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 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 engage in two primary types of offerings: underwritten offerings and best-effort offerings. In underwritten offerings, the investment bank commits to purchasing any unsold securities at the negotiated price with the issuer. In best-effort offerings, the issuer won’t sell as much as expected if the investment bank fails to generate sufficient interest in the offering.

When investment banks assist in selling securities, a conflict of interest arises. The issuer aims to maximize the sale price, but the investment bank wants to minimize its risk of buying overpriced securities. This can indirectly benefit its other clients by offering lower prices.

Corporations often use shelf registrations to sell new issues of seasoned securities directly to the public. Shelf registrations allow them to spread out the sale of additional securities over time as capital is needed. This approach helps avoid the common downward price pressure that can result from a single large offering.

Corporations can issue more securities through dividend reinvestment plans (DRPs). Existing shareholders have the choice to reinvest their dividends in new shares from the issuer. They can also use rights offerings where existing shareholders are given the option to buy new shares at a discounted price.

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 in 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.

Since less disclosure is usually required of issuers, private placements tend to have lower offering costs than public offerings. However, because private placement securities are less liquid, investors demand a higher return on their capital resulting in lower security prices and, therefore, a higher cost of capital for the corporation.