Lesson 2 of 10
A primary market refers to that segment of capital markets that deals with the new issues of securities. In this market, companies obtain funding by selling their companies shares to the investors.
This process of selling new shares to investors is called underwriting, and the sale itself is referred to as initial public offer, It is also know as floating on the market, or listing.
Let us understand this with the help of the market practice followed in the US. The process is similar in other major markets also.
A firm wanting to get listed will first contact many investment banks who will facilitate the IPO process. In case of a very large offering, there will be a syndicate of investment banks instead of just one bank. The firm will negotiate the terms for the IPO, and finally select a lead manager for the IPO. The terms will include things such as the fees, marketing strategy, timing, etc. It will also include the underwriting terms. Usually, a syndicate of banks (the lead-managers) underwrites the transaction. This means that they take the risk of distributing the securities. If they are not able to place the full issue, they will have to hold some securities themselves.
At this stage, the lead manager will advice on the terms and pricing of the issue. Then, a preliminary notice is filed with the SEC, providing details about the issue and the issuing company. This is the preliminary prospectus, which has to be approved by the SEC. Once approved, it becomes the IPO prospectus, which is then use to market the securities. This process may take several weeks.
Once the SEC has accepted the preliminary prospectus and the registration documents, the lead manager is responsible for marketing of the issue. Marketing involves road shows, advertising, public notices, and talking to investors, etc.
The managing underwriters may underwrite the IPO on either a firm commitment or best efforts basis. In a firm commitment offering, the underwriters will purchase the shares at a discount (of usually 7%) and resell them for the full public offering price to institutional and individual investors. In contrast, a best efforts offering means that the underwriters are only committing their best efforts to sell the shares. Here the price risk remains with the issuing company rather than the bank.
In case of private placement, the issue is placed directly with a few selected small number of investors. This is also known as non-public offering. Typical investors include large banks, mutual funds, insurance companies and pension funds. The private placement does not have to be registered with the Securities and Exchange Commission.
Private placements are much cheaper than IPOs. However, this method cannot be used for large issues because a small group of investors will have limited risk appetite. Also, these issues are not traded in the secondary market, as opposed to IPO securities, which once listed are traded in the secondary market. This makes it difficult for investors to liquidate these securities.
Another type of new issue is the seasoned new issue. This refers to offering an additional amount of already existing security.