The Choice between Public and Private Debt: A Survey

Vol 23, No 1; Article by Jayant R Kale and Costanza Meneghetti; March 2011

The key insight from the seminal work by Modigliani and Miller (1958) is that market imperfections are necessary for financial decisions such as the debt vs equity to impact firm value. When firms choose debt finance, they must also decide between public debt (e.g., corporate bonds) and private debt (either bank or non-bank). While there are excellent articles that summarise the research on the various aspects of the choice between equity and debt financing, to the best of our knowledge, this paper is the first to survey research on the firm's choice between public and private debt and on the subsequent choice between bank and non-bank private debt. There is significant diversity in the sources and design of debt financing used by firms and evidence suggests that these decisions affect firm value. We present the major theoretical and empirical findings of the research on a firm's decision to choose between public and private debt, as well as among the types of private debt. Our discussion of the extant research suggests that the choice between public and private debt is governed by four basic factors, which are not mutually exclusive. The first is the degree to which a firm needs certification; the greater the certification need the greater the preference for bank debt. Second, issuing public debt may result in the leakage of (valuable) proprietary information and, thus, firms with greater proprietary information will prefer bank debt. Third, when monitoring of managerial actions (such as investment choices) creates value, bank debt will be preferred over public debt. Finally, firms will exhibit a preference for bank debt when the flexibility to renegotiate debt contracts is valuable, for example, when the firm is in financial distress.