In 2006, for the first time, more equity capital was raised by private placements than by initial public offerings (IPOs) on the three largest US stock exchanges. Public equity offerings on the New York Stock Exchange (NYSE), Nasdaq and the American Stock Exchange raised $154bn, while so-called 144A private placements raised $162bn. According to research from brokerage firm Piper Jaffray, in the same year, the number of small and mid-sized companies choosing to exit the public US equity markets increased by 73%, more than doubling the increase of 34% in the previous 12-month period. This trend was mirrored in the debt markets. If debt is included in private placement volumes, the US market alone exceeded $1000bn in the first half of this year for the first time; a 43% increase on the same period in 2006.
Many believe that this largely US phenomenon is driven by the onerous burdens stemming from the Sarbanes-Oxley Act 2002. But ironically, rules from the US regulator, the Securities and Exchange Commission (SEC), offer an increasingly attractive way to avoid such obligations. If US markets have agonised over the leaching of potential stock market listings to foreign exchanges, then it is equally true that the private placement market – in which stocks can be sold without the need to register them with the SEC, and where issuers thereby avoid onerous regulatory and reporting requirements – is doing just as good a job at stealing business away. The 144A market – named after an SEC rule that enables large, sophisticated investors, the so-called qualified institutional buyers, to trade private placements freely among themselves – is driving such volumes.
Investment banks are keen to exploit the growing desire to raise capital while avoiding the regulatory burdens of Sarbanes-Oxley and the quarterly reporting treadmill of traditional share offerings. In May, Goldman Sachs launched the Goldman Sachs Tradable Unregistered Equity OTC Market (dubbed GSTrUE) for listing unregistered 144A securities; the ability to trade those securities will be added at a later date. Alternative investment firms Oaktree Capital Management and Apollo were the first to test the waters on Goldman’s platform, but Goldman says that there are more deals in the pipeline.
Following suit
As a signal of the potential of this growing market, other investment banks have been quick to follow Goldman’s example. Bear Stearns launched its Best Markets platform in August, and another group of investment banks – Merrill Lynch, Lehman Brothers, Morgan Stanley and Citigroup – have since joined forces to launch another rival platform, Opus 5, which is expected in the autumn.
Nasdaq, too, is capitalising on this trend. It already had a platform for listing private placements, called Portal, which has thus far had a relatively low profile. In July, it extended its capability to include trading.
The founders of Oaktree stated at the time that they were happy to sacrifice a little public market liquidity, and even take a slightly lower valuation, in return for a less onerous regulatory environment and the benefits of remaining private. But, in fact, the demand and pricing ‘discount’ that many assumed would be the price that issuers had to pay for privacy was negligible. Oaktree’s sale of a 14% stake was upsized from 13% and raised more than expected ($800m); equally important, like any good (public) IPO, it traded up in the aftermarket, rising from an offer price of $44 to $50 the day after issue.
Industry commentator Roger Ehrenberg, former CEO of Deutsche Bank’s hedge fund platform DB Advisors and now president and COO of Monitor 110, a New York-based company that helps investors extract investable information from the internet, believes this was a landmark deal. “It is a clear sign that many issuers are shying away from the expense and scrutiny of public markets. This really shines a bright light on the regulatory burdens of being a public company. And Oaktree proved that there is a growing institutional appetite for high quality private placement issues, even if such securities have lower liquidity,” he says.
Market direction
The reasons behind shifts in capital formation vary but, whether from a desire to escape regulatory burdens or the pursuit of more flexible financing, combined they seem to imply that, as much as regulators and industry initiatives work to improve transparency and access, the markets are heading in the opposite direction: moving away from public exchanges to private markets that are more opaque and more lightly regulated.
John Jacob, executive vice-president of Nasdaq, denies that market activity is moving away from the public domain. “Capital formation has just become more targeted. The 144A market is simply a way to specifically target an institutional investor base that such issuers want at the moment.”
| Rupert Hume-Kendall, chairman of ECM at Merrill Lynch, agrees that it is more a sign of evolution than a shift away from public markets. “It is just that there is now a more viable alternative to the public markets that previously did not exist. Markets open up as the requirement for them develops. Five years ago, there would have been very few funds able to take privately issued equity and very few corporates, or indeed financial institutions, that would have felt comfortable issuing equity privately,” he says. |
Increasing transparency
Moreover, Mr Jacob argues that recent developments are bringing transparency to previously opaque markets. “In Portal, we have added the ability to display and access trading interest to a market that already existed in 144A securities. Before we did that, if an investor wanted to sell, their only recourse was to call the underwriter and ask them to find someone to buy it. We are simply adding transparency and liquidity to an existing market that was dark and fragmented.”
Mr Ehrenberg, however, believes that private placement exchanges pose a more serious threat to the listed new issuance market in the US. “I think they will quickly detract from the Nasdaq, NYSE and Amex. [These] private exchanges will effectively skim the cream off the market. The very highest quality issuers will forgo the public markets to issue on the private exchanges. If you could be assured of getting a valuation that’s roughly the same as the public market, why would you ever choose the public market?”
Adding transparency and liquidity will accelerate this trend, adds Mr Ehrenberg. The more liquidity there is, he says, the more investors and issuers will be attracted to a market.
More fundamentally, does the emergence of a more vibrant and increasingly liquid private placement market make any difference to capital markets overall? Does the growth of the privately placed market have the ability to undermine or detract from the public markets?
| The SEC declined to comment, but Thomas Huertas, acting managing director of wholesale and institutional markets at the Financial Services Authority (FSA), the UK regulator, thinks not. |
Market choice
Mr Huertas argues that the decision about on which market to raise funds has always stirred questions about which type of regime a company wants to be subject to. Recently, that debate has focused on the difference between the US, with a Sarbanes-Oxley type of regime, and other markets, such as the UK, which do not have Sarbanes-Oxley, and it is perhaps no surprise that the 144A market has had a great deal of success in that context. But he says that the most important thing is that firms and their advisers have a choice.
“It’s an alternative by which issuers can raise funds,” he says. “There is a difference with respect to some of the requirements, but the fundamental aspect of markets – namely providing information to investors so that they can evaluate the risk and make an investment decision – is definitely present in the 144A market and, in [the FSA’s] view, is present in all of the over-the-counter (OTC) markets. It may have some effect on distribution of where IPOs and trading occurs, but does it compromise the overall health of the financial markets? I don’t believe so.”
There are practical issues, of course. For example, to remain outside of the SEC’s purview, 144A issues must not have more than 500 investors; the moment a company passes that point, it must register with the SEC and become Sarbanes-Oxley compliant. While this raises challenges in terms of tracking investment and ownership, it is not rocket science from a technological perspective. If a public exchange can show bids and offers, it is easy for a private exchange to monitor the number of shareholders.
The importance of listed shares or options on shares for employee remuneration is also posited as another potential brake on private placement growth. But, just as it would be easy to develop systems to monitor numbers of investors, so one could see entirely new compensation schemes developed that are pegged off the trading price on the private exchange, for example.
Goldman Sachs stresses that it is not a matter of one market overtaking another. Ed Canaday, a spokesperson for Goldman, says companies will raise money in both the public and private markets depending on their specific situation. “In the private placement area, we see activity coming from issuers that want to remain private companies and are attracted to raising capital through the issuance of equity to a more concentrated universe of sophisticated investors; there is a wide range of companies that are interested in doing that,” he says. “We do not see [the] traditional underwriting and trading businesses diminished in a material way by Rule 144A equity offerings.”
Two-tier market?
Nasdaq’s Mr Jacob also denies that the private market takes anything away from the public market. He argues instead that the growth in private placements simply represents a shift in how companies raise capital. “Companies are just making greater use of a facility that already existed,” he says.
But could the rapid maturing of the private placement market lay the foundations for a twin-track market model, creating one market that is lightly regulated for institutional investors and another that is more heavily regulated for retail investors?
Mr Ehrenberg says he could easily envisage a two-tier market, in which blue-chip firms with strong institutional demand raise capital on private exchanges, and more consumer-oriented companies with deep retail demand raise capital on the public markets.
“In a perfect world, there would be a single market with a single set of regulations and disclosure requirements that would be accessible to all investors,” he says. “The problem is, however, that the financial and logistical costs of being public have created a vacuum, where the marginal blue-chip issuer who is not compelled to raise capital will either pursue a private placement from a strategic investor or a flotation on a private exchange if additional growth capital is required. And most of these issuers will have attractive business models and stable cash flows – like asset managers – yet will be out of reach to all except a small number of institutional investors.
“Is this the best thing for the US securities markets? No,” says Mr Ehrenberg “But is it a necessary and healthy adaptation to a regulatory regime that created significant costs and efforts without a like set of benefits? Yes.”
Mr Jacob disagrees. He maintains that the private placement market is a transitional one, and that a private market issue is generally a prelude to a public market listing. “Increasingly, companies are using the 144A market to specifically tap the institutional market before they transition to the retail market,” he says. “The development of the private placement market has added another stage into the funding cycle, which you could see as three distinct stages: the first comes at the earliest stages of a company’s development, when they seek venture capital or angel funding; the second stage sees them tap the professional institutional market; finally, companies raise capital in the broader retail market.”
He admits, however, that there is little market data to illustrate how many companies that have first issued 144As have subsequently converted to a public market listing. “Nobody has been collecting that data so far,” he says.
Regulation lite
There is a flip side to this debate. If more and more companies are seeking refuge from the scrutiny of the regulators and public markets, it means that more and more securities are being issued outside of the regulators’ purview. Moreover, the Oaktree issuance on GSTrUE was structured in such a way that investors will have virtually no say in how Oaktree is run, no matter how substantial their holding. Are these regulation-lite securities? And if market participants have fretted over covenant-lite loans, should we be worried by governance-lite securities?
The SEC declined to comment on these issues. From a regulatory standpoint, the FSA’s Mr Huertas posits this more as an issue of responsibility being shifted to the kind of sophisticated investors who are able to negotiate as much or as little input as they are comfortable with. For Mr Huertas, it is simply a case of caveat emptor.
“Private placements are, as the name implies, a matter of negotiation between issuers and investors. Investors have the opportunity to demand such initial and ongoing disclosure, as well as such corporate governance arrangements, as they require in order to make an informed investment decision. As a result of such negotiations, issuers of privately placed securities may agree to a variety of covenants and/or corporate governance arrangements,” he says.
Merrill’s Mr Hume-Kendall, however, believes this is more about the market cycle. “This is very much a feature of an issuers’ market. When everyone is chasing shares, they are happier to sacrifice a seat on the board. But I don’t see it as a trend – the pendulum always swings back,” he says.
In any event, Mr Hume-Kendall wonders if the growth in the private placement market will continue in the face of the trouble and uncertainty in the broader financial markets. Just as the subprime woes have slowed the pace of leveraged buyouts and spilled over into the equity markets, so they may slow the volumes going to the private placement exchanges. “When there is any kind of dislocation in the markets, issuers and investors tend to retrench to what they know,” he says. “We may yet see a bit of a slowdown in the private placement market.”
