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This story originally appeared on Investing News.
At their core, private placements are fairly simple to understand — they are essentially offerings in which securities are sold to a small number of accredited investors.
That said, there is plenty more to know about the private placements market, and those familiar with the basics may want to dig a little deeper into the factors companies consider when engaging in this form of capital raise, as well as the specific types on offer and why companies use them.
On that note, here’s a quick look at two different varieties — bought-deal private placements and best-efforts private placements — and when they come into play.
Considering the debt/equity ratio
Private placements tend to involve either debt offerings or private equity securities, and companies must start by deciding which to go with. The former involves raising money by selling private placement debt to accredited investors, while the latter involves selling partial company ownership to raise capital.
It’s vital for companies to keep their debt/equity ratio in mind to ensure smooth operations. If debt costs are more than the returns the company is generating, bankruptcy could be the eventual result. However, exchanging debt for financing could lead to more earnings, ultimately benefiting shareholders.
When selecting how to undertake a private placement, companies must thus weigh their current debt/equity ratio and determine their best course of action for long-term stability.
Using a broker
Deciding between a brokered and non-brokered private placement is also an important step for companies. That said, the two are for the most part identical except for one major difference — the second involves a company selling securities directly to investors instead of hiring a broker to do so.
There are numerous reasons a company might opt not to go with a broker. For one, eliminating a broker saves time and money. Companies that use non-brokered private placements also face fewer regulations. Case in point: Non-brokered private placements do not require companies to register securities with the US Securities and Exchange Commission.
Of course, going it alone can come with disadvantages. Not having a broker can lead companies to devote too much time and energy to selling their securities. Brokers also tend to have more industry contacts that they can use to sell securities, giving them a leg up over companies.
Finally, there’s the chance that opting for a non-brokered private placement could reflect negatively on the company involved, making it appear as if it has been unable to secure a broker to sell its securities.
What is a bought-deal private placement?
In terms of the specific types of private placements a company may undertake, bought-deal private placements are one variety. They take place when an investment bank commits to purchasing all the securities being issued by a company (the issuer).
This type of private placement can be a popular option for companies as it eliminates the risk of not selling all the securities that are up for offer; that of course means the issuer will raise the funds it needs, which is generally good news for investors. At the same time, engaging in bought-deal private placements typically means companies will receive the bare minimum of funds, as buyers will usually receive a lower price if they purchase all securities at once.
While those circumstances can certainly offer benefits to investment banks, they can also lead to more risk — investment banks may not be able to sell all the securities they purchase, for example. There’s also the chance that the securities may decrease in value after the investment bank purchases them. That is why buyers typically negotiate a discount.
Interestingly, law firm Morrison Foerster states that bought-deal private placements are easier to accomplish at specific times. For instance, if a bought-deal private placement occurs immediately after an issuer’s earnings announcement and the filing of its latest quarterly report, chances for insider trading may be reduced and the need to update disclosure information may be eliminated.
“Waiting until the issuer’s earnings announcements and the filing of the Forms 10-K or 10-Q will also make it easier for the underwriters to conduct due diligence and for the underwriters to obtain a comfort letter from the issuer’s auditors,” the law firm notes.
What is a best-efforts private placement?
A best-efforts private placement involves an underwriter who ultimately decides whether a deal is worth the risk and agrees to do their best to sell as much of a private offering as possible. This type of deal doesn’t put the onus on buyers, as they will not be held responsible for unsold securities.
Such private placements are typically used for more high-risk securities where the underwriter may not be fully confident of selling the full allotment.
According to the American Law Institute, best-efforts private placements are the most common type of private placement offering. Since those participating in best-efforts private placements are not required to commit to purchasing securities in advance, it can be easier for companies to raise capital this way.
Best-efforts private placements offer other benefits to companies and their investors as well. One is that under a best-efforts private placement, underwriters only receive a flat fee, meaning companies have a chance to receive a higher return on their securities.
This is an updated version of an article first published by the Investing News Network in 2015.
