Intimate world of private placements
Private placements (PPs) are private as opposed to public securities. In the case of PPs, securities are offered directly to a limited number of investors and are exempt from stock exchange listing or public registration and usually unrated.
The most common form of private securities are long-term, fixed-rate debt. These securities tend to be ‘buy and hold’ and are not generally traded in a secondary market, although secondary markets do exist.
The US Private Placement (USPP) market, though smaller than the public markets, is of significant size. In 2004 there were around $45bn(€36bn) of new issuance in the PP market.
Traditional USPPs are permitted because of a general statement in Section 4(2) of the 1933 Securities Act which allows issuers to not register, providing they meet certain criteria. The offering must be limited to a certain number of ‘accredited’ investors and there should be no advertising or press releases in the US. The predominant investor group are insurance companies, led by Met Life and the Prudential.
According to Jocelyn Monk, Global Head of Private Placements at Royal Bank of Scotland Capital Markets (RBS), PPs are an important source of funds for many companies.
“Many corporates need longer-term finance than is available from bank loans. Those companies with no credit rating from one of the recognised agencies, however, are effectively shut out from accessing the public markets, which are increasingly demanding a credit rating as a pre-requisites.”
It is not just un-rated companies which access the PP markets. The public markets often require minimum issuance sizes, which is not the case for PPs. The company might require funding spread over different time horizons and so the maturity profile of the deal may have different tranches. There are additional cost advantages to avoiding registration and much simpler disclosure requirements.
Advisory costs are significantly lower and the whole process can often be completed much more quickly.
“The key to the private placement market is that it is relationship-driven and deals are tailor-made,” says Marie Fioramonti, managing director of international private placements for Pricoa Capital Group.
“Each deal takes a different time to arrive, be that weeks or months, as information flows between borrower and lender. The agent bank liases between the client and investor(s) to gauge investor interest and requirements. The relationship between client and investor is thus much closer than in the public markets.”
One of the bigger UK investors in private placements is Prudential M & G, where Calum McPhail is head of private placements. He also stresses the importance of the relationships between lender and investor. “In our market, investors are typically buy and hold, so relationships are a very important part of the investment.
We endeavour to meet with all of the companies in which we invest. The screening processes for every deal are intensive, as we undertake all our own analysis, not relying on any third-party credit rating input.”
As well as getting to know the individual company, each individual deal is unique and must be analysed too. Each investor will have a bilateral agreement with the borrowing company, setting out the deal’s terms and conditions. Most, but not all, PPs will involve financial covenants, which private placement investors value greatly.
McPhail says: “While we cannot argue that private placements are liquid, we believe that the existence of financial covenants are mitigants to the liquidity issue. We do not have to hope that we identify detrimental news before other investors because, with a covenant in place, the company must come and talk to us directly to avoid tripping the covenants. Away from public scutiny we can work together to restructure the transaction, or give them the breathing space to get through the problem.
“In studies undertaken in the US comparing distressed securities held in public and private portfolios,” continues McPhail, “it was calculated that there was a 25 basis point advantage in terms of recovery rates, to having financial covenants – not something you get from day one but certainly an advantage that will accrue with time.”
More recently, the USPP market has also come to provide a significant source of funds for European companies looking for capital.
Indeed in 2003, more than half the US PP issuance was derived from European companies and the share in 2004, though down slightly, was still more than 45%.
Although there is plenty of PP supply from European companies, these deals are usually sold to US investors. European investors are not significant players in today’s PP market, although in the past there have been similar investment channels in place.
Christian Lutz is head of corporate loans at insurer Allianz. “We have been active in this area in Germany for many, many years,” he says. “After the war, insurers became an important source of long-term debt capital. During the 1980s, however, many participants dropped out because the capital market provided better conditions for borrowers. Investment rules for insurers were very strict compared to banks; collateral was needed to back each loan. The supply of loans dried up for the insurers.
“Allianz was one of the few to stay in the market. However, we have seen in the last couple of years, a revival of ‘Schuldschein’ notes which are loans issued against promissory notes, typically with maturities of seven-10 years.”
The Schuldeschein growth is in part due to the European market’s increased interest in credit products generally and to the search for yield in this low interest rate environment.
Lutz says: “Another reason for increased demand from German investors may be the fact that the (relatively) simple documentation is in German, unlike the usual private placements offered by US investors and the issue is in euros. We are trying to modernise the investment rules for insurers in Germany in co-operation with the supervisory authority, aiming to increase the popularity of these loans.”
“I do believe that the lack of resources is a significant reason why more European investors are not involved in PPs,” argues McPhail. “While many institutions are staffing up their credit teams, they do not yet have spare capacity. European investors tend to be much more benchmark-focused than those in the US and are more concerned with relative rather than total return, which perhaps argues against investment in PPs. And another potential problem is that the EU is not unified, unlike the US, in terms of its legislation. But I believe the differences between the European legislations are not that significant and should not be a deterrent to an investor seeking involvement in PPs.”
“Another great advantage of private placements for us is the name diversification we achieve,” says Fioramonti. “It is hard to outperform a public market index when everyone has the same names in their portfolios. Yes, this is a labour intensive asset class but diversification, covenants, direct relationships with the companies in which we’ve invested means that we believe we can make better credit decisions than is sometimes possible in public bond markets.”
And McPhail warns that the current benign credit environment might be masking some dangerous situations in the public markets. He says: “When it gets tougher and we see defaults, that may force a wakeup call for many who have been caught out, and it should reinforce the benefits of covenants.”