THE ECONOMICS OF THE PRIVATE MARKET
Features of the Market
Although the SEC adopted Rule 144A only in 1990, the 144A market has developed so that it is easily distinguished from the traditional private placement market. In our view, the essential feature of the new market is that it is not information intensive, which is to say that it has taken on the main features of the public bond market. The most visible and discussed similarity to the public market has been the underwriting of 144A offerings. Indeed, this aspect serves as the basis for our definitions of a 144A security and the 144A market. 108
Nature and Size
Measuring the development of the underwritten 144A market is especially difficult because many market participants, as well as the information services that collect data on the private placement market, consider a 144A security to be any private placement that relies upon the documentation required for a financing pursuant to Rule 144A. Unfortunately, this definition includes private placements that are, other than the documentation, no different from traditional private placements. Thus, relying upon these data, for which we have no alternative, necessarily leads to an overstatement of the size of the underwritten 144A market.
Using the broad definition, gross issuance of 144A securities has expanded rapidly since the inception of the 144A market in 1990. The volume of offerings in 1992 was about $33 billion, almost double that in 1991 (the first full year the rule was in effect) and nearly two-thirds of the volume in the traditional market (table 9).
The difficult question to answer is, How much of the broad measure of 144A issuance has been underwritten? No direct estimates have been made, but an indirect estimate of underwritten issuance can be obtained by assuming that issues with two or more credit ratings have been underwritten. Underwritten offerings, whether in the public market or the 144A market, typically have at least two ratings because the underwriters otherwise incur significantly higher regulatory capital charges. Available information from the SEC shows $4.4 billion of 144A issues with at least two ratings in 1991 and $6.0 billion in the first eleven months of 1992. 109 These figures are roughly in line with market estimates, which place underwritten issuance in 1991 at slightly more than $3 billion and in the first half of 1992 at roughly double that pace. 110 Even the larger figures from the SEC suggest that the underwritten market is still in an early stage of development.
Characteristics of Underwritten 144A Securities
Besides being underwritten, 144A securities have assumed many other features of publicly offered bonds. The terms and documents generally conform to the standards used in the public market; in particular, bonds have ''public style'' covenants, which are fewer and considerably less restrictive than those found in traditional private placements. Underwriters charge roughly the same fees as those for a public offering, but the issuer avoids the considerable expenses associated with public registration. The underwritten 144A securities also generally have two credit ratings; and, in many instances, the offering memorandum is styled like a prospectus in a public offering. Also, 144A offerings are usually transferred through the book-entry system operated by the Depository Trust Company. All of these features are a part of underwriters' efforts to market 144A private placements to traditional public market investors, such as mutual funds, pension funds, and groups within life insurance companies responsible for public bond investments. 111 Furthermore, underwritten private placements have been comparable in size more to public offerings than to traditional private placements: In 1991, for example, the average issue for 144A securities, broadly defined, was $92 million, nearly double that for non-144A placements. Finally, the terms of the securities are rarely negotiated with investors but are typically set before the offering.
Despite this similarity to public bonds, underwritten 144A securities generally have not yet achieved the same degree of liquidity as public bonds, and thus their yields contain a premium. 112 In the first year of the market, the premium was reported to be about the same as that on traditional private placements. More recent reports suggest, however, that the liquidity of 144A securities has increased and that the premium has decreased, as major dealers have allocated capital and traders to making markets for 144A securities. 113
Thus far, the proportion of foreign issuance has been greater in the 144A market than in either the traditional private or the public bond market. Based upon the broad measure of 144A issuance, approximately one-third of the total volume of 144A offerings in 1991 and 1992 was accounted for by foreign issuers, including U.S. subsidiaries of foreign companies. In contrast, 17 percent of the traditional private placements and 6 percent of the public offerings were by foreign issuers.
Several factors lie behind foreign use of the 144A market. One is that the adoption of Rule 144A itself served to publicize the already existing advantages of the private placement market to foreign companies. Thus, the effect of the rule has been to alter foreigners' perception that all offerings in the United States are subject to excessive regulatory burdens. Indeed, market participants concede that some of the foreign issuance done under Rule 144A could have been as easily accomplished before the rule's adoption. 114 Moreover, since the rule's adoption, investment banks have devoted greater effort to bringing foreign issuers to the private placement market. A second factor boosting foreign issuance has been the low interest rates in the United States relative to those in European countries. The increase in 1991 in foreign issuance in the public bond market and the record pace of offerings in 1992 attest to the yield advantage in U.S. markets. A final factor is that the premium in yields on foreign bonds issued in the private placement market has declined.
Among other aspects of foreign issuance in the 144A market, many foreign issuers have been well-known corporations, but at the same time, about 20 percent of the issues have come from first-time borrowers in the United States. 115 The major sources of issuance from abroad have been the United Kingdom and Mexico. Through November 1992, more than half of the foreign issues studied by the SEC were involved in global offerings, and virtually all the global offerings originated with an offshore entity. In contrast, about half of those foreign-related offerings confined solely to the 144A market involved U.S. subsidiaries of foreign corporations. 116 About 50 percent of the volume of foreign 144A securities in 1991-92 came from financial institutions, and most of that was in medium-term notes.
Despite the attention given to foreign use of the 144A market, U.S. companies have accounted for nearly 70 percent of the volume through 1992. Domestic issuers in the 144A market have typically been those companies with special circumstances that preclude issuing in the public bond market, where yields are lower. In some cases, the companies have not wanted to spend the time nor incur the expense required to register the securities with the SEC. Among these have been private companies that, in the past, have borrowed in the traditional market but have now found more favorable pricing in the 144A market. Also included are nonregistered subsidiaries of publicly registered parents that have issued debt in the subsidiaries' names. In other cases, companies with outstanding public securities have turned to the underwritten 144A market to protect the confidentiality of the specific circumstances leading to the borrowing.
Another group of domestic companies has used the 144A market as a temporary alternative to the public bond market. These companies normally issue public securities but have turned to the 144A market to avoid any delays arising during the registration process that could cause issuers to miss favorable financing opportunities. The 144A private placements sold under these circumstances have included registration rights, which obligate the issuer to register the bonds with the SEC within a specified time. Failure to do so results in the bonds' carrying higher coupon rates. Most companies selling these types of 144A securities have been rated below investment grade.
During the first two years after the adoption of Rule 144A, life insurance companies were the largest group of investors in 144A securities. As the 144A market has developed features of the public bond market, however, the composition of investors has shifted toward those, such as mutual funds and pension funds, that generally concentrate investments in public securities. Information on buyers of 144A securities from a sample of new issues studied by the SEC implies that the share of life insurers' purchases of straight debt fell from roughly 75 percent between April 1990 and August 1991 to 60 percent between September 1991 and April 1992 (SEC, 1993). Over the same two periods, the combined share of mutual funds and pension funds rose from a little over 10 percent to nearly 40 percent. Market participants indicate that the composition of buyers has continued to shift toward mutual funds and pension funds and, in addition, that many life insurance companies have shifted responsibility for investing in 144A securities from their private placement groups to their public market groups. Thus, the dominance of the life insurance companies in the later period of the SEC study likely understates the growing significance of public market investors in the 144A market.
Public market investors are attracted to the 144A market because its public-like features suit their investment style. In contrast to the buy-and-hold strategy of investors in traditional private placements, many public market investors follow a total-return strategy in which they attempt to increase the return beyond the security's coupon rate of interest. To do so, these investors look for undervalued securities offering the potential for capital gains. 117 Such investors require liquidity, because they do not expect to hold the securities to maturity. From this perspective, public market investors have found the liquidity in the 144A market to be sufficient.
In contrast to the move of public market investors to the 144A market, buyers of traditional private placements are unlikely over time to find this market attractive. The comparative advantage of traditional market investors is in credit analysis and credit monitoring, neither of which is required extensively in the 144A and public markets. And, in the buy-and-hold strategy of traditional investors, liquidity is of little importance.