PHOENIX - Private placement bond deals accounted for $20.93 billion in 2016, helping push overall municipal volume to an all-time high, even as there continue to be questions about the transparency and wisdom of some of those transactions.
The surge in private placements helped the market reach a record $445 billion in volume for the year, and represented a dramatic increase from just a few years ago. Though private placements have leveled off from a peak of $23.4 billion three years ago, last year's total was still almost eight times the 2010 level, and up from $20.13 billion in 2015.
"2016 saw a disproportionate increase in risky sector issuance not only because of an increased interest among borrowers to finance speculative projects but also because investors were pursuing higher yields and underwriters higher fees," said Matt Fabian, partner at Municipal Market Analytics. "It follows that private placement issuance would be rising for the same reasons. All of those dynamics generally remain in place [so there is] no reason to think it will decline."
The Municipal Securities Rulemaking Board said after its meeting last month that it plans to propose a rule change formally requiring dealers to apply for CUSIP numbers when conducting private placements, something the board has long interpreted to be true already. Also late last year a Financial Industry Regulatory Authority official said that dealers should expect FINRA examiners to ask for lists of direct placement deals and the details of those transactions. Regulators have been concerned that some securities are being misclassified as bank loans not subject to securities laws, and some market participants use the terms "bank loans" and "private placements" almost interchangeably, adding to the confusion.
The largest private placement deal of 2016 came in May, when the Illinois Finance Authority sold $528.15 million of revenue refunding bonds for the Presence Health Network. Another deal that stands out came in September when the Greenville County School District, N.C. privately placed $452.5 million of installment purchase refunding bonds for the school district of Greenville project.
"Market conditions for borrowers seeking certain types of execution, such as draw down bonds to mitigate negative arbitrage or alternative structures, are some reasons why issuance has spiked up recently," said Robert Gall, senior vice president at HJ Sims, which has a team dedicated to working on private placements. "Events such as recent outflows by publicly traded mutual funds allow for opportunities to work with privately held institutions that are not adversely impacted by outflows from the tax-exempt bond funds."
Gall said that issuance of these types of private placements can be cyclical, based upon liquidity in the bond market, and are more typically issued to finance start-up or expansion projects, turnaround situations, or assets that have had financial difficulties.
"Does there need to be certain market dynamics in place for PP's to work better? Yes, typically outflows in the general bond funds," Gall said. "Market conditions for borrowers seeking certain types of execution such as draw-down bonds to mitigate negative arbitrage or alternative structures, could have caused the spike is private placement use since 2012. Events such as recent outflows by publicly traded mutual funds allow for opportunities to work with privately held institutions that are not subject to outflows like the tax-exempt bond funds."
Mark Kim, chief financial officer at DC Water in Washington, said issuers can be attracted to selling their bonds this way rather than through a public option for a variety of reasons, including the complexity of the offering, the lower cost, and the ease of execution. DC Water executed a private placement deal in September 2016 when it sold $25 million of tax-exempt environmental impact bonds to the Goldman Sachs Urban Investment Group and Calvert Foundation.
"There are really two primary reasons for DC Water to do it," Kim said: DC Water wasn't comfortable with the deal being publicly offered because of its structure, and it found it could save money on fees through the private placement.
"It was a very complex debt instrument," he said. "It would have been very difficult for us to create an offering document that would have satisfied our obligations."
The bond was a first-of-its kind instrument in which either the investors or DC Water could be entitled to a $3 million extra payment. DC Water would get that payment if the financed infrastructure to reduce rainwater runoff is particularly ineffective, a type of risk "insurance" for the issuer. The investors would get a payment if the infrastructure was particularly effective at reducing runoff.
The deal met sharp criticism from Dan Kaplan, a financial services administrator in King County, Wash.'s Wastewater Treatment Division. Kaplan said in an essay submitted to The Bond Buyer that the 3.43% interest rate DC Water paid on the deal looked like a rip-off because the bonds have a mandatory five-year tender, and under ordinary circumstances an issuer could get a much lower rate than that for a deal that refinances in five years.
"An issue with a mandatory tender in 2021 without DC Water's innovative structure might have priced at a 1.40% yield on the high side, a full 2% lower than DC Water's 3.43% interest rate," Kaplan wrote.
DC Water considered the chances that either they or the investors would end up receiving a bonus payment to be only about 5%, Kaplan noted, meaning that in his view the issuer paid a massive premium for insurance against an unlikely outcome.
"And for assuming that small level of risk, Goldman Sachs, the primary investor, found a way to earn 2% (tax-exempt) above the market for holding Aa2/AA+ parity debt of DC Water," wrote Kaplan.
Kim disagreed, saying that he considered the extra cost fair for the risk share it provided.
"The complexity of the transaction is what drove us to the private placement market," he said. "There is no market price for us to judge how to price this deal."
He said that furthermore, DC Water saved a lot of money by placing the debt privately.
"We saved hundreds of thousands of dollars of cost of issuance by not having to have the deal rated," Kim said, although DC Water did contact the rating agencies and offer to have a typical meeting as if the deal were publicly offered. "We didn't have to pay any investment bank any underwriting fees. Those are pretty significant costs."
Kim said that while DC Water has made efforts to be as transparent as possible in doing a private placement, he understands that there is considerable market concern about private placements and bank loans that are often not posted to EMMA. Analysts have repeatedly expressed concerns about such less visible debt, and Kim said he believes issuers need to be careful about their disclosure practices.
"It's far less transparent to do a private placement than it is to do a public offering," he said. "These transactions that are less transparent will naturally draw more scrutiny."
Gall said to determine whether a privately placed deal is a better route than a traditional bond sale, you have to assess the issuer's goals.
"The structural benefits need to be weighed against covenants that can resemble private equity deals relative to typical, and often more flexible covenants in a public bond offering," he said. "We perform a side-by-side comparison. Normally private placements have less negative arbitrage (due to drawdown structure), higher interest rates and stricter covenants than public bond issues. Borrower decisions are based upon detailed comparisons of these and other factors," Gall said.
