Private Placements and Public Issues

Whenever a company makes a public offering, it is obliged to register the issue with the SEC. It could avoid this costly process by selling the securities privately. The rules on what consti­tutes a private placement are complicated. The securities can generally be sold to an unlimited number of financial institutions, but there are restrictions on the number of less wealthy pri­vate individuals who can participate.

One of the drawbacks of a private placement is that the investor cannot easily resell the security. However, institutions such as life insurance companies invest huge amounts in cor­porate debt for the long haul and are less concerned about its marketability. Consequently, an active private placement market has evolved for corporate debt. Often, this debt is negotiated directly between the company and the lender, but if the issue is too large to be absorbed by one institution, the company will generally employ an investment bank to draw up a prospec­tus and identify possible buyers.

As you would expect, it costs less to arrange a private placement than to make a public issue. This is a particular advantage for companies making smaller issues.

In 1990, the SEC adopted Rule 144A, which relaxed its restrictions on who can buy and trade unregistered securities. The rule allows large financial institutions (known as quali­fied institutional buyers) to trade unregistered securities among themselves. Rule 144A was intended to increase liquidity and reduce interest rates and issue costs for private placements. It was aimed largely at foreign corporations deterred by registration requirements in the United States. The SEC argued that such firms would welcome the opportunity to issue unregistered stocks and bonds that could then be freely traded by large U.S. financial institutions.

Rule 144A issues have proved very popular, particularly with foreign issuers. There has also been an increasing volume of secondary trading in Rule 144A issues.

Source:  Brealey Richard A., Myers Stewart C., Allen Franklin (2020), Principles of Corporate Finance, McGraw-Hill Education; 13th edition.

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