THE ECONOMICS OF THE PRIVATE MARKET
Terms of Privately Placed Debt Contracts
Private placements generally have fixed interest rates, intermediate- to long-term maturities, and moderately large issue sizes. Their contracts frequently include restrictive covenants. These terms differ from those found in other markets for debt, for example, the markets for bank loans and publicly issued bonds.
On average, private placements are larger than bank loans and smaller than public bonds. In 1989, the median new commercial and industrial (C&I) bank loan was for about $50,000; more than 96 percent were less than $10 million (chart 2). 13
When loan size distributions were computed by volume rather than number, large loans naturally accounted for a larger share (chart 3). The mean loan size was about $1 million. The 3.6 percent of loans for $10 million or more accounted for 58 percent of total loan volume. Although most are small, loans for as much as $100 million are not extraordinary.
In contrast, the median private placement issued by nonfinancial corporations in 1989 was $32 million, and the mean was $76 million (charts 4 and 5). None was less than $250,000 (compared with 70 percent of bank loans in that category). Most private placements were for amounts between $10 million and $100 million. 14
The median public issue was $150 million, and the mean public issue was $181 million. Most public issues were larger than $100 million (charts 6 and 7). None was smaller than $10 million, and only 15 percent were smaller than $100 million. 15
In interviews, market participants often remarked that the private market is cost-effective mainly for issues larger than $10 million, whereas the public market is cost-effective for issues larger than $100 million. The data are consistent with this assertion, as only 10 percent to 15 percent of private placements and underwritten public issues (excluding medium-term note issues) fall below the respective boundaries.
These cross-market patterns in size of financing are often attributed to economies of scale in issue size, that is, to declining costs to the issuer, including fees and interest costs, as issue size increases. 16 Such arguments are usually based on a perception that, holding all else constant, interest rates are lowest in the public market and highest in the bank loan market and on a perception that fixed costs of issuance are highest in the public market, smaller in the private market, and lowest in the bank loan market. 17
An alternative, possibly overlapping explanation is that the three markets specialize in providing different kinds of financing to different kinds of borrowers and that relevant borrower characteristics are associated with issue size. In particular, borrowers of large amounts are often big and well-established firms that require relatively little initial due diligence and loan monitoring by lenders, whereas those borrowing small amounts often require much due diligence and monitoring. Thus, borrowers of small-to-moderate amounts usually must borrow in the private placement or bank loan markets, where lenders are organized to serve information-problematic borrowers, whereas those borrowing larger amounts usually can issue in the public market because they are not information problematic. As we show later in part 1, both explanations are important, but the second explanation is probably more important in determining the market in which a borrower issues debt.
Distribution of size of debt instruments, 1989