Choice Between Public and Private Debt

Proprietary Information Models

Usually, in order to obtain public debt financing, a company has to reveal some strategic information to prove its creditworthiness.

The creators of this type of model argue that companies with proprietary information that is likely valuable to rivals, will prefer banks (private debt) to public debt, because banks have the potential to keep the sensitive information more confidential and kept away from the firm’s rivals(Campbell, 1979).

Another model developed by Bhattacharya and Ritter (1983) assumes if one company reveals its technological information, it can get better financing market terms, but will lose its R&D competitive advantage over its competitors. Thus, the company should decide its strategy by trading off the effects of a bilateral bank-firm agreement, where the information is kept confidential, and a multilateral financial agreement, in which the bank reveals the private information to the firm’s competitor who is borrowing from the same bank in order to increase the solvency of both firms.

To conclude, Yosha (1995) came to the conclusion that firms that have sensitive information that cannot be revealed to its competitors, prefer a bilateral debt financial agreement over public debt and this bilateral agreement can also trigger a positive stock response because it’s a signal that the company holds positive information.

Bank versus non-bank private debt

Johnson (1997) showed that the proportion of fixed assets in the balance sheet is negatively related to the proportion of non-bank debt, which indicates that non-bank financial institutions serve riskier firms, i.e., safer firms are more likely to borrow from a bank than a riskier one.

Furthermore, Carey, Post and Sharpe (1998) found that banks usually serve low-risk borrowers, while non-bank financial institutions serve high-risk ones. As a matter of fact, not only regulations and requirements limits banks’ risk-taking ability, but they also want to protect their reputation by only serving firms with medium-low risk.

It is also important to retain that all firms present different capital structures, since they use different types of debt and present a different correlation between firm profitability and leverage.