THE ECONOMICS OF THE PRIVATE MARKET
Issuers in the Private Placement Market
Most private placements carry fixed interest rates and are of intermediate- to long-term maturity. Because firms generally find short-term and floating-rate loans no harder to obtain than long-term, fixed-rate loans (for reasons described in section 5), we infer that private issuers prefer a fixed rate and a long term. 41 In this study, we do not analyze firms' reasons for seeking long-term, fixed-rate debt financing. Commonly cited motivations include a desire to reduce the uncertainty associated with interest rate fluctuations or with funding long-term investments with short-term loans.
Broad Industry Types of Issuers
Most issuers of private placements are nonfinancial businesses or financial institutions (table 4). In 1989, businesses accounted for 61 percent of the total volume of private placements and financial institutions for 30 percent. State and local governments were responsible for only thirty-one issues in 1989, and only four were for more than $25 million.
Borrowers that are information problematic have access to the bank loan market for working capital and intermediate-term loans, but normally they cannot obtain longer-term financing in the public bond market, as buyers of publicly offered bonds generally do not devote staff and other resources to the credit analysis required for investment in these companies. Investors in private placements, however, have developed the necessary capacity for initial due diligence and loan monitoring and have achieved economies of scale enabling them to offer favorable borrowing terms to informationproblematic firms.
The information problems that borrowers pose for lenders span a spectrum. A firm's position on this spectrum tends to be correlated with both its size and its observable credit risk. Information problems posed for lenders tend to increase as borrower size decreases partly because smaller firms enter into fewer externally visible contracts with employees, customers, and suppliers. Larger firms enter into more contracts and larger dollar volumes of contracts. The terms of these contracts, and the large firms' performance under them, are generally observable at relatively low cost; for example, they are often reported in the financial press. Facts about contract performance reveal information about a firm's likely future performance, and when such facts are widely available, a firm will find building a reputation for good performance easier. In general, the larger the costs to a firm of losing its good reputation, the smaller the agency problems that must be managed by its lenders. 42
Size may also be related to information problems because size is correlated with age. Younger firms, which tend to be smaller, generally have not yet had time to acquire a reputation. 43 Similarly, observable credit risk may be positively correlated with information problems because risk is correlated with age. 44 Younger firms tend to be riskier because they may not yet have achieved organizational stability and the marketability of their product lines may not be well established. Risk may also be associated with information problems because the incentive to engage in behavior that expropriates wealth from lenders is more acute in observably riskier firms. 45
Most issuers of private placements are mediumsized firms and can be described as only moderately problematic. Very problematic, typically small borrowers usually lack access to the private market, where lenders' capacity for due diligence and especially for monitoring is often not as high as that of banks and some other lenders. Such borrowers may also be able to obtain better terms in the bank market. A bank loan generally contains more restrictive covenants than a private placement, has a considerably shorter maturity, and involves more monitoring by the bank. Consequently, smaller companies borrowing from banks are, in effect, issuing a safer security than they would have issued in the private placement market and can thus obtain a lower rate. 46 The shorter maturities, tighter covenants, and floating rates may make bank loans less-than-perfect substitutes for private placements for such companies, but such terms may be preferable to no loan at all or to a loan with a very high interest rate.
Extremely problematic borrowers, such as start-up or very small firms, may be unable to issue outside debt, especially straight debt, and may be forced to rely on equity financing. Sources of long-term funding for such companies include equity funds, mezzanine debt funds, and venture capital funds. These sources are particularly attractive to firms that are unable to provide collateral for an intermediate-term bank loan. Equity and mezzanine debt funds typically extend financing through a combination of subordinated debt and equity. The principal difference between the two is that equity funds usually require a larger equity interest-often in excess of 20-25 percent. Venture capital funds typically invest in developing companies and require an equity interest. Again, these alternative sources, like bank loans, are not perfect substitutes for standard private placements, as they require the borrower to give up an equity interest in the firm. For many smaller, owner-managed firms, this may be a drawback. 47 However, equity funds may be the only source of financing for those firms too small or too risky even for the bank loan market.
Firms with Information-problematic Financings
Large, non-information-problematic firms with complex financing requirements have often used the private placement market. Such companies tend to issue straight debt in the public bond market but turn to the private placement market for complex transactions that public market investors are not well prepared to evaluate. Private placement investors have developed the specialized skills for analyzing the credit risk of these transactions and can command loan spreads sufficient to provide a satisfactory return on their services. Examples of such transactions are project financings, capitalized equipment leases, joint ventures, and new types of asset-backed securities. The private placement market often serves as a testing ground for new types of securities, which may eventually move to the public market as investors become more familiar with their structure and the methods for analyzing their credit risk. One frequently cited example is asset-backed securities, which reportedly originated in the private market but are now issued in the public market as well.
Firms with Specialized Needs
Another category of firms using the private placement market consists of borrowers that could issue in the public bond market-and in some instances have done so-but turn to the private market for reasons unrelated to the complexity of their financings. Included in this group are privately held U.S. companies and foreign companies that wish to preserve their privacy. Foreign issuers in the U.S. private placement market also avoid the conformance to U.S. generally accepted accounting principles that would be required if they issued in the public debt market. Corporations contemplating acquisitions or takeovers also have often relied upon the private placement market to protect the confidentiality of their transactions and thus decrease the likelihood of competing offers.
Many large companies have used the private placement market to raise funds when time is a factor. For example, when in 1989 the Congress significantly curtailed the tax advantages of issuing debt for Employee Stock Ownership Plans (ESOPs), many large firms sold large ESOPrelated issues just before the new tax laws became effective (July of that year). More than $7 billion of ESOP notes were issued in the private market in June 1989. More generally, corporations have relied upon the private market when funds were needed before a time-consuming public registration could be completed. 48 Often these transactions are to finance acquisitions, and in many instances the issues are sold with registration rights, which places in interest rate penalty on the issuer if the securities are not registered publicly within a specified period of time. 49
Another special circumstance leading firms to use the private market involves financings requiring nonstandard or customized features, such as delayed disbursements or staggered takedowns. In general, selling securities with such specialized terms in the public market is not possible, but investors in private placements often have the flexibility to accommodate issuers' preferences.
Firms with privately placed, medium-term note programs may also be considered a group that issues in the private market for reasons related mainly to regulatory and practical restrictions in the public markets. Medium-term notes have made up an increasing share of total private placement issuance over the past four years. In 1991, for example, medium-term note issuance totaled $6.2 billion, representing 8.3 percent of total private bond issuance. However, this amount was small relative to public medium-term note issuance in 1991, which totaled $73.5 billion. Most firms that have private, medium-term note programs are either private or foreign firms that issue no public securities or public firms that issue privately while waiting to establish a public program.
Issue Size, Fixed Costs of Issuance, and Choice of Market
Besides information problems and regulatory requirements, fixed costs of issuance can affect a borrower's choice of market. 50 As noted in part 1, section 2, most private placements are for amounts between $10 million and $100 million. Focusing first on the tradeoff that can be decisive for issues around $100 million in size, issuance expenses are generally lower for private than for public securities, primarily because they are not registered with the SEC and because they are not are underwritten. Public issuers incur both registration and underwriting expenses. For large issues that are not information problematic, however, the higher fixed costs of a public offering are often offset by the availability of lower interest rates, which reflect the greater liquidity of public bonds and the smaller costs of credit analysis that public lenders bear. Consequently, a company that could issue in either market would find, all else being equal, that the choice hinged upon the size of the offering. For issues smaller than some size cutoff, lower issuance costs make the private market less expensive; for larger issues, lower yields make the public market less expensive. Currently, market participants place the break-even point for the two markets between $75 million and $100 million. 51
At the other end of the spectrum, private placements below $10 million are relatively uncommon for three reasons. First, private placements involve some fixed costs of issuance, which can make total costs of small private issues high. Also, most buyers of private placements would demand high interest rates on small issues to cover their fixed costs of due diligence and loan monitoring. Finally, prospective issuers of small amounts tend to be smaller than the average private market borrower. Such issuers may be too information problematic for private market lenders, whose monitoring capacity is not so high as that of banks and some other lenders. Consequently, as noted above, small companies tend to rely on other sources of funds, one being the bank loan market. As in the private placement market, fees can cause the effective interest rates on bank loans to vary inversely with loan size; nonetheless, for most small borrowers, bank loans are preferable to private placements. 52
Because mainly small and medium-sized companies are information problematic and because such companies typically borrow small or moderate amounts, differential fixed costs of issuance as well as the need for an informationintensive lender lead such companies to borrow in the private placement or bank loan markets rather than the public market. The most important factor in determining the market in which a firm issues, however, seems to be the extent of the information problems the firm poses for lenders.
Other Factors Influencing Market Choice
Apart from gaining access to credit markets through financial intermediaries, informationproblematic firms often gain other advantages from issuing private placements. Borrowers have the opportunity to establish relationships with lenders, the terms of the securities can be tailored to some degree to suit the borrowers' needs, the advancement of funds can be staggered or delayed, and confidentiality concerning the borrowers' financial condition and business operations can be maintained. Restrictive covenants, however, impose costly restrictions on borrowers and thus are seen as a disadvantage. In addition, prepayment penalties eliminate borrowers' opportunity to refinance the bonds at a cost saving, regardless of the level of interest rates. Nevertheless, medium-sized or hard-to-understand borrowers in search of long-term, fixed-rate funds are often willing to trade off the risk control features of private bonds against their perceived benefits.
Evidence from Stock Prices
Previous studies of the reaction of stock prices to announcements that firms had placed bonds privately support the hypothesis that the private placement market is information intensive. In one study, Szewczyk and Varma (1991) hypothesize that, if a company is information problematic, its stock price should rise in response to the announcement of a private placement. Stock investors might view the private placement as a signal that the firm is more creditworthy inasmuch as institutions with access to private information are willing to invest in the firm. If stock investors view the successful placement of private debt as a signal that the firm is engaging in value-enhancing projects, they are likely to bid up the price of the firm's stock. In addition, stock investors may realize that the private placement probably results in the monitoring of the firm's management by additional lenders.
For a sample of public utility companies issuing private placements between 1963 and 1986, Szewczyk and Varma found that their stock prices, on average, significantly exceeded the predicted change after the announcement of a private placement. Moreover, the greatest positive response was shown by utilities that had not issued debt publicly, that is, those for which the least amount of public information would have been available. As a check on the results, Szewczyk and Varma also examined stock prices of utilities that had not placed debt privately. In response to the utilities' announcements of public debt offerings, the changes in their stock prices fell short, on average, of predicted changes.
Research by Bailey and Mullineaux (1989) and Vora (1991) also supports a conclusion that private placement issuers tend to be information problematic. In contrast, James (1987) and Banning and James (1989) find a negative stock price response, but it comes for private placements used to pay down bank loans. In such situations, the number of lenders monitoring management may not increase, and the intensity of monitoring might decrease. Taken as a whole, the results support a conclusion that private issuers are information problematic, but not as problematic on average as bank borrowers.