A primary market is the market for a security that is being issued for the first time. Primary market investors buy securities directly from the issuer, not from each other. There are two types of primary markets:
- General public distribution: Securities are offered to anyone who has the wherewithal to purchase them.
- Private placement: The shares are bought by an investment bank, often with a small but select list of major institutional investors.
The following are the key players in the primary market process:
- Issuer: The corporation, municipality, government agency or investment company offering securities for sale to investors.
- Underwriter: An investment bank that serves as intermediary between the issuer and the investing public.
- Syndicate: A group of investment banks which jointly underwrite and distribute an offering.
The Initial Public Offering Process:
- The underwriter usually places an advertisement in a business newspaper announcing a new offering as well as the list of syndicate members; this type of ad is called a tombstone.
- Concurrent with placing the tombstone, the underwriter will produce a preliminary prospectus which will be circulated to those interested in investing in the offering. This document is often called a red herring because it bears a red-lettered warning stating that it is still under SEC review. The prospectus is usually modified significantly before a final version is released.
An offering is called a hot issue if, once it goes public, the market bids up the price far in excess of the initial offering price.
- Pro: To the investors who bought it at the initial price, a hot issue is a good thing because they can sell their shares immediately at a substantial profit.
- Con: However, it is not necessarily a good thing for the underwriter's client, because it makes it obvious that the offering price could have been much higher - and the proceeds from the offering price are the only money the issuer will see from this exercise.
For more on IPOs, see the IPO Basics Tutorial
The term investment bank, as used above, may be a little confusing to those unfamiliar with the structure of the
An investment banker will prepare the offering's registration statement as required by the SEC, manage or participate in the syndicate and ensure price stability as the issue is distributed. In the case of a private placement, the investment banker will also act as the agent.
Types of Underwriting Commitments
There are different flavors of underwriting, each a good fit for a particular set of circumstances:
- Firm commitment: The underwriter assumes all risks of bringing a new security to market by buying the entire issue and re-selling it to investors.
- Best efforts: The underwriter acts strictly as an agent endeavoring to do its best to sell the offering to the public, but it neither buys the securities nor guarantees proceeds.
- All-or-none: The offering is cancelled if the underwriter cannot sell all shares.
- Standby: The underwriter of a rights offering agrees to buy any remaining portions of a new issue offered to current shareholders, if the offering is undersubscribed.
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