Chapter 14   Primary Markets

• Primary markets include all types of securities, but are distinguished by the fact that the security is being sold for the first time
• After a security is offered in the primary market, it becomes part of the secondary market
• Primary market offered consist of (1) new offerings of companies that have sold securities to the public before, and (2) IPOs, where a company is selling securities to the public for the first time.

I.  Traditional Process

• investment banks are the key players in the primary market
• investment banking is a function, performed by securities houses and commerical banks
• advising: investment banks advise the issue about the timing, terms, and pricing of the issue, as well as the regulation involved in selling the issue to the publics
• underwriting (optional)
• investment bank buys the securities from the issuer, and then resells it to the public, bearing the price risk of the new issue
• price is set about 2 days prior to the security floatation (firm commitment)
• resale price - guaranteed price = gross spread or underwriter's discount
• size of the discount depends on type of security, size of issue, and market conditions

• typically several investment banks are involved in underwriting an issue
• lead or managing underwriter --underwriting and advising (20% of the spread)
• syndicate --help underwrite (25% of the spread)
• selling group --help sell, do not underwrite (55% of the spread)
• IPOs are typically underpriced
• 1980s: first day return 7%
• 1990-1998: first day return 15%
• 1999-2000: first day return 65%
• why?
• reduces risk for the underwriter
• issuer will to accept underpricing for a prestigious underwriter
• best efforts placement is the alternative to underwriting
• investment banks sells issue at highest possible price, but no guarantees about that price
• issuer retains the price risk of the new issue
• best efforts is typically done with firms deemed risky or with limited market recognition
• distribution and support in the secondary market
• lead underwriter will maintain large investory of securities to support the secondary market
• who underwrites?
• commercial banks & insurance companies
• restricted In U.S.  under Glass Steagall until 1999 in terms of type of securities, and percent of revenue coming from underwriting activities
• no restrictions on commercial banks outside U.S.
• securities houses
• top ten underwriters do over 75% of underwriting
• also involved in secondary market as dealers and brokers

II.  Regulation

• SEC regulates primary market
• rules deal with disclosure of information to protect investors from fraud
• rules against insider trading to ensure a level playing field
• issuer must register a new security
• provide a prospectus (called a red herring)  which includes information about
• nature of the firm
• features of the security
• risk
• firm managment
• certified financial statements
• firms are liable (criminal and civil) for incorrect information, and so is the underwriter if it does not practice due dilligence
• waiting period between registration and SEC approval
• firm may distribute preliminary prospectus, known as red herring
• if SEC approves, determining information is complete, then registration is effective
• then sales are allowed
• issuing firms can also get prior approval for several new issues within a 2 year period
• Rule 415, shelf registration rule (1982)
• allows issuer to take quick advantage of market conditions
• some types of securities are exempt from registration requirements
• federal debt, municipal debt, commercial paper of FDIC insured banks
• small offerings (less than $1 million)
• intrastate offerings

III.  Variations in Underwriting

• bought deal
• an investment bank presents an offer to buy debt securities (specified terms) to a potential issuer
• issuer has little time to accept/reject
• if issuer accepts, the issuer is said to have "bought the deal"
• only a lead underwriter, no syndicate lined up so greater risk of capital
• usually issue is presold to institutional buyers
• auction or competitive bidding
• an issuer sets terms of issue, then places it up for bid among competing underwriters in effort to place issue at lowest cost
• required for some municipalities and public utilities
• no evidence that this is a cheaper way of placing a new issue
• preemptive rights offering
• new stock offered to existing shareholders at below market value (subscription price)
• prevent dillution of voting rights
• private placement
• issued placed directly with a small number of buyers with no general solicitation to public
• institutional investors, like insurance co., investment co., pension fund
• "sophisticated" investors
• capable of evaluating and bearing the risk of the securities
• usually bonds
• no registration w/ SEC required
• must still offer a prospectus
• growing in popularity
• rule 144A (1990)
• lifted the 2 year resale restrictions on private placements among institutional investors