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THE ECONOMICS OF THE PRIVATE MARKET

Principal Themes of Part 1 and Key Definitions

As noted in the introduction, previous studies have tended to characterize private placements as close substitutes for either publicly issued corporate bonds or for bank loans. Besides providing a detailed description of the market, part 1 develops the theme that neither of these views is correct.  Private placements have some of the characteristics of bank loans and public bonds, as well as some unique characteristics.

Studies characterizing private placements as similar to public bonds note that both are securities and both tend to have long maturities and fixed rates. Such studies focus on regulatory and issuance costs as the factors that motivate borrowers to issue privately rather than publicly. In these explanations, some issuers choose the private market to avoid delays and disclosure associated with SEC regulations. Other, relatively small issues are said to be done in the private market because fixed costs of issuance are smaller there, offsetting interest rates that are somewhat higher than in the public market. Large issues are said to be sold in the public market because fixed costs are spread over a larger base, making lower rates the dominant consideration for issuers.

Although regulatory and issuance costs can affect a borrower's choice of market, other economic forces are of greater importance. The traditional private placement market is fundamentally an information-intensive market. Private market borrowers or their issues are information problematic, and so a key activity of private market lenders is the gathering or production of information about borrower credit quality. The italicized terms are drawn from theories that emphasize the asymmetry of information that often exists between borrowers and lenders. Many borrowers have better information about their prospects than lenders, and they can often take actions once a loan is made to reduce the likelihood of its repayment. To determine the interest rate at which to lend to such borrowers, lenders must engage in due diligence during origination;  and to control moral hazard risk once a loan is made, they must engage in loan monitoring. 7

Lenders in information-intensive markets are generally financial intermediaries. Because due diligence and loan monitoring involve fixed costs, it is economically efficient that only one or a few lenders lend to an information-problematic borrower, rather than the large number of small lenders of a prototypical theoretical securities market. In theoretical models of informationintensive lending, atomistic lenders (small savers) lend to an intermediary, and the intermediary in turn lends to the ultimate borrowers and is responsible for due diligence and monitoring.  Real-world information-intensive intermediaries differ from other intermediaries, such as money market mutual funds, in that they have developed the capabilities required for lender due diligence and monitoring. 8

Firms that issue bonds publicly are generally not information problematic. Public market investors rely mainly on reports by rating agencies and other publicly available information for evaluations of credit risk at the time of issuance and for monitoring.

Information problems are conceptually separate from observable credit risk. For example, a subordinated loan to a large, highly leveraged manufacturer of auto parts may be quite risky, but lenders' evaluation and monitoring of the risk may be a relatively straightforward exercise involving publicly available information (financial statements, bond ratings, and some knowledge of the auto industry). In contrast, a loan to a small manufacturer of specialized composite materials may have low risk but require extensive due diligence by lenders to evaluate and price the risk and considerable monitoring to keep the risk under control. The loan may be low risk because the firm has recently received a large, stable defense subcontract and requires additional financing only to support a highly profitable increase in production.  These facts, however, are unlikely to be widely known and must be discovered and verified by lenders.

Although information problems and observable credit risk are conceptually separate, they are correlated with one another and with firm size. For example, small firms tend both to be riskier and to pose more information problems for lenders.  Market participants sometimes use a firm's size as an index of its access to different credit markets:  A large firm has access to all markets, a mediumsized firm has access to the private placement market but not to the public market, and a small firm lacks access to either market. Firm size is often a good indicator because of its correlation with information problems, but the extent of the information problems that a firm poses for lenders usually is the primary determinant of the markets in which the firm may borrow. In many instances, for example, large firms with outstanding public debt have borrowed in the private placement market when their transactions involved complexities that public market investors were not prepared to evaluate.

To be information problematic, a loan must impose more costs on lenders during the initial due diligence stage or the loan monitoring stage, but not necessarily at both stages. For example, the cost of due diligence for a public issue by a large, complex corporation may be greater than that for a private placement by a medium-sized firm. However, the private placement might still be information problematic because it included many more covenants than the public issue and required more monitoring by lenders than public investors are prepared to undertake.  Similarly, a private placement by a large, wellknown firm that included few covenants and required little monitoring might still be information problematic if it were a very complex or novel issue. In such a case, public lenders would be unprepared to perform the necessary due diligence; only information-intensive lenders would be prepared to do so.

The traditional private placement market thus has much in common with the bank loan market, even though it is a market for securities. Bank borrowers are often small or medium-sized firms for which publicly available information is limited. The prospect for loan repayment is discovered by loan underwriting procedures that are broadly similar to due diligence procedures in the private placement market, and bank borrowers are typically monitored after loans have been made.

Because of these similarities, some studies have grouped bank loans, private placements, and other information-intensive loans under the heading of private debt, in some cases implying that all varieties of such debt are fundamentally the same. However, all information-intensive lending is not the same. Most important, borrowers in the bank loan market are, on average, substantially more information problematic than borrowers in the private placement market. Also, private placements have mainly long terms and fixed rates whereas bank loans have mainly short terms and floating rates; other differences as well exist among the various nonpublic markets for debt.

  1. Outstandings of public bonds of nonfinancial corporations are the sum of bonds rated by Moody's Investors Service and publicly issued medium-term notes. Private placements are estimated by subtracting the figure for public bonds from outstandings of all corporate bonds reported in the flow of funds accounts. Data for bank loans are from the flow of funds accounts.

  2. In some contexts, due diligence refers specifically to activities directed toward compliance with SEC regulations. In this study, the term refers to all credit analysis performed by lenders before and during origination or issuance. Moral hazard risk refers not so much to the risk of fraud or unethical actions as to the risk that a firm's shareholders or managers will take actions that increase the risks borne by bondholders.

  3. A few words of explanation of this terminology may be helpful. In common parlance and in the traditional academic literature, financial intermediary refers to an institution that gathers funds from many (often small) savers and then lends at a profit. Intermediary also sometimes refers to an institution or a person that brings together lenders and borrowers in direct markets, for example an underwriter in the public bond market.  In some recent academic literature, however, intermediary has come to mean an institution that lends to informationproblematic borrowers. We use the terms informationproducing lenders or information-intensive lending instead of intermediary and intermediation because such a lender need not be an intermediary in the traditional sense (some information-producing lenders are wealthy individuals) and also because many intermediaries, such as money market mutual funds, do little credit analysis.  

    Recent theoretical literature has also not always clearly distinguished different types and circumstances of credit analysis. The terms credit evaluation and monitoring often refer to analyses done both before and after a debt contract is signed. We refer to that done before as due diligence and to that done after as loan monitoring. A distinction between the two is important to our analysis.

Organization of Part 1 and Summary of Findings

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