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THE ECONOMICS OF THE PRIVATE MARKET

Summary

A capacity for due diligence and loan monitoring is a prerequisite for a significant volume of direct investment in private placements by a lender. Life insurance companies, finance companies, banks, and a few other financial institutions have this capability. However, life insurers dominate the private debt market, partly because they have large pools of funds suitable for investment in longerterm, fixed-rate, illiquid securities. Insurance companies also have a long history of lending directly to middle-market firms that has allowed them to develop expertise and cost-effective risk-control technologies. This expertise may constitute a barrier to entry for other financial institutions, including most pension funds, which might otherwise seem to be suited to lending in this market. Regulatory and other obstacles also discourage pension funds and mutual funds from participating heavily in the market. Banks have the necessary expertise in credit monitoring but for several reasons have not found private placements to be suitable investments. As in other credit markets, finance companies have carved out a niche in the private market for higher-risk borrowers.  This segment constitutes a small part of the overall market, but it is one in which the insurance companies have little interest.

Some market participants feel that, over the long term, pension funds will overcome the obstacles that have precluded their large-scale participation to date and will be much more important providers of funds in this market, much as they have replaced life insurance companies as the major source of finance in the private equity market. The immense growth of their assets projected for the future may force pension plans to consider investments in markets new to them.  However, the information-intensive nature of the traditional private market is unlikely to change; so if pension funds are to be a larger source of finance, they will likely become so through indirect investments in funds managed by insurance companies. The alternative is for pension funds themselves to acquire the capacity for conducting due diligence and monitoring.

Private Placements, the Theory of Financial Intermediation, and the Structure of Capital Markets

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