THE ECONOMICS OF THE PRIVATE MARKET
The private placement market is rife with information problems. As noted in part 1, the risks of lending to private market borrowers are often hard to observe and to control because relatively little public information may be available about them and because their businesses, corporate structures, or financings may be complex.
The lack of publicly available, timely information about the terms of private debt, including prices and other market conditions, is another information problem. Such information is valuable, and the collection, processing, and sale of it to borrowers is the primary business of agents. Lenders, however, also need such information, and agents are involved in transmission of information to them as well.
How Agents Gather Market Information
Agents can learn about current market conditions in four major ways: by observing deals in which they participate, by asking lenders, by asking other agents, and by subscribing to newsletters and other information clearinghouses.
Observation of deals in which an agent participates is most reliable, as the agent sees all offers and counteroffers and knows all details of the initial and final terms of the debt contract. However, a large flow of deals with a variety of credit ratings and levels of complexity is required to support a constant reading of current prices and terms for the spectrum of private placement contracts. According to indications from market participants, even agents with very large volumes of business rely on multiple sources of information, not just on their own deals.
Agents also ask lenders about the terms of deals in progress and about completed deals. Such inquiries are perhaps the primary way that small agents keep up with market conditions. Lenders have mixed incentives to share information. On the one hand, judicious limits on the flow of information to agents may give lenders an advantage in negotiations. On the other hand, lenders also want information from agents and thus will enter into informal sharing arrangements with them. Lenders also cultivate agents, especially those doing a large volume of business, because they want to be offered securities and to be placed at the beginning of the queue in sequential distributions. 140 Lenders can reward agents by responding promptly to offers, by not imposing nuisance costs while deals are in progress, and by sharing information. Because they have the most to gain by cultivating large agents, which have both the largest flow of deals to offer and the best information, lenders are most likely to share information with them. Apparently, agents seldom share information with one another, perhaps because they are in competition.
In recent years, several newsletters and other publicly available sources of information about private market deals have appeared. None offers a complete picture of the market, and some offer information that is slightly dated. However, market participants indicated that they do gather information from these sources and find it useful. The newsletters themselves gather information by asking lenders and agents (and sometimes borrowers) about deals recently completed and those in progress.
Interestingly, some lenders reportedly seldom share information with the newsletters. This situation is consistent with their incentives to share information only with agents from which they expect favors in return. Agents also have incentives to limit information flows, but these are not so strong as the incentives of lenders. At the margin, the interest of agents may be to increase the efficiency of the private market, as improvements in terms available to borrowers (due to improved information flows) may increase the flow of deals. However, large agents may lose some of their informational advantage from such an improvement in efficiency.
How Lenders Gather Information
Lenders' sources of information are similar to those of agents, but lenders have an advantage in that they observe not only the terms of debt contracts that they buy but also at least the initial terms of all contracts they are offered. Many of the larger private market lenders we interviewed stated that they are offered many more than 500 deals in a typical year but that they purchase only a small percentage of them. They could reduce their prescreening costs by specifying more precisely to agents the kinds of deals they will buy; however, doing so would reduce the size of their window on current market conditions. Several market participants mentioned that private market lenders actively lobby agents to offer them every deal and are unhappy with agents that fail to do so. 141
Lenders also gather information from agents, typically by inquiring about the final terms of deals they were offered but did not participate in. They may also make such inquiries of other lenders, though the sense of market participants' comments was that these inquiries are less frequent. Newsletters do not appear to be a primary source of information about market conditions.
Economies of Scale
Besides being able to spread fixed costs of performing agent operations over a larger volume of business, large agents (and large lenders) have an advantage in gathering the information required to operate in the private placement market. Not only are they able to glean more information directly from deals they participate in, but they have more to trade when making inquiries of other lenders and agents. Such economies of scale may translate into larger profits. They may also act as a barrier to entry of new agents, as such agents will typically have neither large deal flows nor information to trade. The effect on the profit differential between large and small lenders may be less significant, because large lenders tend to be lead lenders and small lenders can free-ride by buying pieces of the deals the large lenders commit to buy.
Since data on the costs and profitability of agents are not available, quantitative evidence of economies of scale and on the competitiveness of the agent market is limited. However, economies of scale often foster concentration of an industry, and the agenting industry is somewhat concentrated. In 1991, the top five agents of debt had 41 percent of the market by volume, the top ten had 65 percent, and the top twenty had 89 percent. Of course, as discussed earlier, such concentration could result from a combination of economies of scope and concentration in the markets for other financial services.