The capital market refers to the arena where securities are created and traded between investors. Within this capital market are a primary market and a secondary market, each of which serves a different purpose. Those markets work together to promote economic growth while allowing companies to raise capital via investors.
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What Is the Primary Market?
The primary market is where securities are created so they can be sold to investors for the first time. Above all, the primary market issues new securities on an exchange to allow companies, governments and others to raise capital.
Securities issued through a primary market can include stocks, corporate or government bonds, notes and bills. Those issuing securities can sell them to reduce debt on their balance sheets. Also, they can expand a company’s physical footprint, develop new products, or fund other business goals.
In a typical primary market transaction, there are three players. First, there’s the company issuing the new securities. Secondly, there are investors who purchase them. Finally, there’s bank or underwriting firm that oversees and facilitates the offering. The bank or underwriting firm determines the accurate value and sale price of the new security.
How Primary Market Securities are Sold
Once a company or government issues a security and the underwriting team determines its value, it can be sold. There are four ways investors can buy securities through the primary market:
1. Initial Public Offering (IPO)
An initial public offering or IPO is when a company makes shares available to the public for the first time. An IPO can be a fast way for a company to raise capital if there’s sufficient interest from investors. For example, Facebook’s IPO in 2012 raised $16 billion, making it one of the largest technology IPOs at the time and enabling the company to expand its operations significantly.
However, by going public, companies have to adhere to regulations imposed by the Securities and Exchange Commission.
For investors, IPOs can be risky. If the company performs well, investors could see solid returns if they bought shares at a low price. On the other hand, once-private companies may struggle once stock hits the open markets. If they can’t maintain momentum, demand for shares may falter. As a result, investors could take a loss if the share price drops below the IPO.
2. Rights Issue
A rights issue or rights offering creates new shares while restricting investor access. In this case, a company can offer certain investors new shares at a specific price. For example, a company could extend this benefit to its employees or current shareholders.
The investor can exercise their rights and purchase the new shares at that price, However, they could sell their rights to someone else. The company raises money and investors who exercise their rights expand their holdings. One potential downside, however, is that increasing share volume dilutes value.
A notable example is HSBC Holdings’ rights offering in 2009, which raised approximately $17.7 billion. This move helped the bank strengthen its capital base during the global financial crisis while allowing existing shareholders to maintain their stakes.
3. Private Placement
Private placements are another form of primary market transaction, where securities are sold directly to a select group of institutional or accredited investors. This method allows issuers to bypass public offering procedures and regulations, often resulting in quicker transactions.
They can help startups and early stage companies keep funding growth without going public. For instance, Airbnb conducted a private placement in 2020, raising $1 billion from private equity firms to strengthen its balance sheet during the Covid-19 pandemic.
4. Preferential Allotment
Preferential allotment is similar to private placement. It also offers share to a select group of investors. The investors selected don’t necessarily need to be shareholders or have any connection to the company. But companies can control the transfer of shares to other investors.
Primary Market vs. Secondary Market
The other side of the capital market coin is the secondary market. The secondary market is where existing shares of stock, bonds and other securities are traded between investors, after they’ve been issued on the primary market. These trades happen on an exchange, such as the New York Stock Exchange or the Nasdaq.
When buying stocks on the primary market, they’re purchased directly from the issuer. With the secondary market, the issuing company doesn’t play a part. This is what you might automatically think of when you think of stock trading. Following an IPO, investors can buy or sell company shares on an exchange.
For example, you decide you want to buy 100 shares of XYZ company. You log in to your online brokerage and place an order for 100 shares. A seller who owns those shares sells them to you when the bid and ask price align. The bid price is your target price you want to pay for the shares. The ask price is the seller’s target price for selling. The bid-ask spread is the difference between the two numbers.
Role of Investment Banks in the Primary Market
Investment banks play a crucial role in facilitating primary market transactions. Acting as underwriters, they help issuers structure securities, set pricing, and manage regulatory requirements.
These banks often take on significant risk, especially in IPOs, as they may purchase the securities from the issuer before reselling them to investors. Their expertise and resources are critical in ensuring the success of primary market offerings.
Bottom Line
For companies, the primary market Investing in the primary market may be less common than investing in the secondary market for the typical investor. While individual investors can invest in a company’s IPO through online brokerages that offer this option, they should understand the risks involved.
Investing Tips
- Consider talking to your financial advisor about investing in an IPO or another primary market option. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you’re investing at the secondary market level, it’s important to choose the right online brokerage for your needs. While many brokers now offer commission-free trading, they’re not all alike. When comparing brokers, check the fees and then consider things like the types of accounts you can open, trading minimums and maximums and the user-friendliness of the trading platform. Also, check out the range of research tools that are available and whether professional investment help is available on standby.
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