Over the past few years, the municipal securities market has experienced a growing number of municipal issuers that have met their borrowing needs by going directly to investors to access capital. This practice is commonly referred to as a “private placement.” There are many reasons why an issuer may elect to issue a private placement including: a relatively small borrowing size, uncertainty on how well-received their debt might be to investors in the open market, an attempt to reduce borrowing costs, and/or to avoid continuing disclosure requirements.
Private placements are an alternative to the traditional open-market bond issuance mechanisms such as a competitive or negotiated issuance. Although private placements are typically smaller transactions, the size and frequency of these offerings has dramatically increased this year. Participating in private placements can be beneficial to institutional investors, but there are risks and challenges associated with these transactions that must be addressed, including:
- Determining if you meet the Qualified Institutional Buyer (QIB) designation
- Illiquidity profile of private placements
- Difficulty in determining credit quality
- Lack of initial and continuing disclosures
- Lending concentration limitations, and
- How to identify the right level for your bid
Before participating in a private placement, the buyer must meet the SEC’s definition of a Qualified Institutional Buyer (QIB), which is defined as an institution with either of the following:
- A minimum of $100 million in securities on a discretionary basis
- A minimum net worth of $25 million
Private placement securities are not actively traded in the secondary market; therefore, the bonds are highly illiquid. Investors who want to own private placements should be under no impression that they will be able to easily liquidate the securities after purchase. Private placements also rarely have cusips, the prevailing unique identifier in the securities markets. Furthermore, if an investor wishes to liquidate the bonds before they are retired, the sometimes-prolonged process involves the location of another qualified institutional buyer to make the purchase and the participation of the transfer agent to facilitate the transaction. While some issuers and their advisors may agree to apply cusips to the transaction, the liquidity is virtually unchanged but it may help to track the credit on an ongoing basis.
Just because a deal is issued as a private placement doesn’t necessarily mean there are inherent issues with the underlying credit quality. However, private placements typically don’t include the standard language found in an official statement for new issues. Therefore, it can be difficult to meet your pre-purchase due diligence requirements regarding credit analysis. Private placements are also not subject to the SEC’s continuing disclosure requirements, which can present challenges tracking the credit for post-purchase monitoring. If the issuer is willing to apply cusips to the transaction, it can help to mitigate these challenges when working with a firm that has a robust municipal credits database.
Many financial institutions are subject to lending concentration limits. Due to the illiquidity of private placements in the secondary market, they should be treated more like a loan rather than a security in the bond portfolio. Because of this, they might fall under lending concentration limits established within internal policies or those required by the regulators. Investors considering the addition of private placements should thoroughly review whether or not they might exceed these limitations beforehand.
These risks should all be assessed in order to come to an appropriate bid for the private placement offering. Just because the issuer has outstanding bonds with excellent ratings doesn’t mean the private placement bonds being offered should be priced at a similar level. All things equal, private placements should be priced at yield levels higher than traditional municipal bond issues in the open market. Other considerations, such as the challenges in tracking the credit and lack of disclosures, should also be factored into the pricing of private placements. This can be challenging to many financial institutions who are not actively involved in pricing municipal securities. When bidding on a private placement, it’s crucial to avoid overly aggressive bids that result in an asset that doesn’t earn enough yield relative to the risks.
While these risks present challenges to municipal investors considering participation in private placements, there are benefits to consider as well. More often than not, these offerings are from your local communities where your institution has a vested interest in showing support. This can also help to increase and/or maintain the integrity of public funds on deposit. The best practice when bidding on a private placement is to ensure the yield level accurately accounts for the illiquidity of the asset, the underlying credit quality, and the overall structure.
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