Primary and Secondary Markets

The sale of securities by the issuer to investors occurs in the primary markets, while the sale of securities between private investors occurs in the secondary markets.

Primary Markets

Initial public offerings (IPO) describe the issuer’s first sale of a security to the public, while additional units are called seasoned offerings. The issuer usually hires an investment bank to assist in the sale of securities by finding investors (book building).

Investment banks take part in two main types of offerings: underwritten offerings, in which the investment bank agrees to buy any unsold securities at the price negotiated with the issuer, and best-effort offerings, in which the issuer will not sell as much as expected if the investment bank fails to attract enough interest in the offering. Investment banks hired to assist in the sale of securities generally have a conflict of interest in that the issuer wants to maximize the sale price of their securities, but the investment bank can reduce its risk of having to buy overpriced securities and indirectly help its other clients by offering lower prices.

To sell new issues of seasoned securities directly to the public, corporations sometimes use a shelf registration – spreading out the sale of additional securities over time as capital is needed and avoiding the common downward price pressure caused by a single large offering.

Corporations may also issue additional securities through dividend reinvestment plans (DRPs) where existing shareholders may opt to reinvest their dividends in new shares from the issuer or through a rights offering where existing shareholders are offered options to purchase new shares at a discount.

Corporations can also offer their securities to private qualified investors through private placements, usually with investment banks’ help. Qualified investors are generally assumed to conduct thorough due diligence before making investments, and thus less disclosure is generally needed for private placements. However, private investors usually demand a higher rate of return due to the inherent lack of liquidity of the private securities.

Secondary Markets

Transactions of existing securities (usually not involving the issuer) take place in the secondary markets. The secondary markets support the primary markets by offering liquidity to the initial investors in a security. This liquidity helps issuers attract more demand for their security offerings in the primary markets, leading to higher initial sale prices and a lower cost of capital.

Question

What is a likely benefit of a corporation issuing new securities in a private placement instead of an initial public offering?

1. Lower cost of capital.
2. Cheaper offering costs.
3. More liquidity for investors.

Solution

The correct answer is B.

Private placements generally involve fewer regulatory requirements and lower marketing and underwriting expenses compared to an IPO. However, private placements typically result in less liquidity for investors (as the securities are not publicly traded), and they may not necessarily lead to a lower cost of capital.

A is incorrect. While private placements can offer quicker access to capital, the cost of capital might not necessarily be lower. In fact, it can sometimes be higher because the investor base in private placements typically demands a premium for taking on higher risks due to lower liquidity and less public disclosure compared to a public offering.

C is incorrect. Private placements are typically sold to a limited number of institutional or accredited investors, and these securities are not traded on public exchanges. As a result, they are generally much less liquid than securities sold in an IPO, which are listed on public exchanges and can be bought and sold by a wider range of investors.