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When we think about investment banks, as well as the activities that they undertake, we tend to think about initial public offerings, debt syndication, and other such activities that are very visible to the public eye. However, the reality is that a lot of investments that are routed via investment banks are actually private placements.
In this article, we will have a closer look at what private placements are and why they are used by certain types of investors:
A private placement is a sale of shares, just like the initial public offering. However, in the case of an initial public offering, the company has to disclose its finances to the general public. Then, they also have to offer the shares for sale to the general public. This creates an information hazard, especially if the company wants to keep its data private.
Hence, in such cases, the private placement is a useful option. Private placement is different from venture capital investments. This is because it is regulated by the securities agencies. However, there is no need for the company which is selling its shares to register with the regulatory bodies before offering a private placement. Also, there is no compulsion for the selling company to share information regarding its operations or finances with the buyer. It may choose to do so, or it may not! In many cases, selling companies make prospective buyers sign non-disclosure agreements before any details related to the strategy or the finances of the firm are shared.
There are certain salient features of private placements. These features have been listed below:
Accredited Investors: Companies selling their shares in private placements cannot sell them to any individuals. In most countries of the world, there are laws in place, which prevent private placements to retail investors. This is because the levels of disclosure in these investments are not much. The government wants to make sure that the people investing in these schemes are capable of bearing the fallout if the decisions go wrong. In the United States, an individual or an organization has to get themselves registered as an accredited investor before they can be pitched assets in private placements. Investment banks have a database of such accredited investors as well as the sectors in which they are looking to make a deal. This is where the services of investment bankers come in handy. They enable the deal between the investors and investees to take place.
Faster Turnaround: An initial public offering is a lengthy process. A company has to first get itself registered with the securities and exchange commission. Then, it has to create a draft prospectus to solicit bids. There are several documents that need to be created and several regulations that need to be complied with before money is raised using initial public offering. Hence, a company has to spend a lot of time i.e., months before it can raise money from the general public. If the company needs the money urgently, then it can use the private placement route. Companies that opt for private placements are exempt from most of the disclosure norms. Hence, capital can be raised faster using that route. Investment banking firms have expertise in this area. They can help companies raise money within a few weeks at a fair valuation.
Exclusive Opportunities: Private placements are a good opportunity from the investor's point of view as well. This is because companies that reach the private placement stage have a proven business model. However, they are not so well known that a public issue can be arranged for them. Hence, private investors get to invest in exclusive opportunities. There are many investors who have made supernormal profits solely by investing in private placements. This is the reason that they, too, cultivate relationships with investment banks.
Still Remains Private: Even after companies have made private placement and received the funding, they continue to remain private. This means that they might have some obligations to disclose certain information to their shareholders. However, they do not have any obligation to disclose any information to the public at large. Apart from the disclosure of information, this could also mean that a lot of rules and regulations applicable to public companies would not be applicable to them.
Higher Returns: The companies which opt for private placement do not want to disclose information about themselves. Also, a lot of times, they do not have to get credit checks done by credit reporting agencies. This increases the risk of investment from the point of view of the accredited investor. As a result, to compensate the accredited investors, companies are often willing to pay a higher rate of return. Investment banks help in negotiating the interest rate, which is best for both sides.
In simple words, it means that private placements are effective, albeit expensive method to raise finances. Companies often have to give away a higher stake or accept a lower valuation if they go in for private placements. As far as investment banks are concerned, this is their bread and butter activity and generates a significant amount of revenue.
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