Quiet money runs deep

You don’t hear too much about debt private placements, in part because they’re private. But they’re a serious source of capital for companies shopping for longer terms from buyers eager to deal
By Robert Olsen

Private placements are a generic form of financing that is sometimes misunderstood. Part of the confusion arises from the fact that the term “private placement” can be used to describe several types of financing. For instance: cross-border high-yield financings typically under SEC 144(A) regulations, many other forms of capital, such as convertible debt, funded by institutional investors, or, perhaps most commonly, brokered equity placements. All of the foregoing issuances typically have their terms and conditions pre-structured with the only unknown being pricing, which is determined through private bidding by the various buyers.

A less common, but nonetheless very relevant form of financing for Canadian companies is private placements of term debt. These private placements tend to have longer maturities than bank debt—often averaging 7-10 years and with amortizations that match the life of the underlying assets of the company—filling a void in the capital structure since banks typically prefer to lend on a shorter-term basis.

Debt private placements are not a new concept. However, the changing face of the securities themselves, the investors and, perhaps most importantly, the distribution of these instruments, may leave the impression that debt private placements are no longer prominent forms of capital. Nothing could be further from the truth.

First, a bit of background. In the 1980s and 1990s, several boutique advisory shops were set up to exploit a different kind of private placement. This market opportunity was aimed at insurance companies’ need for longer-term assets (loans) to match their liabilities, but where the financing was more highly structured. In their purest form, private placements at that time were simply longer-term amortizing loans funded by insurance companies with all the terms and conditions highly negotiated including, term, amortization, covenants and pricing.

These boutiques originally did not have capital to invest. Rather, they were originating opportunities exclusively for leading insurance companies. At this time, they were the few sources of debt private placement activity and were generating an estimated $300-$400 million of financing annually amongst them. The insurers also initially had the boutiques manage the assets. But as the portfolios grew and they became more familiar with them, they began to manage the portfolios themselves. With this change, insurers began to build in-house expertise, which in turn led them to originate their own deals. By the late 1990s and into the early part of the 2000s, there was significant activity in private placements. The majority of the capital came from life insurance companies and pension funds. In both cases, the rationale was the same—a need for stable, long-term yields that could be used to match the long- term liabilities associated with life insurance policies or pension benefits.

Historically, much of the debt private placement activity in both Canada and the U.S. has tended to be of higher credit quality. This is because the predominant buyers, the life insurance companies, are highly regulated and are required to put aside significant capital reserves for assets of lower credit quality. A formal rating is not required for a private placement. However, in the U.S. the self-regulating body for the insurance companies (National Association of Insurance Companies) has its own internal rating system. A rating of NAIC 1 or 2 is considered investment grade or near-investment grade. A rating below NAIC 2 is considered below investment grade and requires significantly greater capital reserves.

However, notwithstanding the need for higher capital reserves for non-investment grade assets, most insurance companies in the U.S., Canada and other Anglo countries such as the UK and Australia, have an appetite and capital allocation for these higher-yielding assets. The need for higher yield has been particularly acute since the credit crisis because benchmark interest rates have been at historic lows. Life insurance companies typically have an allocation of 3-5% of fixed income assets to be non-investment grade. As shown in the accompanying chart, the major Canadian life insurance companies each have significant fixed-income portfolios, resulting in significant capital available for higher-yielding private placement debt.

The appetite for non-investment grade private placements doesn’t stop with insurance companies. Recent low interest rates coupled with weak market performance has had a dramatic impact on the actuarial liabilities of pension funds, which have steadily grown. In order to meet these obligations, pension funds are also desperate for high-yielding instruments. Given that pension funds are looking for long-term assets and are less regulated than insurance companies, non-investment grade private placements are an ideal asset.

One asset class that has really taken off as a result of these institutional investors’ search for yield is the public U.S. high yield market (see sidebar, second chart). The liquidity associated with public securities gives many investors the comfort to take on the additional risk that accompanies the returns they are looking for. However, what they gain in liquidity, they may be giving up in structure: most public high-yield bonds are unsecured and typically have very few covenants. By contrast, a private placement term-loan financing will be customized to the situation and will often contain structural enhancements compared to a publicly traded bond. Further, the perceived liquidity of a public high-yield bond may not always be the reality. For example, the aforementioned 144(A) issuances can remain unregistered, which effectively limits issuer information to a restricted group of investors. This, in turn, reduces the market interest, and therefore liquidity, of the underlying security. In the Canadian context, 2010 saw only 14 deals worth approximately $3.4 billion, creating little active trading, and therefore relatively low liquidity versus the U.S. market.

If investors are willing to take on the additional risk associated with high-yield instruments, even without getting significant liquidity, it is reasonable to assume that they would entertain doing similar deals on a private basis—especially if the deals are structurally enhanced. Certainly, from the standpoint of many issuers, there is incentive to issue in the private market rather than the public one in order to avoid the cost and competitive pressure associated with public disclosure.

Private placements of debt have been around for many years. In that time, they have transformed from highly structured deals primarily originated by specialty boutiques to a form of security that can be accessed through boutiques, large investment banks or even directly from institutional investors. At the same time, the activity in longer-term debt securities has exploded, driven by both investor demand and issuer desire. All of this suggests that there is a significant amount of capital available for private placement transactions. For companies looking at raising longer-term capital, this may well be an untapped source of funds—the trick, as always, is finding how best to turn that tap on.

Andrew Luetchford, a managing director in Deloitte’s Capital Advisory group contributed to this article.

Robert Olsen is global co-leader of Deloitte’s Capital Advisory practice, sourcing debt and/or equity capital for private and public companies. E-mail: robolsen@deloitte.ca.

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