166 The Economics of the Private Placement Market Mark Carey, Stephen Prowse, John Rea, and Gregory Udell December 1993

Summary: The private placement market is an important source of long-term funds for U.S. corporations. Nonetheless, it has received relatively little attention in the financial press or the academic literature, partly because of the nature of the instrument itself. In particular, a private placement is a debt or equity security sold in the United States that is exempt from registration with the Securities and Exchange Commission by virtue of being issued in transactions "not involving any public offering." Thus, information about private transactions is often limited, and following and analyzing developments in the market are difficult. Indeed, the last major study of the private placement market was published in 1972, and only a few articles have appeared in economics and finance journals since then.

This study examines the economic foundations of the market for privately placed debt, analyzes the market's role in corporate finance, and determines its relationship to other corporate debt markets. One key characteristic of the private placement market is that it is information intensive, meaning that lenders must on the their own obtain information about borrowers through due diligence and loan monitoring. Many borrowers in this market are smaller, less-well-known companies or those with complex financings, and thus they can be served only by lenders willing to perform extensive credit analyses. Such borrowers effectively have no access to the public bond market, which provides funding primarily to large, well-known firms posing credit risks that can be evaluated and monitored with publicly available information.

In this respect, private market lenders, which are mainly life insurance companies, resemble banks more than they resemble buyers of publicly issued corporate debt. However, the private placement market is not exactly like the bank loan market: Private placements are mainly longer-term, fixed-rate debt, and borrowers in this market are on average larger and less information problematic than bank borrowers. Private placements typically have fewer and weaker covenants and are less frequently secured than bank loans.

The study compares the terms of private placements with those of public bonds and bank loans and analyzes the characteristics of borrowers, their motivations for using the private market, and the operations of lenders. It presents an explanation grounded in theories of financial intermediation and financial contracting for the structure of the market and for the differences between the private market and other markets for corporate debt. It also describes the process by which private issuance occurs, focusing on the role of agents, which advise issuers and assist in distributing securities.

Finally, the study analyzes some recent occurrences affecting the market, including a credit crunch in the below-investment-grade segment, the adoption of Rule 144A by the Securities and Exchange Commission, and the changing role of commercial banks. In the past, life insurance companies were the primary buyers of low-rate private placements, but most have stopped buying such issues, leaving many medium-sized borrowers with few alternatives for long-term debt financing. The study's explanation for the crunch, which empahsizes a confidence of market and regulatory events, highlights the fragility of information-intensive markets.

The adoption of Rule 144A in 1990, which clarified the circumstances under which a privately placed security could be resold, has led to the development of a market segment for private placements that are not information intensive. This new segment is thus fundamentally different from the older, traditional market and has many characteristics of the public bond market. Its primary attraction for borrowers has been the availability of funds at interest rates only slightly higher than those in the public market without the costs of registration.

Commercial banks act both as agents in the private placement market and as providers of loans that compete somewhat with private placements. The study considers the prospects for a substantial increase in competition between the bank loan and private placement markets and for a substantial change in banks' roles as agents.

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