Primary and Secondary Markets

Sales of securities by the issuer to investors take place in the 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 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, also usually with the help of investment banks. 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.

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, which leads to higher initial sale prices and thus 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?

A. Cheaper offering costs

B. More liquidity for investors

C. Lower cost of capital

Solution

The correct answer is A.

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.

 

Reading 44 LOS 44i:

Define primary and secondary markets and explain how secondary markets support primary markets

Click here to access 3,000 CFA practice questions.

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