Banks lend against a firm’s liquidation value, what its buildings, inventory and receivables would fetch if sold separately, and monitor it through EBITDA-based covenants. EBITDA is Earnings Before Interest, Taxes, Depreciation and Amortization. That suits a deposit-funded institution, whose loans must be safe and easy to value. It fails firms like software companies, whose continuation value far exceeds their liquidation value: you can’t sell the software engineer. Even after default a bank cannot capture that value: the Bank Holding Company Act limits it to 5% of a non-financial firm’s voting shares, so it cannot take control and sell the business intact.

Post-2008 regulation widened the gap. Basel III raised capital requirements, and the 2013 interagency guidance on leveraged lending discouraged bank loans above six times debt to EBITDA. Direct lenders, nonbank funds often organized as business development companies (BDCs), lend against continuation value instead, taking blanket liens on the whole enterprise and, after default, control of it. A BDC borrows from banks on credit lines and lends to firms, adding its own spread. Jang, Kim, Sufi and Chen compare their borrowers with those of banks using UCC filings, the public notices lenders file to record claims on collateral. Direct-lending borrowers are younger, intangible-intensive and mostly owned by private equity sponsors; where private equity is absent, direct lenders barely appear. By the authors’ estimates, regulation explains less of the growth than this comparative advantage. Direct lenders are specialists, not substitutes for banks.

The monetary consequence comes from a companion paper, Haque, Jang and Wang. Banks lend to BDCs, which lend to firms. When the Fed tightens, banks cut loans to firms. Those firms turn to BDCs, and BDCs draw on their bank credit lines. Total credit falls less than it otherwise would. The rate the firm pays, however, now stacks two spreads:

$$ r_{\text{firm}} = r_{\text{policy}} + s_{\text{bank}\to\text{BDC}} + s_{\text{BDC}\to\text{firm}}, $$

and the bank spread widens with tightening. So when the Fed tightens, firms still get credit through BDCs, and lending falls less, but they pay more for it. They borrow more at higher rates, which means more growth now and more default risk later.

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