Scholars argue that private lending can hide companies from view.
Regulations deter corporate fraud by requiring transparency, but a growing share of the money companies raise dodges that transparency: American companies are now borrowing billions of dollars behind closed doors.
Instead of borrowing from banks or raising money out in the open where outsiders can spot early signs of financial trouble, many companies now turn to private lending firms that supply all the money they need to cut deals out of regulators’ view.
In a recent article, two business law scholars warn that this trend could leave the public with little or no information about many U.S. companies. The authors—Jared A. Ellias of Harvard Law School and Elisabeth de Fontenay of Duke University School of Law—caution that, when basic facts about ownership, debt, and performance stay hidden, investors and regulators misjudge what companies are worth, which can make the financial system more fragile.
Ellias and de Fontenay observe that, for much of the 20th century, companies usually borrowed from a single bank. The bank would lend most or all the money a company needed. Since the bank was the only party the company had to pay back, the bank would closely watch the company’s finances and behavior.
Ellias and de Fontenay note that the borrowing pattern shifted in the 1980s: Banks began splitting giant loans into pieces and selling them to many large investors, who traded those loans back and forth.
Ellias and de Fontenay argue that this shift made information more visible, because borrowers had to share much more about their finances, and the prices of loans themselves served as an early warning when a company was in trouble. They contend that these visible price signals helped steer money toward stronger businesses and away from weaker ones—so money flowed to its most efficient uses.
According to Ellias and de Fontenay, the pattern has flipped again recently. Instead of many banks and investors sharing a loan, private credit firms—large private lenders that have enough cash to fund and hold the entire loan—now finance many deals. Ellias and de Fontenay posit that, as a result, almost no one outside the deal sees the transaction.
They also explain why both the borrowers and the lenders favor this setup. For companies that borrow money, borrowing from a single private lender makes the process faster, quieter, and more flexible because the companies negotiate with one decision-maker rather than a roomful of banks and investors.
As for private credit, firms can charge high interest rates and negotiate terms that favor them, in part because competition on these private deals is thinner, Ellias and de Fontenay argue. They also point out that, unlike banks, private credit firms do not face the same layers of regulation, which lowers costs and lets them move faster.
Despite these advantages, Ellias and de Fontenay argue, this model makes already-scarce information even scarcer. They note that many companies have private owners to begin with, so owners do not share basic facts about ownership and performance in routine reports required of public companies. Even so, Ellias and de Fontenay note that, when investors buy and sell these company loans, outsiders could still learn from the price: If the loan price moves up or down, it hints at trouble or improvement, even when ownership is private.
With the rise of private credit firms, Ellias and de Fontenay posit that the public may have little or no information at all about many or most U.S. companies—a segment of the U.S. economy may simply “go dark.”
Ellias and de Fontenay warn that consequences may follow the widened information gap. For instance, they explain that estimates of how much a company is worth can drift far from reality when few people outside corporate deals can see reliable information. In addition, Ellias and de Fontenay posit that with less information comes less scrutiny and enforcement, which makes fraud and dishonesty more likely.
Ellias and de Fontenay also argue that the lack of information could lead to market distortions—money sticking with weak companies when stronger ones go underfunded—and could trigger sharp price swings when reality catches up, hitting Wall Street and retirement accounts alike.
Although Ellias and de Fontenay focus on identifying risks, they propose first steps toward a solution. If the market fails to police deals between private credit firms and companies, they argue, then bankruptcy judges must do it when a company fails. They warn that judges should stop assuming the market has already found the correct price.
Instead, Ellias and de Fontenay urge judges to turn the lights on: demand full information, slow things down when needed, test the price and the financing, and stop any rushed deal that lets one private lending firm force through a solution without a real check.
