Review
On the SIE exam, you learned about the primary market, which is where new securities are offered by issuers to investors. Much of this chapter is a review of SIE-related topics, but many areas go further in depth, requiring a new understanding of the additional details.
While various forms of the primary market exist, all primary market transaction proceeds go back to the issuer. This is the best way to determine if a transaction is considered part of this market. If proceeds go to the issuer, it’s the primary market; if proceeds go to any party other than the issuer, it’s the secondary market (discussed in the next chapter).
Roles in the primary market
There are four roles to be aware of when discussing the primary market:
- Issuers
- Underwriters
- Investors
- The SEC
Issuers are companies, organizations, or governments that raise capital (money) through selling securities. Underwriters, which are sometimes referred to as investment banks, are hired by issuers to market and facilitate the sale of the securities. Investors purchase securities in the primary market. Last, the Securities and Exchange Commission (SEC) is responsible for overseeing the primary market and regulating the financial professionals participating in it.
From small start-up companies to the government, issuers come in all shapes and sizes. Issuers raise capital when a need is identified. Needs could range from expanding a business, hiring a significant amount of employees, or paying for deficit spending (like our government does). Real-world examples of issuers include:
Issuers need help navigating the sale of securities. In most cases, issuers do not have the network or infrastructure in place to sell securities to investors. As you’ll learn in this chapter, selling new issues comes with many rules and responsibilities.
Underwriters are hired by issuers to help navigate the sale and marketing of securities to the public. Investment banking, also known as underwriting, can be a huge business. For example, Facebook’s underwriters made over $100 million during their IPO in 2012. Underwriters have many roles, ranging from general advice to actually selling the security. Real-world examples of underwriters include:
The underwriter of the IPO is not the only financial firm involved in the sale. When the issuer hires an underwriter, they’re really hiring a lead underwriter who will then form a group called the syndicate. We discussed this structure in detail back in the municipal debt chapter, but let’s refresh on the big picture.
The syndicate is made up of several financial firms that will assist the lead underwriter with the sale. For their participation, the lead underwriter shares their underwriting fees with the members of the syndicate. The lead underwriter’s job is to serve as the point of contact for the issuer, manage the underwriting syndicate, and facilitate the sale of the issue to the public by leading the syndicate.
Securities sold in the primary market are sold to investors. Investors could be individuals (like you), financial institutions, or even a form of government. The regulations surrounding new issues were created to protect the investors from fraud and manipulation on behalf of issuers and underwriters.
When a new issue is sold, it will likely be regulated by the SEC. Unless an exemption exists, new issues must be registered with the SEC. Registration requires significant amounts of paperwork and fees, but the goal of registration is to confirm the issuer and underwriter are providing the public with enough information to make an informed investment decision. We’ll discuss more about this process later in this chapter.
Underwriting commitments
We first discussed underwriting commitments in the Municipal bond chapter. Part of this is a review, but we’ll broaden our view beyond municipal bonds.
When a security is sold in the primary market, underwriters take on one of two underwriting commitments: firm or best efforts. An underwriting commitment refers to the liability of the underwriter.
Firm underwriting commitments make the underwriter liable for any unsold shares. The investment bank purchases the security from the issuer and sells it to investors. Many times, thousands of bonds or millions of shares of stock are involved. If there’s not much demand for an issue, the underwriter may only sell a portion of the securities. They are stuck with the unsold units or shares in a firm underwriting.
A firm underwriting is also known as a principal or dealer transaction. When a customer is sold a security from the inventory of a financial firm, a principal (dealer) transaction occurred. With a firm underwriting, the investment bank sells a security that they own and is considered its inventory. The firm makes money if they buy the security at a low price and re-sells it at a marked-up price. This is exactly how dealers inside and outside of finance operate.
A standby underwriting is a type of firm commitment that involves a rights offering. If you recall, a rights offering occurs when an issuer offers their current shareholders the right to purchase new shares being offered to the market. Not every shareholder will take the issuer up on the offer, which leads to some leftover shares. Prior to the rights offering, the issuer typically hires an underwriter to “standby” and wait to see how many shares go unsold. When the rights offering concludes, the underwriter purchases the unsold shares on a firm basis from the issuer and re-sells them to their own customers.
A best efforts underwriting commitment is exactly what it sounds like. The investment bank is doing its best to sell the security, but any unsold units or shares go back to the issuer. Best efforts are less risky for underwriters, but they’ll collect less underwriting fees (less risk, less return).
A best efforts underwriting is also known as an agency transaction. When a financial firm acts as a middleman and connects buyers and sellers, an agency transaction occurred. With a best efforts underwriting, the investment bank is connecting the issuer with the investing public. This is exactly how agents (a.k.a. brokers) inside and outside of finance operate.
There are a few different versions of best efforts underwriting commitments. A mini-max underwriting is one that specifies a minimum and maximum amount of shares. For example, an issuer may have 1 million shares available to sell but requires the underwriter to sell at least 750,000 for the sale to go through. If 750,000 shares cannot be sold, the sale is canceled and money is returned to investors who purchased units or shares.
Also, there’s an all or none underwriting commitment. The underwriter must sell all of the securities in order for the sale to go through. If an issuer has 1 million shares to sell, all 1 million would need to be sold. Otherwise, the sale is canceled and money is returned to investors who purchased units or shares.
As you’ve noticed, there are many different commitment styles available for public offerings. Coming to an agreement on which style to use is an integral part of the agreement between the issuer and underwriting syndicate. Sometimes, these agreements contain market-out clauses, which allow the syndicate to back out of the agreement due to unforeseen market circumstances. If an unexpected event occurs (for example, the Great Recession or the COVID-19 pandemic), demand for the security could fall dramatically, making it much more difficult to sell the security. Many underwriting agreements include this clause to protect the syndicate, especially with firm offerings.
The type of commitment directly influences the amount of compensation paid to the syndicate. The revenue received by the syndicate is chopped up and diverted to the various components of the syndicate (lead underwriter, syndicate members, and selling group members). The compensation breakdown was covered thoroughly in the municipal debt chapter.
Reallowance is a topic that wasn’t covered in the municipal debt chapter because it applies solely to corporate underwritings. Sometimes, broker-dealers that are not part of the underwriting syndicate are hired to sell shares. This typically occurs when an offering is in high demand. When a broker-dealer not part of the syndicate makes a sale of a new issue, they are paid a reallowance, which is taken from a portion of the selling concession. Again, please review the compensation structure in the municipal debt chapter if you’re hazy on the components of the underwriting spread (like the selling concession).
Types of offerings
Primary market offerings can take several forms, but we’ll focus primarily on two for the Series 7 exam: IPOs and APOs.
We’ve discussed initial public offerings (IPOs) previously, which occur when an issuer sells a security for the first time to the public. Common stock IPOs from larger companies are extensively covered in financial media outlets. For example, Uber’s IPO in 2019 garnered a lot of attention and raised $8.1 billion for the company. While Uber sold securities previously through private placements, its IPO was the first time its shares were offered to the general investing public.
Issuers can also raise capital through additional public offerings (APOs), sometimes known as follow-on offerings. In the common stock chapter, we learned issuers authorize a certain number of shares when a corporation is formed, but usually sell a portion of those shares. This allows the issuer to raise additional capital by selling more shares at a later date. If a company has stock outstanding and decides to sell more to the public, it’s considered an APO.
In each circumstance, primary market transactions create proceeds for the issuer. IPOs, APOs, and private placements are the most common forms of primary market sales. In the next section, we’ll dive deeper into the IPO process.
Sometimes new shares are offered to the public, but the proceeds do not go to the issuer. Known as secondary offerings, these transactions are typically the result of large shareholders (usually company executives) selling a significant portion of shares. For example, Mark Zuckerberg (CEO of Facebook) sold $2.3 billion of stock he owned in a 2013 registered offering. The $2.3 billion in proceeds went to Zuckerberg, not Facebook. Secondary transaction proceeds do not go to the issuer.
Another $1.6 billion of Facebook stock was offered by the company itself alongside Zuckerberg’s shares, bringing the total amount sold to $3.9 billion. This is known as a combination offering, sometimes referred to as a split offering. Combination offerings involve some proceeds going to the issuer and some proceeds going to another party. To summarize the Facebook offering, Zuckerberg sold $2.3 billion while the company sold $1.6 billion, adding up to a total $3.9 billion combination offering.
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