Primary market is the place where debt-based, equity-based or any other asset based securities are created, under written and sold off to investors.
What are Primary Markets?
Most of the large-scale growth and development activities of entities such as companies as well as governments need to be financed by raising external capital. This external capital comes in various simple as well as complicated forms. But the two major categories of external capital are debt and equity. Apart from taking a loan from financial institutions, an entity needs to issue some kind of financial instrument/security like bonds or stocks to the investors in an open market.
- Primary Markets Definition
- Primary Market Examples
- Functions of Primary Market
- The Underwriting process
- Costs involved in going public
- IPO price determination
- From the Primary Market to the Secondary Market
Primary Markets Definition
All in all, the primary market is that part of the capital market where new securities are created are directly purchased by the investors from the issuer. And the creation of new securities facilitates growth within the economy. Once the securities are purchased by the investors, they can be traded in a “secondary market” like the stock exchange (NYSE or NASDAQ), bond market or derivatives exchange.
Raising capital in the primary market can happen in one of the four ways.
- Public Issue – This term refers to the company’s issuing of new securities through its initial public offer (IPO) and is “going public”. A large number of investors can purchase these newly issued securities in this open primary market.
- Rights Issue – Rights issue is an invitation to the existing shareholders to purchase additional new shares (in the proportion of their holdings) within a fixed time period.
- Private Placement – private placement refers to raising equity capital (not public) from selected investors like Venture Capital, Funds and insurance companies.
- Preferential Allotment – It is the process by which allotment of shares is done on a preferential basis to a select group of investors.
As noted above, such a market where companies can issue new securities to raise external capital and investors get their first chance to purchase new security is called the “primary market”. The primary market is also known as the new issues market (NIM).
Primary Market Examples
On 6th May 2014, Chinese E-commerce heavyweight Alibaba filed a registration document to go to public in the US in what may be the mother of all Initial Public Offerings in the US history. Alibaba is a fairly unknown entity in the US and other regions, though its massive size is comparable or even bigger than Amazon or eBay.
Reading through Alibaba’s S-1 Filing was very interesting, educating and makes me realize how big their business is and how complex is the Chinese Internet Web. I prepared a full excel-based financial model which you may download from Alibaba Financial Model here.
On 24th March 2014, Online storage company Box filed for an IPO and unveiled its plans to raise US$250 million. The company is in a race to build the largest cloud storage platform and it competes with larger companies like Google Inc and its rival, Dropbox.
I quickly browsed through Box S1 Filing and when I was hoping to see a Cool Blue Box, it turned out to be a diffused “Black Box”. I also prepared a quick and dirty Box Financial Model to further access the gravity of the situation and realized that Box Financials were full of horror stories. You may also want to download the Box IPO Financial Model for further details.
Functions of Primary Market
A beginner would wonder how this IPO is carried out and how the initial price of the new securities being issued is determined. The answer is the “underwriting groups” which facilitate this process for the issuer entity. The underwriter is an important entity in the primary market which carries out the following three functions:
The underwriting group consists of investment banks that do the work of origination and price determination for a given security and then oversee its distribution directly to investors.
The Underwriting process
As mentioned above, a company itself does not actually go out into the primary market to sell securities. Rather, it requires one or more investment banks to do it. That’s the way Wall Street works.
Role of Investment Bankers
Investment banks act as underwriters or middlemen between companies and the investing public. Some of the biggest underwriters on the planet are Goldman Sachs, Credit Suisse First Boston, JP Morgan, and Morgan Stanley. (read more on Bulge Bracket Investment banks)
In most cases, it’s a group of investment banks that acts as an underwriting group or syndicate rather than a single bank. This group has a leading underwriter or the lead “book runner” and the other underwriters or the “co-managers”. The lead underwriter leads the syndicate each of whose members sells a part of the issue. This is done in order to distribute the risk accompanying the IPO as investment banks are hesitant to shoulder all the risk.
Deal Arrangement and Commitment
First, the issuer entity and the underwriting group meet and enter into a deal which includes matters like the amount of money the company will raise, the type of securities to be issued and sundry other details in the underwriting agreement. Whatever be the type of deal agreed upon, one common feature is the agreement by the syndicate group to purchase a portion of the issued securities from the issuer entity and sell it to the public. The syndicate group may commit to raising a certain “guaranteed” amount of capital for the issuer by effectively selling the issued securities to the investors. In another type of commitment, the syndicate may not guarantee the amount that will be raised.
The process of underwriting in the primary market is time-consuming, expensive and also exposes the issuer entity to regulatory as well as public scrutiny more than it ever was. A very important component of an IPO is exposing a company’s account books to public scrutiny, as well as to the oversight of the Securities & Exchange Commission (SEC).
Before anything else, the underwriters and the issuer entity (say the company in general) together take care of the regulatory hurdles of the process. For this, the underwriter helps the company by preparing an initial draft registration statement to be presented before the SEC as well as the investors. This initial draft is often called the preliminary prospectus or more popularly the “red herring” prospectus since it needs to be printed with red ink on the left side of the cover.
After that, the feedback from the SEC and the investors are considered to revise the red herring prospectus. Eventually, after discussions between the company and its bankers, the red herring becomes the “final prospectus”. This final prospectus is then filed with the SEC as a legal document. If the final prospectus is accepted by the SEC, the company crosses the regulatory hurdle of the IPO process.
The process of drafting the red herring prospectus and then reaching the final prospectus involves many rounds of revisions and discussions between the company and its syndicate group. The final prospectus is generally at least a few hundred pages long and is not an easy read given its mundane and redundant contents.
Costs involved in going public
The costs involved in the IPO in the primary market include majorly the fee charged by the syndicate banks in addition to the legal, accounting, distribution and mailing costs. While the legal, accounting, distribution and mailing costs may not amount to any worrisome figure, the underwriters’ fee can often fall into the range of 3 % to 7 % of the gross IPO proceeds.
Twitter went public in 2013, Goldman Sachs was the lead underwriter while the syndicate group also included other underwriters such as Morgan Stanley and JPMorgan. All of them together charged about $ 59.2 million as their fee for underwriting and managing the sale. That was 3.25 % of the $ 1.82 billion raised by Twitter in its IPO.
Further, an event called the “Road Show” needs to be organized by the issuer to market the securities to the potential buyers. It is often called the “dog and pony show” as well. The roadshow is intended to generate excitement and interest in the issue or IPO and is often critical to the success of the offering. In this event the company management including the CEO, CFO and investor relations individual travel across the country to generate excitement and interest among analysts, fund managers and other potential investors like institutional investors by giving presentations. This event itself can cost millions of dollars.
Hence, entering the primary market is no doubt lucrative for the aspirations of the company management. It is a very significant stage in a company’s life too. But on the other hand, it is an equally resource-consuming process at the same time.
IPO price determination
As mentioned in the initial parts of this article on the primary market, the underwriting group helps determine the initial offer price of the shares being issued during an IPO. How do they do it?
Deciding on the number of shares to be issued
First, it is important to recall that before going public, a company is already owned by a small number of people which include the founding members and some early investors like venture capitalists or angel investors. Further, companies often issue a small percentage of ownership to its senior employees as compensation. So such early employees also own some part of the company before the IPO.
For the sake of simplicity of understanding, let’s assume that these owners of the company hold certain different numbers of shares with them. And the sum total of those numbers is equal to the total number of shares that the company is made of.
Now, as the company needs to raise money and decides to go public, these owners need to part with some of their ownership to new owners. For this, the original shareholders of the company need to decide how much of their stake do they want to give away to fuel the company’s growth by the investors’ money that is going to come as the proceeds of the IPO.
Advertising the Public Offering to Institutional Investors
Once the number of shares to be issued is decided, the company advertises its offering in front of the institutional investors first. Of course, this is done with the help of the group underwriting banks with which the company has struck the deal. That is what those roadshows are all about. The target audience of those roadshows is not small or retail investors. In fact, the target market comprises of the institutional investors.
The reason why the company prefers targeting the institutional investors for IPO is that these investors are accredited, sophisticated, more experienced, and have deeper pockets and capacity to take a risk. They include the top pension funds, mutual funds, hedge funds, high net worth individuals as well as long-standing clients. These clients gain importance and preference due to their investment prowess and ability to create stability in the stock price by being the first to receive them.
If alternatively, the company decides to offer the issued securities to the retail investors, the poor fellows won’t be able to absorb the price fluctuations that could take place after the IPO. Most retail investors base their decisions on unsophisticated methods that could also lead them to their life savings by purchasing the stock in this unstable environment.
Understanding the willingness of Institutional Investors
After the roadshows, the institutional investors evaluate the securities being issued and decide upon how many shares they wish to buy. Next, they communicate their willingness to the issuer without knowing the offer price. In fact, they submit their requests and not orders or bids regarding how many shares they want to purchase. These requests are often conditional and specify the price range within which the investor is comfortable. In rare cases, they may not specify any price range.
These requests are processed to get a rough estimate of the demand for the issued securities. This task itself is quite tricky since the total demanded the number of shares is usually much more than the number of shares to be issued. And fearing rejection of their request, most institutional investors tend to request a much higher number of shares than they actually want. So here the issuer and its underwriters need to prudently select those institutional investors which they find worthy of having a stake in the company. The shares are allocated to the select investors based on their reputations/styles known to the best of the company’s and the underwriters’ knowledge. Here, they also try to strike balance among all the different kinds of investors: long term investors, short term investors, domestic investors, foreign investors, etc.
Deciding the final Deal – Pricing and Shares
The supply is already known to the issuer entity and its syndicate group as they have decided how many pieces of security (say shares in general) the issuer has to issue. Thus, the issuer and its syndicate know the demand-supply balance and the average value of the securities in the eyes of the institutional investors. This value becomes the basis of the price at which the securities are offered to those investors.
Finally, the securities are sold to these investors at this price. As soon as the shares are in the hands of the initial institutional investors and they owe the issuer a sum equal to the number of shares times the finalized offer price, the transaction of the securities in the primary market is over.
From the Primary Market to the Secondary Market
Once the securities are sold to the institutional investors and the company is listed on the NYSE (and/or the NASDAQ), the retail investors’ wait is nearly over. The retail investors as well as institutional investors from all over the world flood the NYSE with their orders. The institutional investors who had bought the shares directly from the issuer might give sell orders while the other investors give buy orders. But the price of the securities does not remain the same here.
The price is again determined at the stock exchange by a designated market maker (DMM) (Barclays bank for example). The DMM sets the opening price at the stock exchange based on again the demand-supply balance and the price levels included in the orders received. The opening price is set such that the number of trades that can be executed is maximized based on the number of orders submitted until that time. This process is called price discovery and is handled manually at the NYSE (unlike NASDAQ, where it is done electronically). Once the price is decided, no more orders are taken until the shares start trading on the stock exchange.
Next, the shares start trading on the stock exchange at the opening price and the orders used for price discovery are first fulfilled. This completes the journey of the shares from the primary market to the secondary market because, at the stock exchange, they are sold and bought by entities other than the issuer itself.
Securities are created in the primary market. They stay there for a small amount of time as they are sold at the stock exchange by the institutional investors who bought them during the IPO. But the primary market is extremely important for the company that has decided to go public.
The price determination method is not different from the general concept of demand-supply balance and perceived value of the offering. However, it is equally resourced consuming as is a product launch. But that is worth it. After all, the amount of money that the company is able to raise by going public is determined by how the primary market behaves!
Video on Primary Market
This has been a guide to what is Primary Market, underwriting process, the cost involved, primary market examples. You may have a look at other Investment Banking articles for more information
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