A Brief Legal Introduction to Private Credit

Governance, ownership, and financing today are very different from how we were traditionally taught in commercial law. Ownership is increasingly concentrated through funds (private equity, venture capital, or public funds, but managed by a limited number of administrators), rather than through personal structures. No one wants to issue shares or debt as securities anymore; instead, they seek private financing. The securities market has also evolved into a mechanism for overseeing matters beyond investments, turning corporate governance into a magician’s hat capable of anything.

Financing, although it changed, initially moved in the opposite direction (towards the public markets), only to later shift back (towards the private sphere).

Historically, companies requested loans from banks with collateral, or from the market without collateral (bonds—although, for example, in Chile the Securities Market Law allows issuance with collateral in favor of bondholders). Banks lent from their balance sheets, using part of their capital at their own risk, or from the portion of the balance sheet corresponding to depositors.

This scenario later evolved into something closer to the public market. That is, from a private market between banks and clients, without third-party involvement, we moved to syndicated loan markets. Syndicated loan markets operate as follows: the originator is the bank, which knows its clients’ needs in detail, and seeks fresh capital from market agents who are not necessarily banks. They began to connect the dots. Once those connections were made, a secondary market emerged—meaning the debt itself began to be traded.

Syndicated loans transformed secured lending into a format very similar to bonds: liquid markets, passive and dispersed investors supplying capital, abundant information available, a market that continuously reflects that information in prices (trading prices), and corporations disciplined by the market itself rather than by active intermediaries or banks.

Corporate debt, even under several active managers, became dispersed through syndicated loans. This was the inverse path of ownership and capital, which have been concentrating and privatizing under the so-called private equity.

But today there is a reversal. Corporate debt has shifted toward privatization, just like private equity. Each day we see a more concentrated and private market. That phenomenon is what we now call private credit.

Commercial loans, and other types of financing that serve the same purpose, are today often no longer originated by banks but by investment funds. These loans are not traded; they are held to maturity. Many times, funds exhibit what we might call “collection volatility”: unlike banks, they may grant haircuts or show flexibility, but when they pursue repayment, they are far more aggressive than banks, given the legal avenues at their disposal. In some cases, they take on the entirety of a corporation’s debt and financing needs, rather than acquiring only a portion. These are highly customized loans tailored to the debtor company, among other characteristics.

This has major consequences, as it has changed the capital structure of companies. For example, when a company faces a single loan from a single creditor, that creditor gains control (yes, as defined by the Securities Market Law), unlike the past when companies relied on a network of creditors, loans, types or tranches of debt, with a wide array of agents and passive investors involved.

Funds that originate private credit strategies—such as secured loans, subordinated loans, and distressed investments (with senior secured loans being the bulk of the strategy)—are now also in demand by institutional investors, who want to participate and invest in those funds. This shows there are few signs of decline, as personalized corporate loans increasingly surpass more traditional sources of financing.

The advantages of private credit are significant, especially considering the drafting of these contracts. Capital deployment is much faster, more flexible, with greater confidentiality and certainty. These funds can indeed enhance returns thanks to the illiquidity premium. In case of debtor liquidation, they enjoy priority through secured debt and contractual protections that go beyond what syndicated loans offer. They also employ methods to shield themselves from “creditor-on-creditor violence.”

Funds benefit as well. Asset managers have the opportunity to earn high compensation, deploy capital with minimal regulatory restrictions, and in some cases, leverage their size.

Private credit competes under the same conditions as bank syndication, reaching an ever-wider range of companies. Firms of all sizes can now choose between, on the one hand, syndicated debt subscribed by large consortia of lenders or dispersed bondholders, or, alternatively, structuring and financing all their debt through a single private credit fund—in record time.

This industry is now run by financial engineers. Private credit not only replaces bank loans, syndicated loans, or bonds, but also expands the supply of credit. This expansion refers both to new borrowers and to new instruments. And we could add that, due to the lighter regulatory burden, greater leverage is possible. In other words, it not only changes the way corporate debt is distributed, but also enlarges its scale.

It is important, however, to consider that private credit will alter the flow of information about companies, investors, and transactions. Imagine a corporation owned by one fund that used debt from another fund, both private (managed by different administrators to avoid conflicts of interest). This would prevent information from reaching not only investors but also regulators. It is very similar to the situation where you lend money to a relative for a few days—no major formalities are required.

We see a new equilibrium forming. The lack of scrutiny from regulators, markets, rating agencies, and the public promotes economic activity thanks to extraordinary flexibility in both operations and governance. But the cost of this is the risk of misallocation of capital—on a scale never seen before—along with creating illiquidity in markets that could undermine the public market.

In public markets, debt is traded, giving us the chance to detect in advance whether things are going well or poorly, including regulators who can then take measures. Now that privilege may belong only to a few, such as Blackstone, which—thanks to the variety of companies it owns—has enviable visibility into how things are going. As a result, external third-party valuation becomes much more difficult.

This will also bring a significant change in insolvency proceedings. There will be lower renegotiation costs and greater creditor control (due to concentration in a single lender), accompanied by opacity and the risk of incorrect valuations.

Therefore:

1. -          Greater leverage.

2. -          Credit extended to companies that previously lacked access to certain types of financing.

3. -          A rebalancing of timing/hypotheses on when to let a company fail, likely delayed (more haircuts, refinancing, etc.).

4. -          Debt structures with lower renegotiation costs, thanks to greater coordination and fewer conflicts among creditors.

5. -          Lenders with higher risk appetite compared to Banks.

6. -          A new epistemic field in credit stages, as it expands to firms previously excluded from certain products.

7. -          Zombie companies, as funds avoid recognizing losses in portfolio firms, hoping for a rebound.

8. -          A barrier for specialized distressed debt funds

All of this will reset the landscape.

Public debt remains in the hands of the market, simply because there is a price to rely on. From issuance, through commercialization and trading, all the way to the end—including problematic endings (which is why judges in sophisticated jurisdictions often leave procedures such as Chapter 11 to the market, where specialized investors guide the process). It is possible that now courts, regulators, and even the debtor itself will need to play a more active role to face this rebalancing.

Direct loans—those originated and held by funds—have always existed, with both problems and advantages. Situations such as shareholder loans to the company, disadvantaging other shareholders (conflict of interest), or highly customized credits, can be either defective or virtuous. But we want to highlight something very specific in the following paragraph.

Private credit is not just another product; it is an evolution of the capital markets. Our thesis is not that it serves merely as an alternative source of financing (though circumstantially it does), but rather that it is a manifestation—like private equity—of the privatization of the financial market, given that public markets have been somewhat mistreated by the State. We cannot know whether this is good or bad, whether it increases or decreases the ability to allocate capital correctly. But one thing is certain: the legal regulation of public markets, of the securities market, was not designed with the intention of discouraging the need for capital—yet this has become a clear unintended consequence of financial laws.