Primary and secondary markets

CFA level I / Equity Investments: Market Organization, Market Indices, and Market Efficiency / Market Organization and Structure / Primary and secondary markets

45.i: Primary and secondary markets

Primary markets

When a security is made available to be bought by investors, it is called Initial Public Offering (IPO). This trade takes place in primary markets. The issued security then trades amongst investors in secondary markets.

Public offering: Investment banks manage the process of issuing a security to investors and charge the issuers fees for the same. The process is called book building. They identify the potential investors and also advise the issuer on the pricing of security.

IPO may involve: a) fresh issue of shares, which leads to stake dilution for existing shareholders, or b) sale of stake by existing shareholders.

Generally, the investment banks involved in the offering guarantee the issuer a minimum offering price. If the issue is not fully subscribed, they offer to buy whatever portion remains unsold. It is called underwriting offering. Large issues are handled by a pool of investment banks and brokers who support the lead underwriter build the book. The issuer pays the consortium underwriting fees, which is calculated as a percentage of the total offering size.

The investment bank acts only as a broker in a best effort offering. The unsold issue will not be bought by the investment bank under it. So, there is no guarantee for the full subscription under the best effort offering.

Example 6

Galactico, a biotech company plans to raise $300mn (gross) through an initial public offering of new shares priced at $3/share. Before the IPO, the company had 500,000,000 shares outstanding. The net proceeds to the company are estimated at $285m.

On the day of listing, the shares opened at $4/share and at the close of trading, were trading at $3.9/share.

a) How much stake did the promoters of company dilute to raise the amount?
b) How much return did the subscribers get on the first day of listing of the shares?
c) What was the placement fees paid by the company to the investment banks managing the issue?

Solution:

a) New shares issued = Gross amount raised/Share price = $300,000,000/$3 = 100,000,000.
Shares outstanding before the issue = 500,000,000
Shares outstanding post the issue = 500,000,000 + 100,000,000 = 600,000,000
Post issue stake of existing shareholders = 500,000,000/600,000,000 = 83.33 percent
Stake dilution = 100.00 - 83.33 = 16.67 percent.

b) Investor gain = (Closing Price-Issue Price)/Issue Price = ($3.9-$3)/$3=30%

c) Placement fees = Gross proceeds-Net proceeds to the company = $300 million -$285 million = $15million i.e. 5 percent of the offering.

Private placements are those where the offering is made only to a group of qualified institutional investors instead of general public. These qualified investors are financially more sophisticated and generally have a better understanding of the risk.

Its key advantage is that it can be done faster and at a low cost as it doesn’t require too much disclosure. But since the security doesn’t trade on secondary markets, the investors generally demand a higher rate of return.

Shelf registration: Companies sometimes sell smaller lots securities instead of one single issue, directly in the secondary markets while making all the required disclosures associated with a regular offering.

Dividend reinvestment plans: It is a type of offering where shareholders can purchase more securities in primary or secondary markets, using the dividends the company announces.

Rights offering are where the company gives the existing shareholder the right to purchase securities at a fixed price. The price is generally set below the current market price. Since the right is not binding, it is a type of option.

Secondary markets are the place where issued securities are traded. The key advantage of secondary markets is that they provide liquidity to the investors. Liquidity represents the ease and cost at which a security can be traded. Highly liquid securities are easily tradable and have low transaction cost while the reverse is true for illiquid securities.

Check your concepts:

(45.24) Which of the following is the primary function of the secondary markets?

(a) Issuing new equity
(b) Raising capital
(c) Providing liquidity

(45.25) Which of the following securities is more likely to trade at a higher price?

(a) Privately placed security
(b) Publically place security
(c) Both will trade at the same price

Solutions:

(45.24) Correct Answer is C: The primary purpose of the secondary markets is to provide liquidity.

(45.25) Correct Answer is B: Privately placed securities do not trade in the secondary markets and thus require a higher rate of return. The higher is the required rate of return, the lower is the price of the security. So, the publically placed securities trade at a higher price as compared to the privately placed securities.