THE ECONOMICS OF THE PRIVATE MARKET
The Stages of a Private Placement Transaction
This subsection describes the role of the agent at each stage of private placement issuance, emphasizing the ways in which agents add economic value to the transaction. Readers not already familiar with the details of private issuance may find the description of a sample private placement transaction that appears in appendix F helpful at this point. The example provides a sense of the flow of the process that may be useful background for the analysis in this section.
As shown in the following diagram, a deal passes through five major stages. During the prospecting stage, agents identify potential issuers and compete with each other to gain the issuer's business. Issuers decide whether to place a private issue or to use another vehicle for financing and whether to hire an agent or to issue without assistance.
During the contract design stage, and sometimes during prospecting, agents analyze in detail an issuer's condition, operations, and plans (due diligence) and use this information to set major debt contract terms. They summarize the terms on a term sheet and write an offering memorandum describing the issuer, which is somewhat similar to a prospectus. The memorandum and term sheet are often packaged together and called ''the book.'' If necessary, agents seek a rating of the issue. They then choose an initial strategy for distribution and, in some cases, carry out preliminary inquiries of investors.
During the distribution stage, which is coincident with the design stage for many deals, the agent seeks investors. Negotiations that change the term sheet often occur. In some cases, the agent first seeks a lead lender (traditionally, the investor that buys the largest fraction of the placement) and conducts most negotiations with it; only after the lead has committed to the deal does the agent attempt a broader distribution. In other cases, the agent attempts a broad distribution from the beginning. An initial commitment by a lender is known as ''circling'' the deal. Such a commitment is contingent on approval by the lender's investment committee and on due diligence by the lender that produces satisfactory verification of the information in the offering memorandum. Negotiations about price are conducted in terms of spreads over Treasuries of comparable average life until a deal is fully subscribed, at which time coupon rates are set. 122 If necessary to attract additional investors, the coupon rate may be increased after it has been set, but it may not be reduced even if Treasury rates fall between rate-setting and closing. Similarly, if Treasury rates rise, by tradition the lenders may not demand a higher coupon.
The contract design and distribution stages typically require one to two months. The process of obtaining a rating is the most important source of delays. 123
The penultimate stage, due diligence by lenders, begins when a deal is fully subscribed. Before circling, lenders carry out a significant amount of credit analysis, which often involves gathering some information not found in the offering memorandum. During the due diligence stage, lenders verify the information in the offering memorandum and, if satisfied, present the deal to investment committees for approval. Rarely do investment committees reject a deal for anything but unsatisfactory due diligence. Rejection after circling imposes large costs on other members of the lending syndicate and on agents and borrowers. Agents are less likely to bring deals to a lender with a history of such behavior, and other lenders are less willing to join it in syndicates. Rejections thus in the long run affect a lender's ability to invest in private placements on favorable terms.
In the final stage of private issuance, lawyers hammer out the language of the debt contract, which involves several documents besides the notes themselves (see table 11 for the major documents). 124 The lenders are represented by a bond counsel, which is by tradition chosen by the lead lender but paid by the borrower. The borrower is often represented by its own counsel and is usually assisted by the agent. Transactions can unravel at this point when interpretations of term sheets differ, but such unraveling is relatively rare. Although it varies, the time required for the final stage is usually a few weeks. Once all parties sign the contract (closing), funds can be disbursed to the borrower.
The remainder of this subsection describes and analyzes each of the stages in more detail.
Prospecting, Initial Advice, and Inter-Agent Competition
Commercial banks and investment banks obtain most of their private placement clients through contacts initiated by relationship officers, who are traditional bank loan officers, investment bankers responsible primarily for maintaining relationships with clients, and hybrids of the two. Relationship officers call on current or prospective clients of their organization, attempt to learn about the broad spectrum of client needs for capital and financial services, and in the process often help clients to recognize opportunities and incipient problems. These officers are also able to identify opportunities to sell specific products.
Relationship officers consult their private placement group when they recognize that a private placement may be an appropriate way for a client to raise funds. When several different borrowing strategies might serve a client's interests, some organizations arrange presentations to the client by different groups within the organization, for example, the private placement group and the loan syndication group.
The prospecting process sometimes departs from this description at some commercial banks where most customer contact is by traditional loan officers and where the loan officers' compensation is determined by success in originating loans. This type of compensation scheme may deter loan officers from recommending a private placement over a commercial loan. According to market participants, commercial banks are losing this weakness as they change their organizational structures and compensation schemes.
Agents may also obtain clients through requests by previous private placement clients for help with new transactions. Such requests are sometimes made directly to the agent group, as the client already knows them. Direct requests are also received from potential issuers who want competitive bids from different agents. Relatively few agenting jobs for first-time clients result from prospecting by the private placement group itself.
Agents compete for the right to assist particular private placements, with the degree of competition depending both on expected profits and on the extent to which a borrower seeks multiple bids. Some agents specialize in particular types of transactions, and thus their explicit costs and opportunity costs differ across transaction types, so a given borrower can be quoted a variety of fees. Competition exists also along dimensions other than fees, as borrowers must estimate both the likelihood that a given agent can successfully distribute the securities and the interest rate and other loan terms that the agent can obtain. Borrowers do not typically possess the information required to make such estimates with precision, so they must rely, at least to some extent, on reputations and on the claims made by agents in sales presentations. Agents from an organization with which a borrower has a satisfactory, ongoing relationship thus have a significant advantage in competing for that borrower's private placement business.125
A considerable amount of economic value is added by agents during the prospecting, advice, and competition stage of a transaction. Some borrowers know little or nothing about the private market and may not consider it as a source of funds unless it is suggested by a relationship officer. Even if they are somewhat informed, borrowers will usually not commit to bear the opportunity costs associated with a private market offering without first comparing the opportunities there with those in other markets. Such a comparison can be done only with reasonably current and complete information about the operation of the private market and the terms available there. The costs of gathering such information are much higher for the private placement market than for the bank loan and public debt markets, especially if the borrower has never issued a private placement. Either directly or through their organization's relationship officers, agents provide such information to potential borrowers as part of their marketing efforts and thus improve the efficiency of financial markets.
Economies of Scale and Scope
Although available data do not support precise measurement, the remarks of market participants imply that economies of scale and scope at the prospecting, advice, and inter-agent competition stage of transactions strongly influence the structure of the market for agent services. An agent organization need not be large, but it must bear the staff and overhead costs of near-continuous gathering of information about private market conditions and of maintaining relations with lenders. Thus, the number of relationship officers calling on clients likely to issue private placements must be sufficient to yield clients paying fees that at least cover costs. Although the organization as a whole is not absolutely required to be large, commercial banks and investment banks that serve many corporate clients of medium to large size are more likely to provide a large flow of private placement prospects to their agent groups. Such organizations can thus spread the overhead costs of information gathering over a broader base of revenues. In other words, scope economies may exist between agenting and providing other financial services to medium and large corporations. Commercial banks that focus mainly on small business lending, mortgage loans, or consumer lending will have difficulty making a profit on private placement agenting.
Indirect evidence of economies of scope can be seen in the rankings of the thirty major agents according to their volume of commercial banking and investment banking business (table 10). Bank holding companies were ranked by the total consolidated volume of commercial and industrial loans on their books at the end of 1991. 126 Investment banks were ranked according to the total volume of domestic securities issues of all kinds for which they acted as lead manager. 127 As with the ranking of agents, we claim not that the order of rankings is entirely accurate or important but only that a significant ranking indicates a large volume of activity in the capital markets.
The top twenty-six agents rank among the top twenty commercial banks or the top fifteen investment banks, or both. All of the top fifteen investment banks are major agents, as are all of the top five commercial banks. Fifteen of the top twenty commercial banks reportedly acted as agent at least once. This predominance of large commercial and investment banks in the agenting industry is consistent with the existence of significant economies of scale and scope in agenting. 128
The economies of scale and scope realized at the prospecting, advice, and competition stage influence an agent's strategy and specialization. An agent within a commercial or investment bank that serves mainly Fortune 500 and large international corporations will naturally find most of its clients coming from those groups. As is discussed further below, design and distribution of the private issues of such borrowers is typically different from that for middle-market borrowers, and it is efficient for the agent to gather somewhat different information and to maintain somewhat different relationships with lenders than an agent specializing in serving middle-market borrowers.
Design of Major Contract Terms and Distribution of Securities
Having won an issuer's business, an agent begins designing and perhaps distributing the securities. 129 Design involves setting the terms of the securities, including payment amounts, timing, and covenants. Distribution involves finding lenders that will buy the securities. In contrast to the phases of public issuance, the line between the design and distribution phases is blurred and in some cases does not exist because design of the terms of privately placed securities often involves negotiations between lenders and borrowers. The negotiations may be implicit or explicit and may take place either before or during the period when the securities are offered to lenders. The nature and the timing of the negotiations depend to a large extent on the style of distribution chosen by the agent, which in turn depends on the identity of the agent, the characteristics of the borrower and the loan, and market conditions.
At one extreme, the process can resemble a best-efforts public underwriting. Here the agent uses its knowledge of market conditions and lenders' preferences to design terms that are likely to satisfy lenders, including an interest rate spread. The securities are then offered to many potential investors on a take-it-or-leave-it basis. If the issue cannot be fully sold, the interest rate may be increased or other terms may be changed. There is often no lead lender in the usual sense, although one lender may be designated as lead.
At the other extreme, the agent may contact one or a few potential lenders immediately upon receiving a mandate from the issuer and inform them of the identity of the borrower and the likely amount of the loan. Reactions of the lenders and ensuing negotiations influence the terms of the securities. By the time the term sheet is finalized, distribution may be pro forma because all or almost all of the lenders may have made informal commitments. Any unsold portion is made available to investors at large, although they have no opportunity to negotiate the terms.
Between these extremes is a continuum of styles. One part of the design phase, however, does not vary much across styles: due diligence.
Agents of traditional private placements do not bear the market price risks associated with public underwriting, as nonunderwritten placements never appear on agents' books. Agents are nevertheless at risk, in three ways. First, they are paid only for successful placements, and thus their investment in a particular transaction of staff time and other resources is at risk until closing. Deals can unravel for many reasons; one is a lender's discovery after circling but before formal commitment that the offering memorandum misrepresented the borrower's circumstances.
Second, the agent's reputation with lenders is at risk. Lenders also invest time and resources in evaluating potential loans, and the semiformal loan commitment that circling a deal represents is based mainly on the information in the offering memorandum and term sheet. If in performing its own due diligence a lender finds an offer memo to be materially incomplete or inaccurate, it will be less likely in the future to expend resources in considering transactions proposed by that agent. Also, if an agent is associated with too many placements that later decline in credit quality or go into default, lenders will be less likely to deal with that agent.
Third, private placement agents have been named as parties in some lender-liability lawsuits. Agents must thus take the potential costs associated with such suits into account when estimating the profits from assisting a transaction.
Agents control these risks by conducting a close examination of a borrower's business, financial position, and plans. They perform this due diligence immediately after they receive a mandate to assist a borrower's placement and, to some extent, before that. This examination resembles the due diligence performed by lenders and usually includes a visit to the borrower's headquarters or other relevant sites. Besides controlling risks, the examination provides the agent with information needed to write the offer memo and term sheet.
Some commercial banks and investment banks are sufficiently concerned about these risks that private placement agenting jobs must be approved by a credit committee. Some market participants stated that their committees reject a substantial fraction of agenting jobs.
Value Added from Due Diligence by Agents
Two ways in which agents add value are by pre-screening borrowers and by gathering information needed by potential lenders. Each of the large private market lenders is offered hundreds of placements in a typical year and refuses all but a small fraction. 130 At the typical large lender, an initial evaluation occurs when the agent offers the transaction. This evaluation is based mainly upon information in the offering memorandum and term sheet. Some proposed transactions can be quickly rejected, because they fail to meet the investor's credit criteria, its yield objective, or its diversification requirements. Others require more extensive evaluation, but this is still based on information in the offering memorandum and any additional information communicated during negotiations. Lenders typically perform their own due diligence to verify the information in the offering memorandum only after circling a deal.
The typical placement is offered to many potential lenders. The process would be inefficient if each of them gathered all the information required either to reject or to circle a deal and if each had to weed out obviously unqualified borrowers. In such a situation, the aggregate staff costs associated with private placement lending would be much larger.
Agents improve the efficiency of the intermediation process by performing these two functions. To do so, they must perform due diligence similar to that done by lenders during the verification stage. As noted, such examinations of borrowers begin during the prospecting, advice, and interagent competition stages. 131 At this point, many potential borrowers that are not actually able to issue are weeded out on the basis of a modest amount of information-gathering and effort by the agent. Resources are saved because only one organization processes and rejects the ''applications'' of such borrowers and because only one organization gathers the information that appears in the offering memorandum. 132
This division of labor works because agents that do not perform adequate due diligence will quickly acquire a bad reputation. 133 Lenders do not actually commit funds based only on an agent's due diligence, but they are willing to incur the costs of initial evaluations. If they later find that the agent did not conduct a thorough evaluation or misrepresented the facts, they can prevent further losses by backing out of the deal. In the relatively small community of private placement professionals, the agent's reputation will be tarnished, not only with that lender but with other lenders as well. The agent will then be at a competitive disadvantage, as lenders will be less willing to consider placements offered by it in the future. Thus, the incentives of agents (with regard to due diligence) are kept closely enough in line with those of lenders that the efficiencies of having agents perform much of the pre-screening can be captured.
Determinants of the Style of Design and Distribution
The terms of a private placement are determined mainly by market conditions and the risks associated with lending to the borrower. Securities issued by risky or informationproblematic borrowers must include more covenants or a higher rate of interest or both. However, the process by which the terms are determined may influence the nature of the terms and the costs associated with issuance. The process includes the negotiating strategies adopted by the issuer and agent and the way in which lenders are identified.
For example, an agent may be uncertain whether or not lenders will insist on a covenant restricting a borrower's interest coverage ratio. If the agent makes preliminary inquiries, the lenders will know that such a covenant is negotiable and will be more likely to insist on it. The agent may offer securities without the covenant to lenders sequentially, hoping to find some that make counteroffers not including the covenant. 134 But a sequential offering runs the risk that some lenders that would enter negotiations if they saw the covenant on the term sheet will reject the deal entirely. Returning to such lenders after completing the sequence is difficult. Also, sequential negotiations can be time-consuming and costly, and in a long-run equilibrium agents' fees must reflect costs. Thus, competitive pressures often militate against sequential offerings. Instead, the agent may offer securities to many lenders simultaneously, on a first-come, first-served basis. If the issue is not fully subscribed, terms can be changed in response to lenders' counteroffers and another offering made. However, a simultaneous offering can be more expensive than a sequential offering that is quickly subscribed, as more lenders are involved. Also, for placements that require a lead lender, a simultaneous offering to the universe of lenders may be infeasible because smaller lenders will not consider some deals until a lead lender has circled.
In cooperation with the borrower, an agent makes decisions on four matters in determining the style of a distribution:
Decisions are aimed at obtaining good terms while limiting the agent's costs of design and distribution. 135 At the outset, the agent commits to assist the issuer for a fee equal to a fixed percentage of the loan, and thus the agent's profits are directly related to its costs. Agents usually avoid high-risk strategies because they collect fees only for successful distributions. They also consider the effects of a strategy on their reputations and relationships with lenders. Negotiating strategies that annoy lenders may hamper an agent's ability to do business in the future.
In this context, several factors appear to be the primary determinants of the decisions that are made. One is the complexity or severity of the information problems posed by the borrower's business, financial structure, and corporate structure and by the complexity of the financing in progress. Complexities force potential lenders to invest more resources in credit analysis and, in some cases, not all lenders will have the necessary expertise. There is an incentive to find a lead lender for such placements, as the agent can use the lead's commitment as a signal to other investors that necessary analyses have been done and that the terms are satisfactory. There is also an incentive to offer the placement initially to only one or to a few potential lead lenders, as they will be more likely to invest in the necessary analysis if they know that competition to buy the placement will be limited until the terms are set. 136
A second factor is the rating of the borrower and any prospective changes in its condition. Because default risk varies much more across B-rated borrowers than across A-rated borrowers, lenders must do much more analysis of lowerrated borrowers before they can negotiate terms. Here, again, an incentive exists to find a lead lender and to negotiate initially with only a few potential leads. Lenders, being also more reluctant to lend to borrowers that appear to be headed downhill, insist on more stringent covenants to control risk. They will be more likely to enter negotiations if the initial term sheet includes a strong covenant package, as it is a signal that the borrower recognizes the problem and will not impose unusually large negotiating costs on the lender over the term of the loan.
The distribution facilities available to the agent are a third factor affecting distribution strategy. When a financing is highly rated and straightforward, requiring relatively little analysis by lenders, a lead lender may be unnecessary, and offering the placement simultaneously to the universe of buyers of private placements may be possible. Some large investment banks use their fixedincome sales forces to make such offers. Because these sales forces already bear the fixed costs of staying in communication with a large group of buyers, this method can be cheaper to implement than distributions made solely by the less specialized members of the private placement group. Thus, other things being equal, agents with such distribution channels at their disposal are more likely to offer a placement simultaneously to many buyers.
A widespread distribution may not always be feasible. Besides the reasons already given, if a borrower wants to maintain confidentiality about the transaction, the offering is likely to be shown to a limited number of lenders. Lenders can extract a premium from such borrowers, of course, as breaking off negotiations and turning to another potential lender are costly to the borrower. An inexperienced or uninformed agent is more likely to offer a placement to a few lenders at a time and solicit counteroffers from them than to offer to several lenders on a take-it-or-leave-it basis. Such an agent may lack the knowledge required to choose an optimal set of terms and may also have relationships with only a few lenders. A distribution may also be limited if a borrower wishes to establish a relationship with a particular set of investors. Finally, although in principle a broad distribution by a fixed-income sales force may be done quickly for some standard placements, in cases where rapid progress on negotiations and approvals is required the number of lenders often must be small.
Market conditions, too, may influence distribution strategies. When demand is high for placements in general or for particular kinds of placements, agents are more likely to write initial term sheets with fewer and looser covenants and to suggest rates slightly below market.137
This framework is a basis for describing the spectrum of placement design and distribution styles already mentioned. Agents are most likely to choose a style similar to a best-efforts public underwriting (involving an offering to many lenders on a take-it-or-leave-it basis) when the placement has a fairly high rating and standard terms, when the issuer is relatively well known and has no unusual corporate or financial structure, when the issuer does not insist on confidentiality or unusual speed, and when the agent has the means to distribute broadly at low cost. 138
The style at the other end of the spectrum, negotiating terms with one or a few lenders, is most likely for placements that are highly complex or that require confidentiality, speed, or that are motivated in part by the borrower's desire to establish a relationship.
A common hybrid style involves initial negotiations with one or a few potential lead lenders, followed by an offering to many lenders once a lead has been obtained. This style is most common for placements with some complexity, so that the signal provided by the lead's commitment is important, but in which the borrower does not insist on confidentiality nor on speed.
In general, the choice of design and distribution style is the outcome of the complex decision problem previously described. Styles vary widely because the circumstances surrounding individual private placements vary widely. The examples given here hint at, but do not fully capture, the diversity of styles.
Value Added by Agents' Design and Distribution
Agents are used primarily because they have the knowledge, expertise, and organization to place securities on terms more favorable (even after subtracting their fees) than the borrower itself could obtain. Some borrowers acting alone might locate willing lenders at only moderate cost, but they could be at a disadvantage in negotiations because the lenders might assume that, should negotiations break down, the borrower would find locating additional lenders costly. Agents' activities increase the efficiency of capital markets because, in effect, they heighten competition among lenders and reduce the total costs of borrowing.
Strategic Implications of Distribution Methods for Agents
As we have argued, some agents may specialize in serving certain kinds of private placement clients (for example, middle-market companies) because their organizations' relationship officers, the primary source of clients, specialize in serving those clients. To some extent, agents also specialize in styles of distribution. Such specialization both influences and is influenced by specialization in types of clients.
All private placement agents can perform the standard varieties of design and distribution, in which they send offer memos and term sheets to some number of potential lenders and then negotiate with those lenders. One avenue of specialization involves the identity of the lenders an agent ordinarily deals with. Because large insurance companies often find focusing their limited staff time on large or complex placements more profitable, agents that advise on mainly smaller issues may find maintaining close relationships with midsized and smaller lenders more profitable. Conversely, agents that tend to advise on large and complex placements may deal mainly with the largest life insurance companies. A sophisticated borrower surveying the field of agents may find it most advantageous to choose one that frequently deals with appropriate lenders.
A more recent variety of specialization involves the use of public bond sales forces to offer private placements on a take-it-or-leave-it basis to a large number of potential buyers. At present, only a few agents use this method and only for some of the placements on which they work. The relationship officers of these agents provide a steady stream of clients issuing the kind of highly rated, relatively standard placements that are most amenable to distribution on a take-it-or-leave-it basis. According to market participants, such agents apparently are mainly large investment banks. Few, if any, commercial banks appear to use the method at this time.139
Economies of scope between agenting and public debt underwriting do not appear to be enormous. All of the top ten private debt agents listed in table 10 are either investment banks or commercial banks with agents located in securities subsidiaries with debt underwriting powers. However, five of the agents ranked in the next tier of ten had either no securities subsidiary or one with limited powers. Thus, an organization can have a substantial agenting business without also being able to act as underwriter.
Lender Due Diligence and Contract Writing
After enough lenders have circled a deal to make it fully subscribed, the final phases of the private issuance process begin. First, lenders that circled verify the information on which they based their commitments. Large lenders conduct relatively extensive investigations that include trips to the borrower's facility (small lenders may again rely on the lead). If the investigations are satisfactory, formal letters of commitment to lend are dispatched. If lenders find material omissions or misrepresentations, either the deal falls apart or negotiations are reopened.
Following formal commitments, by convention the lead lender nominates a bond counsel to act as the lenders' representative in negotiating the detailed language of the debt contract. The bond counsel is paid by the borrower, which retains its own counsel to assist in negotiations. The agent often also assists in negotiations.
Closing or settlement concludes the process of issuance. The documents are signed, and funds are disbursed to the borrower and the agent.