THE ECONOMICS OF THE PRIVATE MARKET
Appendix B. The Market for Privately Placed Equity Securities
The private placement market for corporate equity securities consists of all equity securities not registered with the Securities and Exchange Commission. The private equity market overlaps to some extent with that segment of the private debt market that includes debt with equity kickers; indeed, private market participants specializing in the debt or equity side often view this segment as part of ''their'' market. For this study, however, we have included bonds with equity kickers as part of the debt market. Even so, the private equity market consists of a wide range of financings-straight equity, venture capital, and equity for mergers and acquisitions-funded by a variety of investors.
Apart from the type of security, the private debt and equity markets differ in several other respects. Insurance companies do not dominate the private equity market as they do the market for privately placed debt. State and large corporate pension funds, endowment funds, finance companies, corporations, and individual investors are all important sources of funds in the private equity market. In addition, the average annual volume of issuance of private debt substantially exceeds that of private equity. Finally, a large amount of financing in the equity market is conducted through private limited partnerships.
Recent Trends in Issuance
Gross issuance of private equity is a fraction of that of private debt. Since peaking in 1989, total issuance of privately placed equity has fallen considerably (table B.1). However, the dollar volume of private equity financing, even at its peak, was less than 25 percent of that in the private debt market.
Much of the recent decline in private equity issuance reflects changes in the activity of limited partnerships, which raise funds through the sale of partnership interests and make equity investments in companies. Sales of these interests, which are themselves treated as private placements, appear to make up the bulk of gross issuance by the financial sector. In 1990, for example, almost 90 percent of total financial sector issuance was in the other financial category, which is dominated by limited-partnership investment funds. The volume of limited-partnership issuance appears to be particularly sensitive to the pace of merger activity in the economy. The sharp decline in mergers and acquisitions in 1991 was reflected in the dramatic decrease in issuance by the other financial sector from $9.4 billion in 1990 to $2.6 billion in 1991.
Chart B.1 shows the relative sizes of gross issuance in the public and private equity markets since 1986 for nonfinancial firms. Until 1991, when firms issued unprecedented amounts of new public equity, the private market made up a healthy share of total gross equity financing by U.S. firms. One reason for the 1991 decline may have been the very high price-earnings ratios in the public market that siphoned issuance from the private market. Indeed, movement on the margin between the public and the private equity markets by smaller firms is likely to be much greater than that between the public and the private debt markets; whereas few public debt issues are for less than $100 million, many public equity offerings are.
Another reason for the 1991 decline may have been the further slowing of merger and acquisition activity among firms. Although firms may have pared their acquisition plans in 1991 in response to the recession, the reluctance of domestic banks to provide senior loans for merger deals may also have contributed to the lower volume of equity issuance by smaller firms. Also, insurance companies cut back their investments in the private equity market in 1991. Market participants note, however, that pension funds, some foreign banks, and a few finance companies may have somewhat stepped up their presence in the market.
Investors, Issuers, and Terms of Issuance
Twenty to thirty years ago, life insurance companies were the major buyers in the private equity market. Not only did they invest directly in companies themselves, they also provided the lion's share of the funds for the limited partnerships, which first appeared in the early 1970s. These investment funds raise capital from institutional investors and provide private equity financing. The funds target small firms with growth potential that, at their current stage of development, are shut out of the public equity market. The funds typically have a life of five to ten years; at dissolution, the general partners (the managers of the fund) take their cut, and the remaining returns are distributed to the limited partners (the contributing investors). These funds have grown in number and size over the past twenty years.
Since 1989, however, the major sources of finance in the market have been corporate and state pension funds. The pension funds invest primarily through limited partnerships as they do not have the expertise to invest directly in companies themselves. Market participants estimate that pension funds now provide more than half of all financing for the partnership funds. Finance companies, endowment funds, corporate investors, and individuals provide the rest. In the early 1990s, insurance companies were only minor contributors of new capital to the market, no doubt because of their reallocation of funds toward lessrisky borrowers in all markets, including the private debt market.
The structure of private equity investments can vary significantly, from simple common stock to preferred stock with a plethora of restrictive features that allow investors to maintain control over the company's direction. Such features typically include the right to elect directors, voting rights for major transactions contemplated by management, antidilution protection, and Board control at the option of investors if certain performance criteria are not met. Market participants expect more complex forms of equity securities to evolve in response to the growth of more specialized partnership funds.
Typical issuers in the market include those firms too small to tap the public markets for financing. Large troubled companies also often look to the private market to obtain equity infusions from financial institutions or wealthy individuals that would be hard to obtain in a widely distributed public offering. In 1991, for example, Manufacturers Hanover and Citicorp raised a total of $1.5 billion in private offerings of preferred stock. In February 1992, Chrysler raised $400 million of equity in a private offering.
The traditional forms of ''exit'' for the private equity investor are either an initial public offering (IPO) or the sale of the company to another (typically corporate) investor. The IPO has been particularly popular in the past couple of years as investors in the public equity market have been very receptive to private companies seeking initial public equity. Market participants also point to the future possibility of selling private equity securities in the secondary market, should that market become sufficiently liquid. Here some disagreement has arisen over the potential effect of Rule 144A. Some feel that the rule will eventually increase liquidity in the secondary market, whereas others feel that it has merely formalized prevailing market practice and consequently will not significantly affect the market. There is general agreement, however, that the market will become more liquid over time-with or without Rule 144A-simply because increasing participation of pension funds in the market will expand the amount of funds invested in equity private placements.
Market participants feel that the share of financing from pension funds could easily grow to 70 or 75 percent and that this growth could be a major factor in the growth of the share of private equity financing that limited-partnership funds provide. They also expect, however, that some large corporate pension funds and some insurance companies will continue to invest directly in companies. Pension funds may be willing to allocate increasing shares of their portfolios to the private equity market for several reasons. First, the private market offers the opportunity to diversify assets outside the traditional public stock and bond markets. Second, to the extent that the private market is less efficient than its public counterpart, it offers investors the chance to make superior returns. Finally, by placing funds with active investors (the limited partnerships) that take controlling positions in companies and monitor and sometimes change management, pension funds can participate in the increased returns generated by the turning around of poorly managed companies.
Gross offerings of privately placed equity by U.S. corporations
1. Figures include common and preferred equity issued in the United States1