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166 the Economics of the Private Placement Market 166 The Economics of the Private Placement Market Mark Carey, Stephen Prowse, John Rea, and Gregory Udell Staff, Board of Governors The staff members of the Board of Governors of The following paper, which is summarized in the Federal Reserve System and of the Federal the Bulletin for January 1994, was prepared in Reserve Banks undertake studies that cover a the spring of 1993. The analyses and conclusions wide range of economic and financial subjects. set forth are those of the authors and do not From time to time the studies that are of general necessarily indicate concurrence by the Board of interest are published in the Staff Studies series Governors, the Federal Reserve Banks, or and summarized in the Federal Reserve Bulletin. members of their staffs. Board of Governors of the Federal Reserve System Washington, DC 20551 December 1993 Preface This study would not have been possible without Kessler, Robert B. Lindstrom, Charles M. Lucas, the generous assistance of an enormous number of Kathryn C. Maney, Terrence P. Martin, organizations and individuals. The opinions Dennis P. McCrary, Thomas Messmore, expressed in the study are not necessarily those of Michael G. Meyers, Stephen T. Monahan, Jr., the Board of Governors, of other members of its Anthony Napolitano, Roger Nastou, Scott J. staff, nor of those who assisted us. Nelson, R. Gregory Nelson, Kevin Newman, Without implying that they agree with or are Ramon de Oliveira-Cezar, Barbara Paige, responsible for the contents of the study, we are Patrick M. Parkinson, Dale R. Paulshock, grateful to the following organizations for their Paul Reardon, Steven H. Reiff, David L. Roberts, participation in formal interviews: Aetna, Bank of Clayton S. Rose, Barry M. Sabloff, Martha S. America, Bankers Trust, Chemical Bank, Citibank, Scanlon, Karl A. Scheld, John E. Schumacher, Continental Bank, First National Bank of Chicago, Terrance M. Shipp, Eric A. Simonson, The First Boston Corporation, Fitch Investors Bram Smith, Dewain A. Sparrgrove, James W. Service, Goldman Sachs and Company, Stevens, Maleyne M. Syracuse, Drew M. Thomas, J.P. Morgan, John Hancock Mutual Life, Lehman Thomas D. Thomson, Richard TB. Trask, Brothers, Massachusetts Mutual Life, Merrill William F. Treacy, Bruce Tuckman, Tracy Turner, Lynch, Mesirow Financial, Metropolitan Life, James C. Tyree, Marc J. Walfish, Russell S. Ward, New York Life, Oppenheimer & Co., The Pruden- Richard S. Wilson, Richard A. Yorks, and tial, Standard & Poor’s, State of Wisconsin Robert L. Zobel. Investment Board, Teachers Insurance Annuity We are especially grateful to those who offered Association, The Travelers Company, and special assistance or who were helpful to an extent William Blair Mezzanine Capital Partners. far beyond the call of duty or public spiritedness: We are also grateful to the following individuals to S. Ellen Dykes for editorial and production for the assistance they provided: assistance; to Edward C. Ettin and Myron L. Loren S. Archibald, Adrian Banky, Steven M. Kwast, who inspired and supported the study; to Bavaria, Donald A. Bendernagel, Allen N. Berger, Lloyd Campbell, Nathaniel S. Coolidge, Salvatore J. Bommarito, Sanford Bragg, Philip E. Leland Crabbe, George Fenn, Mitchell A. Post, Brown, John E. Cartland, III, Robert E. and Stephen A. Sharpe for their many helpful Chappell, Jr., Gerald Clark, Robert Clement, comments; to David Blood, Simon Jawitz, and Richard J. Cobb, Jr., Tim Conway, Patrick J. Robert E. Joyal for special assistance; and to Corcoran, Sally Corning, Paul R. Crotty, Dean C. Jalal Akhavein, Curtis Atkisson, Dana Cogswell, Crowe, Andrew Danzig, Charles E. Engros, Eileen William Gerhardt, and John Leusner for expert Fox, Steven Galante, Andrew B. Hanson, Thomas research assistance. B. Harker, William Hogue, Gwendolyn S. IIoani, Finally, we are grateful for the support of the Gregory Johnson, David S. Jones, John Joyce, Board of Governors, without which this study Gilbey Kamens, Thomas Keavency, Michael B. would not have been possible. Contents Introduction ...................................................................................................................... vii Part 1: An Economic Analysis of the Traditional Market for Privately Placed Debt .............. 1 1. Overview of the Traditional Private Placement Market ...................................... 1 Principal Themes of Part 1 and Key Definitions .................................................... 2 Organization of Part 1 and Summary of Findings .................................................. 4 2. Terms of Privately Placed Debt Contracts ......................................................... 5 Issue Size ........................................................................................................ 5 Maturity and Prepayment Penalties ...................................................................... 7 Types of Payment Stream and Yields .................................................................. 10 Variety of Securities .......................................................................................... 11 Covenants ....................................................................................................... 11 Covenants and Renegotiation .............................................................................. 13 Collateral ........................................................................................................ 14 Summary ......................................................................................................... 15 3. Borrowers in the Private Placement Market ...................................................... 15 Issuers in the Private Placement Market ............................................................... 17 Differences among Firms Issuing in the Public, Private, and Bank Loan Markets ........ 21 Companies Issuing in Both the Public and the Private Markets ................................ 25 Summary ......................................................................................................... 26 4. Lenders in the Private Placement Market ......................................................... 27 Life Insurance Companies .................................................................................. 28 Finance Companies ........................................................................................... 30 Pension Funds .................................................................................................. 30 Banks ............................................................................................................. 31 Other Investors ................................................................................................. 31 Summary ......................................................................................................... 31 5. Private Placements, the Theory of Financial Intermediation, and the Structure of Capital Markets ............................................................... 32 Asymmetric Information, Contracting, and the Theory of Covenants ......................... 34 Information-based Theories of Financial Intermediation .......................................... 36 The Covenant–Monitoring–Renegotiation Paradigm ............................................... 36 Private Placements in a Theory of Credit Market Specialization ............................... 38 Other Empirical Evidence Revelant to the Theory of Credit Market Specialization ...... 39 Summary of Part 1 ........................................................................................... 41 Part 2: Secondary Trading, the New Market for Rule 144A Private Placements, and the Role of Agents ......................................................................................... 43 1. The Rule 144A Market .................................................................................... 43 Features of the Market ...................................................................................... 44 Prospects for Development ................................................................................. 47 2. The Role of Agents .......................................................................................... 47 Who Are the Agents? ........................................................................................ 48 The Stages of a Private Placement Transaction ...................................................... 48 Information Flows ............................................................................................ 57 Price Determination .......................................................................................... 59 Agents’ Fees and Other Costs of Issuance ............................................................ 59 Private Market Efficiency ................................................................................... 60 Private Placements without an Agent ................................................................... 60 Agent Operations under Rule 144A ..................................................................... 61 Summary ......................................................................................................... 61 Part 3: Special Topics ...................................................................................................... 63 1. The Recent Credit Crunch in the Private Placement Market .............................. 63 Definition of Credit Crunch ...............................................................................
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