On the SIE exam, you learned about the primary market, which is where issuers offer new securities to investors. Much of this chapter reviews SIE topics, but several areas go deeper and add important details.
The primary market can take different forms, but one rule always holds: primary market proceeds go to the issuer. That’s the simplest way to classify a transaction.
There are four roles to be aware of when discussing the primary market:
Issuers are companies, organizations, or governments that raise capital (money) by selling securities. Underwriters (sometimes called investment banks) are hired by issuers to market and facilitate the sale of those securities. Investors buy the securities being offered. Finally, the Securities and Exchange Commission (SEC) oversees the primary market and regulates the financial professionals who participate in it.
From small start-ups to the federal government, issuers come in many forms. Issuers raise capital when a need is identified. Needs might include expanding a business, hiring a large number of employees, or funding deficit spending (as governments do). Real-world examples of issuers include:
Issuers often need help selling securities. In most cases, they don’t have the network or infrastructure to distribute securities directly to investors. Selling new issues also involves extensive rules and responsibilities.
Underwriters are hired by issuers to manage the sale and marketing of securities to the public. Investment banking (also called underwriting) can be a major business. For example, Facebook’s underwriters made over $100 million during their IPO in 2012. Underwriters can provide general advice, structure the offering, and sell the securities. Real-world examples of underwriters include:
The underwriter of an IPO is usually not the only firm involved. When an issuer hires an underwriter, it typically hires a lead underwriter, who then forms a group called a syndicate. This structure was covered in detail in the municipal debt chapter; here’s the big picture.
The syndicate includes multiple financial firms that help the lead underwriter sell the offering. In exchange for participating, syndicate members receive a portion of the underwriting fees. The lead underwriter:
Securities sold in the primary market are purchased by investors. Investors can be individuals, financial institutions, or government entities. Regulations around new issues are designed to protect investors from fraud and manipulation by issuers and underwriters.
When a new issue is sold, it will typically be regulated by the SEC. Unless an exemption applies, new issues must be registered with the SEC. Registration involves substantial paperwork and fees. The purpose is to ensure the issuer and underwriter provide enough information for the public to make an informed investment decision. This process is covered later in the chapter.
We first discussed underwriting commitments in the Municipal bond chapter. Some of this is review, but here we’ll apply the concept 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 describes the underwriter’s liability for unsold securities.
Firm underwriting commitments make the underwriter liable for any unsold shares. The investment bank buys the securities from the issuer and then sells them to investors. Offerings can involve thousands of bonds or millions of shares. If demand is weak, the underwriter may sell only part of the issue and must keep the unsold securities.
A firm underwriting is also known as a principal or dealer transaction. In a principal (dealer) transaction, a customer buys a security from a firm’s inventory. With a firm underwriting, the investment bank owns the securities it is selling, so they are treated as inventory. The firm profits if it buys at a lower price and resells at a higher price (a markup), similar to how dealers operate in many industries.
A standby underwriting is a type of firm commitment used with a rights offering. In a rights offering, current shareholders receive the right to buy newly issued shares. Not all shareholders exercise their rights, which can leave unsold shares. Before the rights offering begins, the issuer typically hires an underwriter to “stand by.” After the rights offering ends, the underwriter buys any unsold shares from the issuer on a firm basis and then resells them to its customers.
A best efforts underwriting commitment means the investment bank agrees to use its best efforts to sell the securities, but any unsold units or shares are returned to the issuer. Best efforts commitments are less risky for underwriters, so underwriting fees are typically lower.
A best efforts underwriting is also known as an agency transaction. In an agency transaction, a firm acts as a middleman that connects buyers and sellers. With a best efforts underwriting, the investment bank is acting as the link between the issuer and the investing public.
There are a few different versions of best efforts underwriting commitments. A mini-max underwriting specifies a minimum and maximum number of shares. For example, an issuer may offer 1 million shares but require the underwriter to sell at least 750,000 for the offering to proceed. If the minimum can’t be sold, the offering is canceled and investors receive their money back.
Also, there’s an all or none underwriting commitment. The underwriter must sell all of the securities for the offering to proceed. If an issuer offers 1 million shares, all 1 million must be sold. Otherwise, the offering is canceled and investors receive their money back.
As you can see, public offerings can use several commitment styles. Choosing the commitment is a key part of the agreement between the issuer and the underwriting syndicate. These agreements sometimes include market-out clauses, which allow the syndicate to back out due to unforeseen market events. If an unexpected event occurs (for example, the Great Recession or the COVID-19 pandemic), demand for the security could drop sharply, making the offering difficult to sell. Market-out clauses are especially important in firm commitment offerings because the syndicate’s risk is higher.
The commitment type also affects syndicate compensation. The revenue received by the syndicate is divided among the different participants (lead underwriter, syndicate members, and selling group members). The compensation breakdown was covered in detail in the municipal debt chapter.
Reallowance was not covered in the municipal debt chapter because it applies only to corporate underwritings. Sometimes, broker-dealers that are not part of the underwriting syndicate are brought in to help sell shares, often when demand is high. When a non-syndicate broker-dealer sells a new issue, it may receive a reallowance, which is paid from a portion of the selling concession. If you’re unsure about the underwriting spread components (including the selling concession), review the compensation structure from the municipal debt chapter.
Primary market offerings can take several forms, but for the Series 7 exam we’ll focus mainly on two: IPOs and APOs.
An initial public offering (IPO) occurs when an issuer sells a security to the public for the first time. Common stock IPOs from large companies are widely covered in the financial media. For example, Uber’s IPO in 2019 garnered a lot of attention and raised $8.1 billion for the company. Uber had previously sold securities through private placements, but 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 called follow-on offerings. In the common stock chapter, we learned issuers authorize a certain number of shares when a corporation is formed, but they usually sell only a portion at first. This leaves the issuer the option to raise additional capital later by selling more shares. If a company already has stock outstanding and decides to sell more shares to the public, it’s an APO.
In each case, 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 shares are offered to the public, but the proceeds do not go to the issuer. These are called secondary offerings, and they typically occur when large shareholders (often company executives) sell a significant number 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.
In that same transaction, Facebook also sold $1.6 billion of its own stock alongside Zuckerberg’s shares, bringing the total sold to $3.9 billion. This is called a combination offering, sometimes referred to as a split offering. Combination offerings include both:
To summarize the Facebook example: Zuckerberg sold $2.3 billion and the company sold $1.6 billion, for a total $3.9 billion combination offering.
A PIPE (Private Investment in Public Equity) offering is a private transaction in which a publicly traded company sells equity at a discount to the current market price. Companies often use PIPE offerings to raise capital faster and at a lower cost than an IPO, and they are most common during market downturns. To help protect the security’s market value, these deals often include a lock-up period of six to twelve months, during which investors can’t sell their shares. Since PIPEs are private placements, the investor must be accredited and is often an institution such as a private equity firm or fund.
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