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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.

Issue Size

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

By number of issues

By volume

2.  Loans

3.  Loans

4.  Private placements

5.  Private placements

6.  Public bonds

Size of loan (millions of dollars)
7.  Public bonds

Size of loan (millions of dollars)
The samples of private placements and publicly issued bonds on which the charts are based include only issues by nonfinancial corporations and exclude medium-term-notes, convertable and exchangeable debt, and asset-backed securities.  Numbers may not sum to 100 because of rounding.
  1. The year 1989 was chosen because, as described in the section on the credit crunch (part 3, section 1), 1990-92 may have been unusual years in the private placement market. The nonfinancial subset of all new loans and issues was chosen because data on other types of bank loans are not available.  Sources of data and details of the calculations that produced the charts are in appendix G.

  2. The nonfinancial straight debt subsample represented by chart 4 is fairly representative of all private placements, including convertible, mortgage-backed, and medium-term note issues. See appendix G.

  3. These statistics do not imply that the total number of private placements or public issues exceeds the total number of bank loans larger than, say, $10 million. The number of new bank loans in any year is very large, so even a small fraction of new loans can be substantial.

  4. See Bhagat and Frost (1986), Ederington (1975), and Kessel (1971). For a comprehensive list of studies on the patterns of underwriting fees, see Pugel and White (1985).

  5. One problem with this explanation is that interest costs are not always lowest in the public market for all classes of borrower. This issue is discussed in more detail in the subsection ''Type of Payment Stream and Yields.'' Another problem is that empirical evidence of a relation between yield and issue size within the public market is weak.

    Interest rates may be higher in the private and bank loan markets for various reasons, one of which is that lenders must be compensated for the fixed costs of due diligence and monitoring they perform. Lenders charging no fees must demand a higher yield on smaller loans to recover such fixed costs.

Maturity and Prepayment Penalties

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