and Geoffrey Fuller, McKnight and Zakrzewski on the Law of Loan Agreements and Syndicated Lending (OUP 2019), 234–237.

223 See Jeremy McClane, ‘Reconsidering Creditor Governance in a Time of Financial Alchemy’ (2020) 2020 Columbia Business Law Review 101.

224 Tung (n 20) 166 (noting that, ‘Overall, the evidence suggests that while syndication and secondary loan trading might theoretically dampen bank’s monitoring incentives, lead banks and selling banks anticipate and address this concern for the benefit of syndicate members and loan purchasers, respectively. Lead banks have reputational stakes in refraining from opportunism in a syndication, and both lead banks and selling banks take steps to bond themselves as monitors’).

225 A practical example of such a situation is The Twitter deal. A detailed discussion of this deal is beyond the scope of this paper.

226 This is also in line with the recent literature, advocating for the role of debt in dual class share structures. See Dey, Nikolaev and Wang (n 24).

227 The UK Companies House, ‘Companies Register Activities: 2022 to 2023’ (2023) https://www.gov.uk/government/statistics/companies-register-activities-statistical-release-2022-to-2023/companies-register-activities-2022-to-2023

228 The UK Companies House, ‘Companies Register Activities: 2021 to 2022’ (2022) https://www.gov.uk/government/statistics/companies-register-activities-statistical-release-2021-to-2022

229 The UK Companies House, ‘Companies Register Activities: 2020 to 2021’ (2021) https://www.gov.uk/government/statistics/companies-register-activities-statistical-release-2020-to-2021

230 The UK Companies House, ‘Companies Register Activities: 2021 to 2022’ (n 232).

231 The UK Companies House, ‘Companies Register Activities: 2020 to 2021’ (n 233).

232 The UK Companies House, ‘Companies Register Activities: 2022 to 2023’ (n 231).

233 Jared Ellias and Elisabeth de Fontenay, ‘Law and Courts in an Age of Debt’ (2023) 171 University of Pennsylvania Law Review 2025, referring to Steven N. Kaplan and Per Strömberg, ‘Leveraged Buyouts and Private Equity’ (2009) 23 Journal of Economic Perspectives 121.

234 Ellias and de Fontenay (2023), referring to Goshen and Squire (n 39).

235 The International Monetary Fund, IMF Datamapper, ‘Nonfinacial corporate Debt, Loans and Debt Securities’ (2021) <https://www.imf.org/external/datamapper/NFC_LS@GDD/SWE>.

236 Reuters (n 16) (referring to a report by Janus Henderson).

237 Franco Modigliani and Merton H. Miller, ‘The Cost of Capital, Corporate Finance and the Theory of Investment’ (1958) 48 The American Economic Review 261.

238 See Oliver Williamson, ‘Corporate Governance’ in Claire A. Hill and Brett H. McDonell (eds) Economics of Corporate Law (Vol. I) (2016).

239 Goshen and Squire  (n 39).

240 Frank Easterbrook, ‘Two Agency-Cost Explanations of Dividends’ (1984) 74 The American Economic Review 653.

241 Dorothy S. Lund, ‘Corporate Finance for Social Good’ (2021) 121 Columbia Law Review 1618.

242 Michael C. Jensen, ‘Agency Costs of Free Cash Flow, Corporate Finance, and Takeovers’ (1986) 76 The American Economic Review 324.

243 Buchner et al. (n 121) 4 and 21. See also, Lily Fang, Victoria Ivashina and Josh Lerner, ‘Combining Banking with Private Equity Investing’ (2013) 26 Review of Financial Studies 2139.

244 Buchner et al. (n 121) 4.

245 Buchner et al. (n 121) 4.

246 Aneel Keswani, Anh Tran and Paolo Volpin, ‘Institutional Debtholder Governance’ (2021) 56 Journal of Financial and Quantitative Analysis 2103, 2103–2107.

247 Keswani et al. (n 250) 2103.

248 Keswani et al. (n 250) 2103–2107.

249 Ellias and de Fontenay (n 237). See also, Elisabeth de Fontenay, ‘The Use of Debt in Corporate Finance’ in Encyclopedia of Law and Economics (2nd end, Gerrit De Geest, Edward Elgar Publishing), 179–206.

250 See David Kershaw, The Foundations of Anglo-American Corporate Fiduciary Law (Cambridge University Press 2018). See also The UK Companies Act 2006, ss. 170–177.

251 Ellias and de Fontenay (n 237), 1–4.

252 Sequana [2022] at [52], per Lord Reed.

253 Ellias and de Fontenay  (n 237) 35. See also, Elisabeth de Fontenay, ‘The Use of Debt in Corporate Finance’ in Encyclopedia of Law and Economics (2023).

254 The ranking of debt in the capital structure remains ahead of equity in the UK. This was additionally reaffirmed by The Bank of England as a clarification on the position of creditors in the UK, after the Swiss regulator allowed to wipe out AT1 bondholders of Credit Suisse. See The Bank of England, ‘Bank of England Statement: UK Creditor Hierarchy’ (2023) https://www.bankofengland.co.uk/news/2023/march/boe-statement-uk-creditor-hierarchy. See also, Javier Paz Valbuena and Horst Eidenmüller, ‘Bailouts Blues: The Write-Down of the AT1 Bonds in the Credit Suisse Bailout’ (2023) European Corporate Governance Institute – Law Working Paper No. 705/2023.

255 See The British Private Equity and Venture Capital Association, ‘Guide to Private Equity Debt Funds’ <https://www.bvca.co.uk/Portals/0/library/documents/Guide%20to%20PE%20Fund%20Finance/Debt%20Fund%20Guide-May14-web.pdf> (noting at 8 ‘Tax topics for debt funds’, that ‘These taxes, if they arise, often represent investment return ‘leakage’, which means even if the fund’s investors may in principle qualify for exemptions from relevant withholding taxes (e.g., as tax-exempt or treaty-protected investors) or for relief under a foreign tax crediting system (e.g., as taxable investors), in practice it may be difficult to utilise those exemptions or credits. A debt fund thus prefers, where possible, to have a strategy to minimise or eliminate these taxes without having to look to the particular status of its investors, and to back this up with contractual gross-up in the deal documents for withholding tax on interest.’) [emphasis added].

256 Narine Lalafaryan, ‘Private Capital and The Firm’ (working paper).

257 There is scope for interesting research in behavioural economics to understand behavioural changes of modern-day institutional and retail debt investors and their increasing interest in private credit.