Primary markets Equity, debt, and other
instruments that are newly issued to the public
are said to trade in the primary market. A firm selling securities to the primary market always wants to do so at the highest possible price; it wants each security to sell for as much as possible, in order to maximize its funding and minimize the cost of that funding. Usually, firms enlist the services of an investment banker to underwrite a new stock or bond issue. If one investment bank does not want to bear the full risk of issuing the security, the firm may call on several investment banks—collectively called a
“syndicate”—to do the job. For the most part, investment banking is performed by commercial banks and brokerage houses, although in some countries commercial banks are legally restrained from engaging in some types of investment banking activity. In the United States, for example, the Glass-Steagall Act prohibits commercial banks from
underwriting debt issues that are large relative to their total assets and from underwriting equity issues at all. Japanese regulation of this sort is even more restrictive.
In Germany, on the other hand, there is no legal distinction between commercial and investment banking. Investment bankers handle several tasks, including registering the new issue with the SEC, marketing the issue to brokerage houses, and getting the security rated. Yet perhaps the most important function of investment bankers, as far as the issuing company is concerned, is to
“price” the security, that is to determine how much it is likely to sell for in the open market. Both buyers and sellers of new issues rely on investment bankers to make this determination accurately. If the security is priced far above its actual market value, its price will quickly drop after it is issued, creating losses for the initial buyers. On the other hand, if it is priced far below its market value, then the price will quickly rise, implying that the issuing firm missed out on potential funding.
As a result, investment banks have a strong incentive to exercise care and expertise in pricing new issues, and their reputation for doing so is often their most valuable asset in competing for new business. If the issuing firm already has securities trading on the open market, it is relatively easy to price a new issue. However, about half of all security issues are initial public offerings
(IPOs). In these cases, the market has never had the opportunity to assess the value of the issuing firm, and so the investment banker must make a judgement about the appropriate price for the security.
Once the issue is priced, it usually makes its way to the public by one of two underwriting methods. In
“firm-commitment” underwriting, the investment bank buys the whole issue at the determined price and then resells it through its brokerage houses. In “best-efforts” underwriting, on the other hand, the investment bank brokers the security from the issuer to the public but does not purchase it for its own account. Because the investment bank puts its own money behind securities underwritten with firm commitment, the market tends to look more favorably upon these issues than upon best-effort issues.
An alternative way of issuing securities in the primary market is with a private placement. In this case, the issuing firm bypasses the underwriting process and sells its securities directly to a private investor or group of investors. One advantage of this method is that the
SEC waives registration requirements for private placements under certain conditions. Because large institutional investors
(e.g., insurance companies and pension funds) typically buy private placements, the SEC believes that the disclosure restrictions intended to make information available to the public are unnecessary in these cases. With the rapid growth of institutional investors in recent years, private placements are becoming an increasingly important feature of modern capital markets.
In 1982 the SEC approved Rule 415, allowing so-called shelf registration. This procedure allows firms to register a security issue with the SEC but not actually issue the security until a later time
(up to two years). This allows the firm and investment bank to wait until the time is just right and then move quickly, already having the regulatory hassle out of the way.