NEW YORK-With too much capital chasing too few deals, privately placed debt financing has become a borrower’s market in recent years, leading to a sharp rise in leverage and risk.
“The types of deals we’re talking about are high-end junk deals for high-tech, early stage, (often) privately held companies that have venture capital and a bank line of credit,” said Robert C. Nash March 30 at a Practising Law Institute seminar on private placements. Nash is a partner in the Chicago law firm of Chapman and Cutler.
“As their success indicates they’ll be around for awhile, it is logical for them to lengthen out the maturities of their debt. They may stay in the high-yield debt market, going from (private Rule) 144A deals to the public (debt) market when they are no longer a story credit with a complicated financial structure.”
Outstanding long-term corporate debt has risen dramatically during the past five years, to more than 50 percent of overall market capitalization for all types of companies from less than 35 percent.
“You have doubled your capacity to borrow or, I’d say, you’ve gotten yourselves into trouble,” said Nash, whose firm represents institutional investors.
It takes two to tango, however. The buy side, the institutions that lend companies money through debt private placement agreements, are awash in cash they need to invest fast in interest-bearing securities.
“There is more money out there chasing too few deals,” said Timothy F. Hodgdon, senior counsel for the Teachers Insurance and Annuity Association of America, New York.
TIAA is a pension and insurance company for the employees of more than 6,000 colleges and universities. It had a $91 billion investment portfolio at the end of 1997, of which $21 billion was in private placements.
The association expects to invest another $15.5 billion this year, a third of it in private placements. Considering that a typical individual investment for TIAA ranges between $25 million to $35 million, pressure to evaluate and close deals is intense, Hodgdon said. This pressure is exacerbated by issuers who inform him, in effect, that if he doesn’t hurry up an make a quick purchase decision, they will take their deal to another of the several or more other potential investors lined up, he said.
“In the last two-to-three years, there has been a very big change in the overall marketplace. There has been a tremendous turnaround from traditional private placements, Regulation D negotiated transactions, to (Rule) 144A deals,” Hodgdon said.
Traditional, or Regulation D, private placements are designed around the concept that there will be a single buyer for the debt security who will hold it to maturity. The borrowing company then can negotiate alterations in its agreement with the lender should circumstances change during the life of the debt issue.
Rule 144A private placements, a comparatively new instrument authorized by the Securities and Exchange Commission, permit the original institutional buyer to resell the debt securities in the secondary market to other institutional investors.
“A Rule 144A private placement really is a hybrid that looks as much as possible like a public debt issue but legally the process is private,” Hodgdon said.
They may waddle and quack like a public debt issue underwritten, or purchased outright, by an investment bank and registered with the SEC by means of extensive disclosure contained in a formal prospectus, but private placements are a different bird, said Scott J. Gelbard, managing director of fixed income capital markets for Credit Lyonnais Securities (USA) Inc., New York. And the newer breed of Rule 144A private placements offers less security to investors than either public debt issues or even traditional Regulation D private placements.
The U.S. Supreme Court affirmed this gaping difference in 1995 when it decided that underlying misrepresentations of fact contained in a buy-sell agreement for a private placement could not be considered securities fraud, Nash said. Only a prospectus prepared in connection with a public debt offering is required to meet the strict disclosure requirements in a formal offering statement, the court ruled.
Time pressures to close deals fast also have compounded the problem of deteriorating deal quality, a problem that not only affects institutional buyers but can easily come back to haunt issuers. For example, some deals have been pulled at the last minute when it was revealed there exists an investor group with a rightful claim to repayment priority for credit it already has extended. Companies seeking to raise capital through the private placement of debt can do much to avoid these problems by hiring law firms that specialize in private placements, panelists said.
In the mid-1980s, the SEC set in motion one cause of deal closing time pressure when it allowed companies wishing to sell public debt to file shelf registrations well in advance. This authorization enabled public debt issuers for the first time to line up the required paperwork and SEC approvals, then tap the markets fast when rates and investor demand were most favorable.
In so doing, the SEC made public debt issues more competitive with private placements. In turn, the private debt markets responded by reducing their processes to 10-45 days from the two-to-four month period typical before the existence of shelf registrations.
Pressure to reduce attorneys’ fees also has reduced the amount of due diligence involved in advance of deals closing, the speakers said. One good way to get proper attention without inflated legal bills is for borrowers to “insist on written estimates, with detailed assumptions included, from lender’s counsel,” Hodgdon said.
The varied assaults on the caliber and integrity of private placements have “left [this] market in a somewhat painful state and not with the best reputation in the world, although there have been efforts in the last few years to improve the situation,” Nash said.
