THE ECONOMICS OF THE PRIVATE MARKET
Lenders in the Private Placement Market
Although various institutions hold some traditional private placements in their portfolios, life insurance companies purchase the great majority of them. For example, for a sample of 351 placements issued during 1990-92, life insurance companies purchased 83 percent of dollar volume, whereas the next largest type of investor, foreign banks, purchased only 3.6 percent (table 7). 62
Lending in the private placement market is also concentrated in the hands of a relatively few lenders. Although the sample lists 315 separate investors, most participated in only one deal or in a few deals and bought only small amounts. The top twenty investors were life insurance companies and accounted for 56 percent of dollar volume.
The concentration of private placement lending in the hands of a relatively few lenders and a few types of lender has probably occurred for four reasons. First, the large proportion of informationproblematic borrowers in the traditional private market necessitates that major buyers of private placements be intermediaries. Intermediaries can capture economies of scale in due diligence and monitoring and can also build and maintain over long periods the reputations for fair dealing that are important when debt contracts must include covenants.
Second, financial intermediaries tend to specialize in a few liability-side lines of business (for example, banks mainly take deposits) at least partly because of regulatory restrictions. Given such specialization, the natural tendency of lenders to seek superior risk-adjusted returns will lead to specialization on the asset side. Different debt instruments are associated with different patterns of risks, and different lenders have different abilities to implement a cost-effective and appropriate set of risk control measures in order to earn superior risk-adjusted returns on any given type of asset. For example, banks' short-term deposit liabilities lead them to make short-term loans, whereas insurance companies' longer-term liabilities lead them to purchase longer-term assets.
The risks most commonly associated with traditional private placements of debt are credit risk, asset concentration risk, interest rate risk, and liquidity risk. Extensive credit evaluation and monitoring are required to control credit risk in private placements, whereas appropriate diversification can control asset concentration risk. Interest rate risk may be controlled by matching private placements with liabilities of similar duration, or other hedges. With regard to liquidity risk, if a lender holds private placements, its liabilities must not be redeemable on demand, or other parts of its portfolio must be sufficiently liquid to meet any likely withdrawals. The relative efficiency with which different classes of financial intermediary can undertake to control these risks, as well as legal and regulatory constraints, determines the institutional pattern of investments in private placements. Although many financial intermediaries can effectively control the credit and asset concentration risks associated with private placements, life insurance companies are especially well positioned to control the liquidity and interest rate risks. 63
A third reason for the concentration of private placement lending is the concentrated structure of the insurance and related markets. At the end of 1991, the twenty largest life insurance companies held 51 percent of industry assets. Because these companies have a large volume of funds to invest, their domination of the private placement market is natural. A final reason for concentration is that large lenders have an advantage in obtaining private placements because their large volume of investments permits them to participate in the market continuously, giving them up-to-date information about the state of the market (see part 2, section 2).
Apart from the statistics shown in table 7 and some data for the life insurance industry that are discussed in parts 2 and 3, little detailed information on investors in private placements is publicly available. Consequently, much of our discussion is based on interviews with market participants. To summarize this information, life insurers buy a broad spectrum of private placements, but many of them focus on senior, unsecured debt. Finance companies are also said to be significant buyers of private debt, but they tend to specialize in highrisk investments and, consequently, require that borrowers provide collateral and equity kickers, such as warrants or convertible bonds. They have developed special expertise in due diligence and monitoring involving collateral and equity features. Though commercial banks have the capabilities for credit analysis, they are not significant buyers of private placements, probably because their short-term, liquid, floating-rate liabilities are not well matched by private bonds. Regulatory and other restraints prevent or discourage major investors in public bonds, such as most pension funds and mutual funds, from investing heavily in private bonds.