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Chapter 14. Primary Markets. Traditional Process Regulation Variations in Underwriting. Background. all types of securities security being sold for the first time new offerings of firms with publicly held securities -- SEO seasoned equity offering IPOs
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Chapter 14. Primary Markets • Traditional Process • Regulation • Variations in Underwriting
Background • all types of securities • security being sold for the first time • new offerings of firms with publicly held securities -- SEO seasoned equity offering • IPOs • after initial offering, security is in secondary market
I. Traditional Process • investment banks play key role • function performed by different institutions • roles: (1) advising (2) underwriting/best efforts (3) distribution & support
(1) advising • timing of offering • terms of security • pricing • regulation
(2) underwriting • optional • investment bank buys securities from issuer, then resells to public • investment bank bears the price risk
price set 2 days prior to issue • security floatation • firm commitment • resale price - guaranteed price = gross spread = underwriter’s discount
size of discount depends on • type of security -- bonds lowest, stock IPOs highest • size of issue -- smaller issues have larger discount • market conditions • .5% - 7% (table 14-1)
group of investment banks • several investment banks bear price risk • lead underwriter -- bulge bracket firm • syndicates help underwrite • selling group • syndicate AND • other firms -- help sell issue, do not underwrite
tombstone • advertisement • lists all of the underwriters • details of issue • after sale has taken place • to get more underwriting business
IPOs typically underpriced • 1980s: first day return 7% • 1990-98: 15% • 1999-2000: 65% • why? • reduces risk for underwriter • issuer accepts underpricing for prestigious underwriter
who gets “hot” IPOs? • Lucent 1996 • Red Hat 1999 (Linux) • “spinning” • underwriters allocate shares to preferred customers
(2) best efforts placement • alternative to underwriting • investment bank promises to use “best efforts” to sell issue • but no guarantee of price -- issuer retains price risk • done with firms with limited market recognition
(3) distribution & support • underwriters expected to support secondary market • hold large inventory of securities
who underwrites? • commercial banks, insurance co. • U.S. firms restricted under Glass Steagall until 1999 • no restrictions on firms outside U.S.
securities houses • top ten underwriters do over 75% of underwriting • also leading brokerage firms and dealers
top underwriters, 2003 • Equity & bonds 1. Citigroup 2. Merrill Lynch 3 . Morgan Stanley
II. Regulation • SEC regulates primary market • disclosure of information • insider trading
security registration w/ SEC • prospectus • nature of firm • features of security • risk • firm management • certified financial statements
firms liable for incorrect info • criminal and civil • underwriters possibly liable • must show due diligence in reviewing info
red herring • waiting period for SEC approval • firm distributes preliminary prospectus • saying so in red ink • red herring
SEC approval • registration is effective • SEC determines info is complete • NOT accurate • NOT a recommendation • investment bank now offers security for sale
Shelf registration rule • SEC rule 415 (1982) • issuer gets prior approval for several new issues w/in 2-year period • investment grade • NOT IPOs • allows issuer to move quickly when market conditions favorable
Exempt from registration • U.S. government debt • municipal debt • commercial paper • small offerings (< $1 million) • intrastate offerings
III. Variations in Underwriting • Bought Deal • investment bank presents offer to firm to buy entire block of debt securities -- issuer accepts/rejects w/in days -- if accepts, issuer “bought the deal”
only 1 underwriter -- greater risk of capital -- issue usually presold to institutional buyers
Competitive bidding • auction • issuer sets terms of issue, places up for bid to competing underwriters -- competition will lower cost • required for municipalities, utilities • no evidence that this is cheaper
Pre-emptive Rights Offering • company w/ stockholders • new stock offered to existing shareholders -- below market value -- prevents dillution of voting rights
Private Placement • issued placed directly with small # of buyers • no solicitation/advertising to public • buyers are institutional investors -- insurance co., pension funds -- capable of evaluating risks
usually bonds • no registration w/ SEC -- but must offer prospectus • PP are less liquid -- limits on resale for 2 years
Growth in private placements • rule 144A (1990) -- allows trading of PP among institutions