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Chapter 14. Primary Markets

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

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  1. Chapter 14. Primary Markets • Traditional Process • Regulation • Variations in Underwriting

  2. 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

  3. I. Traditional Process • investment banks play key role • function performed by different institutions • roles: (1) advising (2) underwriting/best efforts (3) distribution & support

  4. (1) advising • timing of offering • terms of security • pricing • regulation

  5. (2) underwriting • optional • investment bank buys securities from issuer, then resells to public • investment bank bears the price risk

  6. price set 2 days prior to issue • security floatation • firm commitment • resale price - guaranteed price = gross spread = underwriter’s discount

  7. 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)

  8. 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

  9. tombstone • advertisement • lists all of the underwriters • details of issue • after sale has taken place • to get more underwriting business

  10. 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

  11. who gets “hot” IPOs? • Lucent 1996 • Red Hat 1999 (Linux) • “spinning” • underwriters allocate shares to preferred customers

  12. (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

  13. (3) distribution & support • underwriters expected to support secondary market • hold large inventory of securities

  14. who underwrites? • commercial banks, insurance co. • U.S. firms restricted under Glass Steagall until 1999 • no restrictions on firms outside U.S.

  15. securities houses • top ten underwriters do over 75% of underwriting • also leading brokerage firms and dealers

  16. top underwriters, 2003 • Equity & bonds 1. Citigroup 2. Merrill Lynch 3 . Morgan Stanley

  17. II. Regulation • SEC regulates primary market • disclosure of information • insider trading

  18. security registration w/ SEC • prospectus • nature of firm • features of security • risk • firm management • certified financial statements

  19. firms liable for incorrect info • criminal and civil • underwriters possibly liable • must show due diligence in reviewing info

  20. red herring • waiting period for SEC approval • firm distributes preliminary prospectus • saying so in red ink • red herring

  21. SEC approval • registration is effective • SEC determines info is complete • NOT accurate • NOT a recommendation • investment bank now offers security for sale

  22. 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

  23. Exempt from registration • U.S. government debt • municipal debt • commercial paper • small offerings (< $1 million) • intrastate offerings

  24. 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”

  25. only 1 underwriter -- greater risk of capital -- issue usually presold to institutional buyers

  26. 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

  27. Pre-emptive Rights Offering • company w/ stockholders • new stock offered to existing shareholders -- below market value -- prevents dillution of voting rights

  28. 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

  29. usually bonds • no registration w/ SEC -- but must offer prospectus • PP are less liquid -- limits on resale for 2 years

  30. Growth in private placements • rule 144A (1990) -- allows trading of PP among institutions

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