United States: Private Placements Valuation

Private Placements are securities, such as common stock, warrants, bonds, not sold via a public offering but privately to a selected number of investors. In the United States, these securities do not have to be registered with the Securities and Exchange Commission (SEC), as they are sold directly to the private market and not to the general public. Therefore, they do not have to comply with the requirements set by the Securities Act of 1933.

In this paper, we will focus on the debt securities issued in the private placement market.

Private Placement Debt

Debt issued via a private placement does not require a public credit rating. However, the National Association of Insurance Commissioners (NAIC) assigns a private credit designation, if the private placement instrument is held by an insurance company. As of 2015, 93.4% of the private placement securities held by insurers were investment grade (i.e. NAIC rating 1 or 2).

Due to the scarcity of publicly disseminated information, private placement issuances are generally less liquid than exchange traded instruments. This lack of liquidity might be reflected in the higher yields that sometimes investors ask to buy the security.

Since private placement debt is information-intensive, typical investors in the private placement space are insurance companies and pension funds that can provide long-term financing that might be unavailable or too expensive via public sale or from traditional lenders like banks. On the other hand, typical issuers are mid-sized companies that do not have a public credit rating or that do not need to raise funds frequently or in sizable quantity.

Advantages to Borrowers

One of the main advantages for borrowers is that these securities offer the long-term lending of corporate bonds with the confidentiality of a bank loan. Notably, private placements are characterized by a limited disclosure of financial information and an ongoing relationship with the lender, but at the same time they have an average maturity between 7-12 years.

Companies that decide to take the private placement route also enjoy lower costs due to the absence of expenses, such as the registration with the SEC and the need to obtain a credit rating. Furthermore, the lack of regulatory constraints allows borrowers to finance themselves in a shorter time frame.

Typical investors in this asset type (insurance companies and pension funds) usually follow a "hands-off" approach and do not interfere in the decision making of the company.

Advantages to Investors

Frequently, these debt securities include covenant protections that are more stringent than those found in the public issuances. These securities are also often secured by a predetermined collateral.

These features coupled with investors' sophistication has resulted in historically lower default rates and higher recovery rates for this asset class compared to publicly traded bonds.

Duff & Phelps' Valuation Approach

The valuation of private placement debt securities presents many challenges.

Probably the most prominent one is how to model an appropriate credit curve for the security. CDS spreads are not always available for entities that issue this type of debt, as issuers that are active in this asset class do not tap investors on the public side. Even when CDS spreads are available, we implement several adjustments to account for the bespoke nature of the issuance.

While covenants and contractual protections help in managing the deterioration in credit quality and enhance the credit protection for the investor, they also increase the complexity of the valuation of the instrument. Among others, embedded options (issuer's call, investor's put), the compensation to be paid to the investor in case the bonds are prepaid (e.g., make-whole provisions), credit ratings and change in control clauses. Some of these features require interest rate modelling apart from credit risk modelling.

In some cases, the securities might be part of a more complex repack structure, where there is a precise match between the cash flows paid by the underlying assets and the notes. These repack notes might also involve dual currency features where the coupons are paid in the investor's domestic currency and the principal is paid in the issuer's domestic currency.

Finally, to determine an appropriate liquidity discount for the security (or the portfolio in aggregate), we constantly monitor if there is a statistically significant premium between public and private issuances. If a statistically significant premium is found, we then apply it idiosyncratically to the security or globally to the portfolio, depending on the type of statistical relationship discovered.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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