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The Private Placement

Whenever a company makes a public offering, it must register the issue with the SEC. It could avoid this costly process by selling the issue privately. There are no hardand- fast definitions of a private placement, but the SEC has insisted that the security should be sold to no more than a dozen or so knowledgeable investors.

The tendency for stock prices to decline at the time of an issue may have nothing to do with increased supply. Instead, the stock issue may simply be a signal that well-informed managers believe the market has overpriced the stock.11

One disadvantage of a private placement is that the investor cannot easily resell the security. This is less important to institutions such as life insurance companies, which invest huge sums of money in corporate debt for the long haul. However, in 1990 the SEC relaxed its restrictions on who could buy unregistered issues. Under the new rule, Rule 144a, large financial institutions can trade unregistered securities among themselves. As you would expect, it costs less to arrange a private placement than to make a public issue. That might not be so important for the very large issues where costs are less significant, but it is a particular advantage for companies making smaller issues.

Another advantage of the private placement is that the debt contract can be customtailored for firms with special problems or opportunities. Also, if the firm wishes later to change the terms of the debt, it is much simpler to do this with a private placement where only a few investors are involved.

Therefore, it is not surprising that private placements occupy a particular niche in the corporate debt market, namely, loans to small and medium-sized firms. These are the firms that face the highest costs in public issues, that require the most detailed investigation, and that may require specialized, flexible loan arrangements.

We do not mean that large, safe, and conventional firms should rule out private placements. Enormous amounts of capital are sometimes raised by this method. For example, AT&T once borrowed $500 million in a single private placement. Nevertheless, the advantages of private placementБІАААдavoiding registration costs and establishing a direct relationship with the lenderБІАААдare generally more important to smaller firms. Of course these advantages are not free. Lenders in private placements have to be compensated for the risks they face and for the costs of research and negotiation. They also have to be compensated for holding an asset that is not easily resold. All these factors are rolled into the interest rate paid by the firm. It is difficult to generalize about the differences in interest rates between private placements and public issues, but a typical yield differential is on the order of half a percentage point.

Summary

How do venture capital firms design successful deals?

Infant companies raise venture capital to carry them through to the point at which they can make their first public issue of stock. More established publicly traded companies can issue additional securities in a general cash offer. Financing choices should be designed to avoid conflicts of interest. This is especially important in the case of a young company that is raising venture capital. If both managers and investors have an important equity stake in the company, they are likely to pull in the same direction. The willingness to take that stake also signals management`s confidence in the new company`s future. Therefore, most deals require that the entrepreneur maintain large stakes in the firm. In addition, most venture financing is done in stages that keep the firm on a short leash, and force it to prove at several crucial points that it is worthy of additional investment.

How do firms make initial public offerings and what are the costs of such offerings?

The initial public offering is the first sale of shares in a general offering to investors. The sale of the securities is usually managed by an underwriting firm which buys the shares from the company and resells them to the public. The underwriter helps to prepare a prospectus, which describes the company and its prospects. The costs of an IPO include direct costs such as legal and administrative fees, as well as the underwriting spreadБІАААдthe difference between the price the underwriter pays to acquire the shares from the firm and the price the public pays the underwriter for those shares. Another major implicit cost is the underpricing of the issueБІАААдthat is, shares are typically sold to the public somewhat below the true value of the security. This discount is reflected in abnormally high average returns to new issues on the first day of trading.

What are some of the significant issues that arise when established firms make a general cash offer or a private placement of securities?

There are always economies of scale in issuing securities. It is cheaper to go to the market once for $100 million than to make two trips for $50 million each. Consequently, firms БІАААмbunchБІАААн security issues. This may mean relying on short-term financing until a large issue is justified. Or it may mean issuing more than is needed at the moment to avoid another issue later.

A seasoned offering may depress the stock price. The extent of this price decline varies, but for issues of common stocks by industrial firms the fall in the value of the existing stock may amount to a significant proportion of the money raised. The likely explanation for this pressure is the information the market reads into the company`s decision to issue stock. Shelf registration often makes sense for debt issues by blue-chip firms. Shelf registration reduces the time taken to arrange a new issue, it increases flexibility, and it may cut underwriting costs. It seems best suited for debt issues by large firms that are happy to switch between investment banks. It seems least suited for issues of unusually risky securities or for issues by small companies that most need a close relationship with an investment bank.

Private placements are well-suited for small, risky, or unusual firms. The special advantages of private placement stem from avoiding registration expenses and a more direct relationship with the lender. These are not worth as much to blue-chip borrowers.

What is the role of the underwriter in an issue of securities?

The underwriter manages the sale of the securities for the issuing company. The underwriting firms have expertise in such sales because they are in the business all the time, whereas the company raises capital only occasionally. Moreover, the underwriters may give an implicit seal of approval to the offering. Because the underwriters will not want to squander their reputation by misrepresenting facts to the public, the implied endorsement may be quite important to a firm coming to the market for the first time.

10 See, for example, P. Asquith and D. W. Mullins, БІАААмEquity Issues and Offering Dilution,БІАААн Journal of Financial Economics 15 (January February 1986), pp. 61 90; R. W. Masulis and A. N. Korwar, БІАААмSeasoned Equity Offerings: An Empirical Investigation,БІАААн Journal of Financial Economics 15 (January February 1986), pp. 91 118; W. H. Mikkelson and M. M. Partch, БІАААмValuation Effects of Security Offerings and the Issuance Process,БІАААн Journal of Financial Economics 15 (January February 1986), pp. 31 60. There appears to be a smaller price decline for utility issues. Also Marsh observed a smaller decline for rights issues in the United Kingdom; see P. R. Marsh, БІАААмEquity Rights Issues and the Efficiency of the UK Stock Market,БІАААн Journal of Finance 34 (September 1979), pp. 839 862.

11 This explanation was developed in S. C. Myers and N. S. Majluf, БІАААмCorporate Financing and Investment Decisions When Firms Have Information that Investors Do Not Have,БІАААн Journal of Financial Economics 13 (1984), pp. 187 222.