THE ECONOMICS OF THE PRIVATE MARKET
Organization of Part 1 and Summary of Findings
The remainder of part 1 describes and analyzes the traditional market for privately placed debt and explains differences between the private, public, and bank loan markets. Section 2 describes the terms of privately placed debt contracts and compares them with terms of bank loans and publicly issued bonds, including issue size, maturity, rates, covenants, and other terms. As in the information-intensive bank loan market (and in contrast to the public bond market), borrowers and lenders typically negotiate the terms of private placements, especially any covenants that restrict the actions of the borrower. Covenants are an important part of the technology of loan monitoring. Both bank loans and private placements often include financial covenants, such as minimum interest-coverage ratios, that can trigger renegotiation of the loan terms if the borrower's characteristics change. 9 Such covenants are very rare in publicly issued securities.
Private market borrowers, described in section 3, issue long-term, fixed-rate debt privately for several reasons. Many are information problematic, and their issues would not be readily accepted in the public bond market. These borrowers are, on average, smaller than issuers in the public market and larger than those that borrow only from banks. Borrowers that are not information problematic generally find total costs to be lower in the public bond market, unless the securities they issue have novel or complex features requiring extensive due diligence by lenders. Many new types of security have been introduced in the private market, but after their features are widely understood have come to be issued mainly in the public market. Some borrowers also use the private market to issue quickly or to avoid disclosures associated with SEC regulations. Finally, some nonproblematic borrowers with small-sized issues use the private market because fixed costs of issuance are lower.
The operations of lenders in the private market, described in section 4, are typical of informationintensive lenders. Life insurance companies, the principal lenders, evaluate and monitor the placements they buy in a manner that is generally similar to that of commercial banks' loan underwriting and monitoring operations. They usually have loan officers, loan committees, and credit analysts. Some even have specialized workout groups. 10 These characteristics differ from those of typical public bond buyers. 11 Although some buyers of publicly issued debt perform some due diligence and monitoring, their efforts are much less extensive than those in information-intensive markets. The activities of public market borrowers are often followed rather closely by credit rating agencies and investment banks.
Most private market lenders attempt to build and maintain reputations for reasonableness in renegotiations of debt contracts. Covenants in information-intensive debt contracts are frequently violated, triggering renegotiations. In some renegotiations, a lender is in a position to extract considerable rents from a borrower. Borrowers thus prefer to contract initially only with lenders that have a reputation for fair dealing. This preference is especially strong in the private placement market, where loans typically are for long terms and for substantial amounts, and carry punitive prepayment penalties. Life insurance companies may be especially adept at building and maintaining such reputations because doing so is especially important in some of their other lines of business.
Asset-liability management considerations make private placements particularly attractive to intermediaries with long-term, fixed-rate liabilities, such as life insurance companies. By the same token, these features of private placements are unattractive to banks, which must bear the costs of swapping fixed-rate payment streams to match their floating-rate liabilities. Conversely, banks are more likely than insurance companies to find short-term, floating-rate loans to be profitable. Such economies of scope are probably the main reason for the observed division of lending between banks and insurance companies. The reasons for the limited participations of other kinds of intermediaries, such as finance companies, mutual funds, and pension funds, are discussed in section 4.
In the final section of part 1, facts and ideas from earlier sections are combined with financial theory to produce a descriptive theory explaining aspects of the current structure of the bank loan, private placement, and public bond markets. The theory emphasizes that information-problematic borrowers choose information-intensive markets because they can, on the whole, obtain better terms there. Flexible renegotiation of contracts in the event of covenant violations is an important part of the mechanism supporting better terms for borrowers, and the mechanics of covenants and renegotiation influence the identity and operations of lenders. The theory offers several reasons that information-intensive lenders are usually financial intermediaries. It reveals links between the extent to which borrowers are information problematic and the maturity of the loans they will tend to obtain. These links imply that lenders' decisions to serve particular classes of borrowers and to invest in particular varieties of due diligence and monitoring capacity will be influenced by the nature of their liabilities.
The theory also helps explain why informationintensive lending seldom occurs in the public bond market. In principle, the public bond market might well have developed the capacity to lend to information-problematic borrowers. However, three features of private placements make them a better vehicle than public bonds for lending to information-problematic borrowers: limited liquidity, the usually small number of investors in any given placement, and lower barriers to the flow of information from borrowers to lenders. Debt contracts that are vehicles for informationintensive lending are typically illiquid and held by only a few investors. A borrower prefers that a debt contract with many restrictive covenants and a high probability of being renegotiated remain with the lenders in the original negotiations. Those are the lenders whose reputations for fairness the borrower originally determined to be adequate. A borrower also prefers that the number of lenders remain small because renegotiation is less costly. Also, flows of certain information, such as borrowers' projections of future performance, are more difficult to manage in the public market than in the private market because of legal issues related to SEC registration. 12
The argument that the private placement market is information intensive does not imply that regulatory and issuance costs are unimportant. As noted, some issuers that are not information problematic borrow in the private placement market because fixed costs are smaller, issuance is less time consuming, or disclosure can be avoided. However, the remarks of market participants and evidence presented in the body of the study indicate that these factors are less important than the information-intensive nature of private market lending as determinants of its structure and operation. Even if registration requirements were lifted, something resembling the traditional private market would continue to exist. Informationproblematic firms would still need long-term, fixed-rate loans, and life insurance companies would still have long-term, fixed-rate liabilities. As information-problematic borrowers tend to be medium-sized or small, and thus tend to issue smaller amounts, lower fixed costs of issuance reinforce the appropriateness of private placements as a vehicle for information-intensive lending.