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There was a time when companies in need of capital had two main options: sell shares or bonds in the public markets or get a loan from banks.

Today, a growing number of companies of all sizes — both private and public — are turning to private investment funds for loans. This has turned private credit, a once-overlooked corner of the capital markets, into a $2 trillion industry.

New research from Duke Law’s Elisabeth de Fontenay and Harvard Law’s Jared A. Ellias offers insights into private credit’s growth and the broader economic and legal implications of concentrating both equity and debt in private markets, where the health of companies is visible only to a handful of people.

In The Credit Markets Go Dark, the authors argue this trend will bring to corporate debt the same forces of privatization, concentration, and illiquidity that have been reshaping the equity markets with the ascendance of private equity. Several of the largest private credit funds, which manage tens and even hundreds of billions of dollars, are operated by the biggest names in private equity.

And while the rise of private lending may hold some benefits for corporate borrowers, the lack of transparency in a largely unregulated, unscrutinized industry may warrant concern among investors and the general public, de Fontenay and Ellias warn.

“Now everything is headed towards the private markets, which have both really attractive and potentially worrisome features,” de Fontenay said. “What does this do to the entire capital markets, as a system?” Just a few decades ago, large firms were likely to have both their shares and their debt traded publicly.  Today, large firms are often owned by a private equity fund and financed by a private credit fund, so everything about their financials and performance is invisible to the broader market.

The current regulatory structure is ill-matched to a new system in which the entire capital structure of firms large and small is increasingly held by large private investment funds that may influence corporate governance and finance, says de Fontenay, a corporate law and finance scholar and the Karl W. Leo Distinguished Professor of Law at Duke University.

“It is a very different way of operating,” she said. “All our laws and institutions are set up to deal with the old world, and we are not thinking enough about the new world.”

More growth could lead to “more disasters”

The rush towards private credit, which de Fontenay defines as “loans that are not provided or underwritten by banks,” is both a cause and consequence of the enormous amounts of private capital — driven, in part, by institutional investors seeking higher yields from private investment funds in the low-interest rate environment following the 2007-2008 financial crisis.

Corporate borrowers find private credit extremely attractive, since it allows them to borrow large sums in days, rather than the weeks or months it takes for a bank to prepare a debt offering, in the form of tradeable bonds or loans. That speed and flexibility “isn’t something that the public capital markets can achieve in any way, shape or form,” said de Fontenay. In addition, private credit can remove the expense and delay of intercreditor battles over financially distressed borrowers, because private credit often means replacing a large group of disparate creditors with just one — the private credit fund.

De Fontenay and Ellias sought to bring some transparency to this trend by examining data from a small sector of the private credit market that is visible to outsiders: business development companies (BDCs), investment funds that register with the Securities and Exchange Commission (SEC) and lend primarily to small-to-medium size companies, newer companies, and those in financial trouble. They analyzed more than 1,600 balance sheets filed by 335 BDCs between 2006 and 2023, finding that while the median loan size remained stable at about $3.25 million during that period, the number of loans made skyrocketed from a few thousand to well over ten thousand by 2022.

The consequences of this shift to private capital are mixed, says de Fontenay. In theory, more capital circulating in the economy helps more firms grow and innovate, generating value for consumers. But private credit firms may also be extending loans to companies that aren’t in optimal health — and no one, not the public, nor regulators, is in a position to know, de Fontenay says.

“If you're just adding a lot more debt to our current system, yes, you'll get more growth, but you'll also get more disasters,” de Fontenay said. “You'll have more companies in financial distress.”

And private lenders, she notes, have “perverse incentives to hide the performance of their portfolio companies, preventing us from seeing when companies are in distress or not.”

They may continue to extend credit or renegotiate with an underperforming company, leading to “zombie firms” that have just enough money to operate but can’t pay off their debt or invest in growth. And in a worst-case scenario, “all of these companies, at the same time, turn out to be poor performers, and you get the bad news all at once in a big crash,” de Fontenay said.

And when financially distressed firms file for bankruptcy, lack of transparency in private debt transactions leads to another problem: the inability to establish fair valuation. When companies borrow money through public market debt instruments like corporate bonds, bankruptcy judges can more readily establish a distressed company’s value from the trading prices of different slices of debt. But when money is borrowed through private credit, valuation may be left up to individual judges, de Fontenay said, potentially leading to unexpected outcomes.

Despite its sheer size and potential impact, U.S. regulators have declined to interfere with the private credit market. An executive order from the Trump administration may pave the way for retail investors to allocate some of their retirement accounts toward alternative assets such as private equity and private credit.

“That means the amount of money flowing into private credit is going to balloon even more,” de Fontenay said. If there is an influx from retail investors, she added, “The risk that there will be a bubble in private credit is pretty high.”