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Derivatives

The best of both worlds?

US private placements are thriving. Combining many virtues of bond buyers and banks, the investors will listen to credit stories the mainstream market won’t touch. If only some of this common sense would rub off on the public bond market.

How many financial markets had a record year in 2011? US equity options grew through the roof, but they don’t raise money for anyone. When it comes to fundraising, one of the stars of 2011 was the US private placement market.

Issuance reached $50bn for the first time, according to Bank of America Merrill Lynch, which expects it to keep growing. That is quite something, in what was, apart from 2008, probably the most stressful year for financial markets that many practitioners can remember.

The best way to understand this market is as a hybrid – of bond and loan, private and public, US and international markets. Happily, it combines some of the best aspects of each side.

Most of the investors are US insurance companies, who have their own private rating system through the National Association of Insurance Commissioners. But it has a lot fewer grades than Moody’s or S&P, and the investors rely on their own credit analysis.

A handful of large European institutions also participate, notably a few of the big UK fund managers. Deals are even possible in sterling or euros.

What has long been very international is the issuer base. UK firms raised about $10bn in 2011, continental European borrowers another $10bn.

Only 38% of the paper came from US companies, the great majority of which have credit ratings and prefer to use the public bond markets. The PP market’s competitive advantage is for borrowers that for one reason or another want to avoid that.

Issuers may not want competitors to know they are raising funds, or may be obsessively secretive about their pricing. Plenty of others, however, are perfectly happy for the world to know they have used the market.

Some PP borrowers prefer dollars to their home currency, only have a moderate funding need, or want amortising debt. Or – like many family-run companies in Europe, even listed ones – they may not want to get a credit rating.

That was the case for Luxottica, the Italian firm that owns Ray-Ban and makes glasses for Chanel and Dolce & Gabbana. Since 2003 it has done three full scale PPs and a couple of bilaterals with single investors on the side.

Luxottica illustrates another virtue of the PP market – independent thinking. Public bond markets were virtually closed to Italian issuers this autumn – only the very strongest companies, Enel and Telecom Italia, succeeded in issuing at viable rates, and then only in narrow windows.

Yet Luxottica raised $350m in October, more than the $200m it wanted, from a dozen US PP investors, including some new to its credit. They fly to Italy and visit the plant, think about the credit carefully, ask lots of questions, and then lend for 10 years at 4.35%. That was about 160bp below Italy’s 10 year BTP yield at the time.

In November, Portugal’s Cimpor got $40m at 7.3% after a reverse enquiry. There have been no public, institutional corporate bonds from Portugal since January.

Like banks, PP investors talk to the company and make their own credit assessment. They make it carefully, knowing they will basically be stuck with the asset for life. Like bond investors, they will lend for 10 years or more at fixed rates. Like banks, when pricing a deal they don’t care how the deal trades in the aftermarket (it doesn’t) or whether the CDS indices have widened or tightened today. Like bond investors, they want to be paid for the credit risk with interest, not with ancillary business. It sounds like funding heaven.

The market has its drawbacks, of course. It is no escape route for funding-starved Europe: two or three peripheral European deals since the summer do not make a rescue. Nor will PP investors buy the leveraged deals left hanging by the collapsed high yield bond market. Investors are said to negotiate very tough covenant and makewhole packages that can mean they get paid out ahead of other lenders in a default. And investor interest in Europe has grown only sluggishly – many fund managers can’t be bothered to sustain the investment in credit skills required.

But the private placement market has bankish virtues that the bond market lacks entirely. Above all, PP investors recognise that a loan is a two way agreement, with responsibilities for both lender and borrower. If things go wrong, the lenders get round the table with the borrower and try to sort it out. A bit more of that spirit would have helped a lot in this year’s sovereign debt crisis.

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