1.2Public and Private Sources of Capital

Firms raise debt and equity capital from both public and private sources. Capital raised

from public sources must be in the form of registered securities. Securitiesare pub-

licly traded financial instruments. In the United States, most securitiesmust be

Grinblatt40Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw40Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

Chapter 1

Raising Capital

7

registered with the Securities and Exchange Commission (SEC), the government

agency established in 1934 to regulate the securities markets.³

Public securities differ from private financial instruments because they can be

traded on public secondary marketslike the New York Stock Exchange or the Amer-

ican Stock Exchange, which are two institutions that facilitate the trading of public

securities. Examples of publicly traded securities include common stock, preferred

stock, and corporate bonds.

Private capital comes either in the form of bank loans or as what are known as

private placements, which are financial claims exempted from the registration require-

ments that apply to securities. To qualify for this private placement exemption, the issue

must be restricted to a small group of sophisticated investors—fewer than 35 in num-

ber—with minimum income or wealth requirements. Typically, these sophisticated

investors include insurance companies and pension funds as well as wealthy individu-

als. They also include venture capital firms, as noted in Exhibit 1.1.

Financial instruments that have been privately placed cannot be sold on public mar-

kets unless they are registered with the SEC, in which case they become securities.

However, Rule 144A, adopted in 1990, allows institutions with assets exceeding $100

million to trade privately placed financial claims among themselves without first reg-

istering them as securities.

Public markets tend to be anonymous; that is, buyers and sellers can complete their

transactions without knowing each others’identities. Because of the anonymous nature

of trades on this market, uninformed investors run the risk of trading with other

investors who are vastly more informed because they have “inside” information about

a particular company and can make a profit from it. However, insider trading is illegal

and uninformed investors are at least partially protected by laws that prevent investors

from buying or selling public securities based on inside information, which is inter-

nal company information that has not been made public. In contrast, investors of pri-

vately placed debt and equity are allowed to base their decisions on information that

is not publicly known. Since traders in private markets are assumed to be sophisticated

investors who are aware of each others’identities, inside information about privately

placed securities is not as problematic. For example, if a potential buyer of a debt instru-

ment has reason to believe that the seller possesses material information that he or she

is not disclosing, the buyer can choose not to buy. If the seller misrepresents this infor-

mation, the buyer can later sue. Because private markets are not anonymous, they gen-

erally are less liquid; that is, the transaction costs associated with buying and selling

private debt and equity are generally much higher than the costs of buying and selling

public securities.

Result 1.2 summarizes the advantages and disadvantages of private placements.

Result 1.2

Corporations raise capital from both private and public sources. Some advantages associ-ated with private sources are as follows:

•	Terms of private bonds and stock can be customized for individual investors.
•	No costly registration with the SEC.
•	No need to reveal confidential information.
•	Easier to renegotiate.

³In the United States, there is an artificial legal distinction between securities, which are regulated by

the SEC, and futures contracts, which are regulated by the Commodity Futures Trading Commission

(CFTC).

Grinblatt42Titman: Financial	I. Financial Markets and	1. Raising Capital	© The McGraw42Hill
Markets and Corporate	Financial Instruments		Companies, 2002
Strategy, Second Edition

8Part IFinancial Markets and Financial Instruments

Privately placed financial instruments also can have disadvantages:

•	Limited investor base.
•	Less liquid.

Depending on the state of the market, about 70 percent of debt offerings are made

to the public, and about 30 percent are private placements. In some years, private debt

offerings can top 40 percent of the market. In contrast, private equity placements have

averaged about 20 percent of the new capital raised in the equity market.

Corporations can raise funds directly from banks, insurance companies, and other

sources of private capital without going through investment banks. However, corpora-

tions generally need the services of investment banks when they issue public securi-

ties. This will be discussed in the next section.