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THE ECONOMICS OF THE PRIVATE MARKET

Summary of Part 1

The arguments and evidence presented in part 1 of this study imply that, as shown in the following diagram, firms can be placed on an information continuum corresponding to their access to different debt markets. At one end of the continuum are small, new, extremely informationproblematic firms that require a prohibitive amount of evaluation and monitoring and that have little or no collateral to offer prospective lenders. Such firms must either use internally generated funds or obtain outside equity financing (perhaps from venture capitalists). 99  Slightly less problematic, larger firms migrate to commercial finance companies and commercial banks, which provide short-term loans with tight covenants, intensive monitoring, and the renegotiation option. These firms tend to be risky and often borrow on a secured basis. 100  Somewhat larger firms may be able to obtain intermediate-term bank financing or subordinated debt financing from mezzanine debt funds or equity funds. Like bank loan officers, mezzanine fund and equity managers intensively monitor their borrowers. They also control information-related contracting problems partly by exercising some control through their share of the borrower's equity. Somewhat stronger borrowers obtain bank credit on an unsecured basis from commercial banks. Even less informationproblematic firms have access to the private placement market. These firms still have enough information problems to require the services of an intermediary, but they are generally not so problematic as commercial bank borrowers. Thus they can issue long-term debt with looser covenants than those that exist in the bank loan market. Finally, firms that pose minimal information problems for lenders can issue in the public debt markets.

  1. Venture capitalists can be viewed as agents who, acting as insiders, produce information about the prospects of new firms. They design tailored contracts that combine a high measure of control with a risky claim on the success of the firm. See Chan (1983) or Chan, Siegal, and Thakor (1987) for a formal model of the role of venture capitalists in an information-theoretic setting.

  2. Several theoretical papers have shown that collateral may be a powerful tool in solving information-related problems associated with debt contracting (see Chan and Kanatas, 1985, Chan and Thakor, 1987, and Besanko and Thakor, 1987a and 1987b). Finance companies and commercial banks frequently require collateral as part of their loan contract (see Berger and Udell, 1990 and 1993b). Much evidence suggests that secured lending tends to be associated with riskier borrowers (see Berger and Udell, 1990, 1993a, and 1993b, Boot, Thakor, and Udell, 1991, and Swary and Udell, 1988).

Part 2:  Secondary Trading, the New Market for Rule 144A Private Placements, and the Role of Agents

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