Within the financial markets, explain what we mean by "private placements" and name the advantages and

Question

disadvantages.

What will be an ideal response?

Answer 1

Private placements are an alternative to the sale of securities to the public or to a restricted group of investors through
a privileged subscription. Any type of security can be privately placed (directly placed). The major investors in private
placements are large financial institutions. Based on the volume of securities purchased, the three most important
investor groups are 1. life insurance companies, 2. state and local retirement funds, and 3 . private pension funds.
Private placements have advantages and disadvantages compared with public offerings.
The advantages associated with private placements are:
1. Speed: The firm usually obtains funds more quickly through a private placement than a public offering. The major
reason is that registration of the issue with the SEC is not required.
2. Reduced costs: These savings result because the lengthy registration statement for the SEC does not have to be
prepared, and the investment-banking underwriting and distribution costs do not have to be absorbed.
3. Financing flexibility: In a private placement, the firm deals on a face-to-face basis with a small number of
investors. This means that the terms of the issue can be tailored to meet the specific needs of the company.
The following disadvantages of private placements must be evaluated.
1. Interest costs: It is generally conceded that interest costs on private placements exceed those of public issues.
Whether this disadvantage is enough to offset the reduced costs associated with a private placement is a determination
the financial manager must make.
2. Restrictive covenants: A firm's dividend policy, working capital levels, and the raising of additional debt capital
may all be affected by burdensome provisions especially in the private placement debt contract.
3. The possibility of future SEC registration: If the lender (investor) should decide to sell the issue to a public buyer
before maturity, the issue must be registered with the SEC. Some lenders, then, require that the issuing firm agree to a
future registration at their option.