THE ECONOMICS OF THE PRIVATE MARKET
Borrowers in the Private Placement Market
Borrowers in the private placement market generally fall into one or more categories (table 3). Most are information-problematic firms or, if they are not, their financings are complex enough that only information-intensive lenders will be willing to buy them. Others have specialized needs that are a disincentive to public issuance, such as a desire to avoid the disclosure associated with registration. Finally, some have issues too small to be done cost-effectively in the public market. 38
Firms that are not information problematic and that want to issue nonproblematic securities in large amounts generally borrow in the public markets. Those wishing to borrow for short terms or at floating rates generally borrow from banks (or similar intermediaries, like finance companies) or issue commercial paper. Some firms with a preference for long-term and fixed-rate funds, other things equal, may nevertheless end up borrowing for short terms and at floating rates from banks.
In describing U.S. capital markets, market participants often speak of a hierarchy of borrowers and debt markets based on a concept of borrower access. In this hierarchy, nonproblematic firms with nonproblematic issues can borrow in any market; and, for any given financing, they choose the market offering the best terms. Information-problematic firms or issues, however, effectively have no access to the public markets, because public market lenders are not prepared to perform the necessary due diligence and monitoring. Moderately problematic firms may borrow in either the bank or the private placement market, whereas very information-problematic firms must use the bank loan market or cannot issue any outside debt (that is, they may be able to borrow only from those with ownership interest).
From a broad economic perspective, this hierarchy and the differential access of borrowers are not exogenous restrictions on borrowers' actions but are features of an economic equilibrium that is the outcome of choices by both borrowers and lenders. For example, in principle information-problematic borrowers could issue securities publicly, and public bond market lenders could acquire the expertise needed to perform due diligence and loan monitoring. In reality, however, the choices of lenders and borrowers have resulted in an equilibrium in which informationproblematic firms and financings rarely appear in the public markets (see section 5 for an analysis of the economic forces resulting in this equilibrium). In this section, we employ the concepts of access and of a hierarchy of borrowers because they are practical and simplify exposition when the focus is on borrowers alone, taking lenders and the broad market structure as given. We emphasize, however, that the current pattern of access is not set in stone but could change if the economic fundamentals changed.
The set of firms with access to the private market but not to the public market is not the same as the set of private market borrowers. Some private issues are by companies that have access to the public market but choose the private market for special reasons. Similarly, by asserting that very information-problematic firms typically must borrow from banks, we do not mean to imply that all bank borrowers are problematic. In fact, banks serve a wide variety of borrowers.
In the remainder of this section, we explain the taxonomy in table 3 in more detail and then present supporting empirical evidence. The evidence suggests that, as a group, firms with access only to the bank loan and private placement markets differ in several respects from those that have access to the public bond market. Most notably, the average borrower in the former group is significantly smaller than the average issuer in the public bond market. Smaller-sized issuers are often more information problematic and thus must borrow in an information-intensive market. Similarly, firms with access only to the bank loan market are significantly smaller and more information problematic than those having access to the private placement market. Another difference is that the private placements of companies issuing in both the public and the private markets tend to be considerably larger and more complex than private placements issued by companies that borrow only in the private market.
Our principal explanation for these facts involves economic theories centered on asymmetric information, but at least two other explanations are possible. One is that small firms tend to issue in small amounts and differential fixed costs of issuance make the net cost of obtaining funds for relatively small issues lower in the private market. Another possibility is that smaller firms tend to have higher observable risk (defined in part 1, section 1) and different classes of lending institution may have different incentives to take risks. Mispriced deposit insurance may give banks the largest incentives to take risks, whereas the absence of any guarantees may give public bond buyers the smallest. State guaranty associations for life insurance companies, which offer policyholders some protection if their insurer fails, provide intermediate incentives. 39
The three explanations of market choice are not necessarily mutually exclusive. The evidence offers most support for the explanation centered on differences in information problems across firms, some support for differential fixed costs of issuance as a decisive factor in some cases, and little support for the explanation centered on differences in observable risk across firms. The two most important weaknesses of the third explanation are that contract terms (especially covenants) are systematically different in the public and private markets for firms with the same bond rating and that enlarging the set of lending institutions under consideration reveals inconsistencies. 40 Finance companies, for example, enjoy no guarantees similar to deposit insurance and yet reportedly lend mainly to high-risk borrowers. All of the evidence is consistent with the view that the private market normally receives issues that require lender due diligence or loan monitoring. Our characterization of and explanation for the hierarchy thus focuses on differences in information problems.