The Era of Chameleon Capital

Over the past sixteen years the corporate finance markets have been undergoing a dynamic redesigning. First, such an evolution and ongoing remodelling of corporate finance markets is due to the significant rise of private capital (private credit, private equity, venture capital). The gradual and continuous migration from public to private markets has also been prompted by banking regulation that was introduced in the aftermath of the global financial crisis of 2007-2008 (eg The Dodd-Frank Act 2010, Basel III regulations). The low-interest rate environment over the past two decades further played a role in the growth of private capital.

Second, the 2023 banking crisis and the macroeconomic environment post-COVID 19 further stress the significance of debt capital and its dynamic relationship with equity capital, in general, but especially in private companies. This dynamic between ‘equity’ and ‘debt’ is even more nuanced in the context of distressed investments or special capital solutions. With the significant rise of corporate debt levels, there is a lot of scope for private credit investment, including for rescue financing and capital solutions financing.

Third, on the one hand, there has been increased competition not only between banks and private credit funds (‘the dual-track process’), but also between banks, private credit funds, and institutional investors (eg sovereign wealth funds) in providing corporate financing (‘the triple-track process’). On the other hand, banks have started partnering with private credit funds in providing financing. The liquidity issues have also impacted on how private equity and private credit firms work together to provide corporate financing.

Finally, because of the changes in the corporate finance markets post-GFC, modern debt investment in the private capital domain looks a lot like equity, and, where necessary, modern equity may also be designed to look akin to debt. The financing instruments in the private capital domain are blurred. Sophisticated modern investors, such as private credit funds, negotiate bespoke protection and governance measures, including by negotiating for equity upside and board observer rights (or even board representation), or for debt-like or equity-like modern hybrid investments or parallel investments (eg HoldCo payment-in-kind, debt-like pref equity, debt investment with warrants, debt investment and holding golden shares). An example of such a modern influence mechanism relied on by private credit funds is a debt investment combined with holding golden shares. Golden shares are issued on Day 1 of the investment, yet the rights attached to these golden shares are activated upon insolvency, giving these investors (ie the holders of golden shares) the rights, for instance, to replace the board. This enables such investors to keep their debt investment in the firm and simultaneously to have equity control. One reason why some investors might prefer debt and golden shares, as opposed to debt converting to equity, is because equity comes behind debt. However, golden shares have no economic rights attached to them; they are control instruments. A further new development causing further blurring in ‘equity’ and ‘debt’—but this time in the types of investors—is the rise in hybrid funds.

For years in the private capital industry opportunities did not always match the capital that the funds had raised. Such a mismatch was magnified during COVID, as the investment opportunities presented at this time were limited and often did not match the capital that the funds had raised from their investors.  COVID has caused the surge in hybrid funds, commonly also called multi-strategy funds or pod-shops, interested in special opportunities or capital solutions, solving the mismatch issue. With the arrival of multi-strategy funds, there has been further blurring between ‘equity’ and ‘debt’, where the types of investors also started to blur; there is more crossover, and there is a rise in investors that are investing both in ‘equity’ and ‘debt’. The objective of these hybrid funds is to maximise yield for their investors.

Operating in a market where information asymmetry is the game, these sophisticated investors bargain for modern hybrid and parallel investments, crafting bespoke and complex investments with long term interests and objectives in mind (‘chameleons’). In light of these developments, in my new working paper, ‘Chameleon Capital’, I aim to offer two contributions. First, based on qualitative interviews with legal practitioners in private credit, distressed investments, and leveraged finance, I investigate how in commercial practice (ie law in action, as opposed to law in books) the traditional distinctions between ‘equity’ and ‘debt’ investment have been blurring over the years in the private capital domain. Building on this evolution, from the corporate law perspective, I aim to show that the conventional division between ‘equity’ and ‘debt’ investment is only relevant in the context of collective proceedings. For a single investor, or a small group of associated/affiliated investors, such as private credit firms and private equity firms, the distinction between ‘equity’ and ‘debt’ has become further blurred. Yet, the legal characterisation of what is ‘equity’ and what is ‘debt’ in law is very important, including in the context of restructuring of these arrangements.

Second, I examine the implications of blurring from the corporate law perspective. Why is the blurring of ‘equity’ and ‘debt’ important for corporate law and why especially now? The blurring in commercial reality between ‘equity’ and debt’ is relevant when it comes to the incentives, behaviour, and accountability of directors in the context of directors’ duties. The distinction between ‘equity’ and ‘debt’ shines a microscope on corporate law because of the different levels of protection that corporate law offers to a firm’s capital providers: shareholders and debtholders.

Additionally, the blurring between ‘equity’ and ‘debt’ is important when analysing a controlling investor’s duty (typically a controlling shareholder’s duty) and other issues, such as shadow directorship, shareholders’ agreement, the reflective loss principle, legal capital rules, wrongful trading, misfeasance, and others. Moreover, over the past years, there have been various important developments, impacting the corporate law framework worldwide with regards to the treatment of ‘equity’ and ‘debt’.

I take a comparative approach and study the implications of the evolution of corporate finance, and the treatment of ‘equity’ and ‘debt’ in English corporate law, comparing and contrasting it with Delaware corporate law. While this project concentrates on English law and Delaware law, the issues highlighted above are also relevant for other legal systems. Why? The private capital industry is global, with funds operating and investing internationally.

The blurring of ‘equity’ and ‘debt’ in commercial practice (ie the mismatch between law in action and law in books) has important implications for corporate law, including, for instance, its influence on the fight for corporate control. Corporate finance influences corporate control. By exploring the blurring between ‘equity’ and ‘debt’ in the private capital domain, the paper highlights interesting questions about the extent to which legal characterisation in corporate law still plays a residuary role.

Narine Lalafaryan is Assistant Professor of Corporate Law, Faculty of Law, University of Cambridge; Fellow, Cambridge Endowment for Research in Finance; Fellow, Pembroke College, University of Cambridge.

This post is published as part of the special series ‘The Law and Finance of Private and Venture Capital’.