THE ECONOMICS OF THE PRIVATE MARKET
The private placement market is an important source of long-term funds for U.S. corporations. Between 1987 and 1992, for example, the gross volume of bonds issued in the private placement market by nonfinancial corporations was more than 60 percent of that issued in the public corporate bond market. Furthermore, at the end of 1992, outstanding privately placed debt of nonfi-nancial corporations was more than half as large as outstanding bank loans to such corporations.
Despite its significance, the private placement market has received relatively little attention in the financial press or the academic literature. This lack of attention is due partly to the nature of the instrument itself. A private placement is a debt or equity security issued in the United States that is exempt from registration with the Securities and Exchange Commission (SEC) by virtue of being issued in transactions ''not involving any public offering.'' 1 Thus, information about private transactions is often limited, and following and analyzing developments in the market are difficult. 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.2
This study examines the economic foundations of the market for privately placed debt, analyzes its role in corporate finance, and determines its relation to other corporate debt markets. The market for privately placed equity is briefly described in appendix B. In the remainder of the study, the term private placement refers only to privately placed debt.
There seem to be two widespread misperceptions about the nature of the private placement market. One is the belief that it is mainly a substitute for the public bond market: that is, issuers use it mainly to avoid fixed costs associated with SEC registration, and lenders closely resemble buyers of publicly issued bonds. This misperception may have arisen because private placements are securities and because the definition of a private placement focuses on its exemption from registration. Regulatory considerations and lower transaction costs do cause some issuers to use the private market. Principally, however, it is an information-intensive market, meaning that lenders must on their own obtain information about borrowers through due diligence and loan monitoring. Many borrowers are smaller, less-wellknown companies or have complex financings, and thus they can be served only by lenders that 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. Even if registration of public securities were not required, something resembling the private placement market would continue to exist.
The second misperception is that the private placement market is identical to the bank loan market in its economic fundamentals. This misperception may have been fostered by the tendency of some recent studies of information-intensive lending to group all business loans not extended through public security markets under the rubric ''private debt.'' Included in this category are bank loans, private placements, finance company loans, mezzanine finance, venture capital, and other kinds of nonpublic debt. A principal finding of this study, however, is that all information-intensive lending is not the same. In particular, the severity of the information problem that a borrower poses for lenders is an important determinant of the markets in which the company borrows and of the terms under which credit is available.
Besides dispelling these misperceptions, the study describes in detail the nature and operation of the private placement market. It also offers empirical support for the proposition that the private placement market is information intensive and that private market lenders and borrowers are different from lenders and borrowers in other markets. It provides a theoretical explanation for the existing structure of business debt markets that builds upon recent theories of financial intermediation, covenants, debt contract renegotiation, and debt maturity. Finally, it analyzes some recent developments in the private placement market, including a credit crunch, the effect of the SEC's Rule 144A, and changes in the roles that banks play.
Organization of the Study
The information-intensive nature of the private placement market is the theme of part 1 of the study. This part compares the terms of private placements with those of public bonds and bank loans and considers borrowers' characteristics and their motivations for using the private market, as well as the operations of lenders. An explanation grounded in theories of financial intermediation and financial contracting is given for the structure of the market and for the differences between the private market and other markets for capital.
Part 2 focuses on the process of private issuance and completes our basic analysis of the private placement market by considering the role of agents and the effect of Rule 144A. Agents are involved in most private placements: They advise the issuer and assist in distributing securities. In the process, they gather and disseminate information, an important task for a market in which information is scarce.
In 1990, the SEC adopted Rule 144A to revise and clarify the circumstances under which a privately placed security could be resold. Private placements are often described as illiquid securities, but this perception is not entirely accurate. A relatively small secondary market for private placements has existed for years, although the legal basis for secondary trading was somewhat uncertain. 3
Rule 144A 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 traditional private 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 burden of registration requirements. Though still developing, the new market has attracted a significant volume of issuance and thus could be a major step toward the integration of U.S. and foreign bond markets.
Part 3 analyzes two special topics. One is the recent credit crunch in the below-investment-grade segment of the private debt market. Life insurance companies had been the primary buyers of low-rated private placements, but most have stopped buying such issues. Many medium-sized borrowers have been left with few alternatives for long-term debt financing. Our explanation for the crunch, which emphasizes a confluence of market and regulatory events, highlights the fragility of information-intensive markets.
The other special topic is the role of commercial banks in the private market, both as agents and as providers of loans that compete somewhat with private placements. The prospect for a substantial increase in competition between the bank loan and private placement markets is considered, as is the prospect for a substantial change in banks' roles as agents.
Sources of Information
Any analysis of the private placement market is handicapped by a lack of readily available information. Because the securities are not registered with the SEC, only limited data about transactions are publicly available, and most participants disclose relatively little about their operations. Also, relatively little has been written about the market.
In conducting this study, we have relied on public sources to the extent possible, but we have also held extensive interviews with market participants. Our interviewees are active participants in the market and include staff members of life insurance companies, pension funds, investment banks, commercial banks, and rating agencies. The information obtained from these interviews is an important part of our analysis, although our conclusions are based, not on any single test or source of information but rather on the weight of the evidence from extant studies, from new empirical results and theoretical arguments presented here, and from the remarks of market participants.