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Chapter 14. Primary Markets

Traditional Process

Regulation

Variations in Underwriting

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Background

all types of securities

security being sold for the first time

new offerings of firms with publiclyheld securities

-- SEO seasoned equity offering

IPOs after initial offering, security is in

secondary market

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I. Traditional Process

investment banks play key role function performed by different

institutions

roles:

(1) advising

(2) underwriting/best efforts(3) distribution & support

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(1) advising

timing of offering

terms of security

pricing regulation

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(2) underwriting

optional

investment bank buys securities

from issuer,then resells to public

investment bank bears the price risk

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price set 2 days prior to issue

security floatation firm commitment

resale price - guaranteed price

= gross spread

= underwriters discount

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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

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tombstone

advertisement

lists all of the underwriters

details of issue after sale has taken place

to get more underwriting business

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who gets hot IPOs?

Lucent 1996

Red Hat 1999 (Linux)

spinning underwriters allocate shares to

preferred customers

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(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 marketrecognition

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(3) distribution & support

underwriters expected to supportsecondary market

hold large inventory of securities

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who underwrites?

commercial banks, insurance co.

U.S. firms restricted under Glass

Steagall until 1999 no restrictions on firms outside

U.S.

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securities houses

top ten underwriters do over 75%of underwriting

also leading brokerage firms and

dealers

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top underwriters, 2003

Equity & bonds

1. Citigroup

2. Merrill Lynch3 . Morgan Stanley

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0

500

1,000

1,500

2,000

2,5003,000

1999 2000 2001 2002 2003

Total Debt Underwriting, Billions $

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0

50

100

150

200

250

1999 2000 2001 2002 2003

Equity Underwriting, Billions $

equity IPOs

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0

500

1,000

1,500

2,000

2,500

3,000

1999 2000 2001 2002 2003

Total Debt Underwriting, Billions $

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II. Regulation

SEC regulates primary market

disclosure of information

insider trading

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firms liable for incorrect info

criminal and civil

underwriters possibly liable must show due diligence in

reviewing info

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red herring

waiting period for SEC approval

firm distributes preliminary

prospectus saying so in red ink

red herring

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SEC approval

registration is effective

SEC determines info is complete

NOT accurate NOT a recommendation

investment bank now offers security

for sale

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Exempt from registration

U.S. government debt

municipal debt

commercial paper small offerings (< $1 million)

intrastate offerings

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III. Variations in Underwriting

Bought Deal

investment bank presents offer to

firm to buy entire block of debtsecurities

-- issuer accepts/rejects w/in days

-- if accepts, issuer bought thedeal

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only 1 underwriter-- greater risk of capital

-- issue usually presold to

institutional buyers

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Pre-emptive Rights Offering

company w/ stockholders new stock offered to existing

shareholders

-- below market value

-- prevents dillution of votingrights

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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

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usually bonds

no registration w/ SEC

-- but must offer prospectus PP are less liquid

-- limits on resale for 2 years

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Growth in private placements

rule 144A (1990)-- allows trading of PP amonginstitutions