THE ECONOMICS OF THE PRIVATE MARKET
As noted previously, the prices of private market securities are determined primarily by negotiation. In the case of securities distributed on a nonnegotiable basis by fixed-income (public bond) sales forces, the negotiations are implicit in that the agent uses information about market conditions to set a price. This section briefly discusses the mechanics of price determination and the methods that agents and lenders use to set initial and reservation prices.
In most cases, term sheets for private offerings do not include a price or a rate spread over Treasury securities of comparable maturity. 142 When they send a term sheet, agents often orally suggest a price range to potential lenders. Lenders that circle the deal will circle the terms they accept on the term sheet, suggest alternatives for those they do not accept, and state a rate spread and a quantity they will purchase at that spread. The spread and terms may then become the subject of negotiations, or the agent may simply reject or accept the counteroffer. The agent collects counteroffers (the circles) and negotiates until it and the issuer decide that the deal is fully subscribed, at which point investors are notified whether they are in or out of the deal and a coupon rate is set (based on that day's Treasury yield curve and the largest spread among the counteroffers to be accepted). Lenders are thus exposed to a form of interest rate risk during the period between notification of acceptance of their circle and closing. If they hedge risks associated with a circled deal and the deal falls through, they are left with the risk associated with the hedge. Clearly lenders will sometimes have an incentive to back out of a deal during the period between circling and commitment (if interest rates rise), but conventions in the market discourage this action. In general, lenders can pull out of a circled deal without damage to their reputations only if they discover discrepancies when performing their own due diligence.
Agents determine initial prices by various methods. An obvious method is to use spreads for recently issued private placements of comparable risk and maturity. However, partly because private placements are often tailored contracts, the private market is thin enough for some risk levels and maturities so that there may be no comparable recently issued privates. Thus, agents often look for comparable publicly issued corporate debt (especially in investment-grade deals), marking up spreads by their estimate of the public-private differential. Participants' estimates of the average differential are in the range of 10 to 40 basis points for investment-grade securities. 143 A few agents use formal pricing models in their exercises, but comments made in interviews suggest that these are generally used as supplements rather than as primary determinants of prices.
Lenders conduct similar exercises to determine market prices but also must determine reservation prices. At some insurance companies, this determination is effectively done by portfolio managers in a part of the organization separate from that responsible for buying privates. In some cases, portfolio managers mainly compare the returns available from different classes of investments, taking diversification into account. In other cases, they compute required levels of risk-adjusted return on equity and then specify some form of demand schedule to the private placement group. A demand schedule may be as simple as a target volume of private placement purchases in each risk class for a given year, at the best available market prices, or as complicated as explicit required rate of return on equity with quantity constraints attached.