A corporation can sell the entire issue to a single purchaser (generally a financial institution or wealthy individual) or a group of such purchasers rather than sell new securities to the general public or existing shareholders. This type of sale is known as a private (or direct) placement, for the company negotiates directly with the investor(s) over the terms of the offering, eliminating the underwriting function of the investment banker.
Financial intermediaries are the term that might best describe the many types of financial institutions that invest in private placements. Dominant private placement investors in this group include insurance companies, bank trust departments, and pension funds. In what immediately follows, we focus on the private placement of debt issues.
One of the more frequently mentioned advantages of a private placement is the speed with which the private deal is transacted. A public issue must be registered with the SEC, red herrings and final prospectuses prepared and printed, and extensive negotiations undertaken. All this requires time. In addition, public issues always involve risk respect to timing. Private placements, on the other hand, are not subject to SEC registration requirements, because it is felt that persons or institutions with enough capital to buy an entire security issue should be able to acquire on their own the kind of information that registration would disclose. Also, with private placements the terms can be tailored to the borrowerâ€™s needs, and financing can be consummated quickly. However, we need to remember that the qualified large corporation can also tap the public market quickly, and with limited paperwork, through a shelf registration.
Because the private placement of debt is negotiated, the exact timing in the market is not a critical. The fact that there is most often only a single investor or small group of investors is attractive if it later becomes necessary to change any of the terms of the issue. It is much easier to deal with one investor (or small group) than with a large number of security holders.
Another advantage of a privately placed debt issue is that the actual borrowing does not necessarily have to take place all at once. The company can enter an arrangement whereby it can borrow up to a fixed amount over a period of time. For this credit arrangement, the borrower will pay a commitment fee. This type of arrangement gives the company flexibility, allowing it to borrow only when it needs the funds. Also, because the private placement does not have to be registered with the SEC, the company avoids making public certain information that it may deem better left confidential, such as sources of raw materials, a unique manufacturing process, or executive compensation.
Developments in the Market
By selling new bonds to the general public, the issuing corporation can dramatically change its capital structure and thereby end up with much higher debt. Any bonds previously outstanding become less creditworthy and drop in price. Generally, this event risk — decline in creditworthiness brought on by increased financial leverage â€“ cannot legally be prevented by the holders of the companyâ€™s previously issued bonds. With a private placement, however, such event risk can be avoided with tightly written protective covenants.
Another advantage to institutional investors is that the SEC (through Rule 144a) now permits them to resell securities generated in the private placement market to other large institutions. Thus, US companies, as well as foreign companies, can issue bonds and stocks in the market without having to go through public market registration procedures. Then, qualified institutional buyers (QIB) can sell the securities to other qualified institutional buyers, without waiting out any holding period and without subjecting the issuer or security holder to additional regulation by the SEC. As a result, the market becomes broader and more liquid.