What is the difference between the primary and secondary capital markets


Have you ever wondered how the process works when a company is selling shares to the public? This article will take a deep dive into the primary and secondary capital markets and identify the differences.

What is the difference between the primary and secondary capital markets?

In the primary market, companies sell their shares for the first time to large investors. Once these large investors decide to sell their shares, they will be traded publicly on the secondary market (also called the stock market).

Interested to learn more? Read on…


Illustration of the difference between the primary and secondary capital market.


What happens in the primary capital market?

The primary capital market or the “New issue market” is where a company issues stocks or bonds for the first time. The company usually does this through an IPO (Initial Public Offering). The company converts from a privately owned company to a publicly-traded company by issuing shares to investors during the IPO.

Filing with SEC

All companies that want to go public will have to comply with strict regulations. They will have to file declarations with the SEC (Securities and Exchange Commission) or other authorities, depending on the country, and wait until their registration statement is declared “effective” before they are allowed to sell their shares. These declarations include the company’s business details, how the company intends to use the capital raised, and other legal matters.

What is the underwriter’s role in an IPO in the primary market?

Companies will usually hire one or more underwriters. Underwriters are large financial organizations such as investment banks with extensive know-how of the IPO process and good connections to large investors such as Hedge Funds, Mutual Funds, Pension Funds, and Insurance Companies.

The underwriters will help the company file the declarations with the SEC, determine the amount of money the company wants to raise, value the share price, and create a draft prospectus, a marketing document to attract large investors.

How is the share price of the company determined in the primary market?

The share price determined is either a fixed price, based on studies of the company’s financial situation and future outlook or there will be a price range defined, where the lowest price is called “floor price,” and the highest price is called “cap price”. The investors can then bid on this price range, and the price of the share will be determined by the underwriter’s based on the bids.

The underwriters will go on roadshows together with the company’s top management, where they introduce the company to large investors and gauge their interest and commitment to buy a portion of the shares.

If the company can raise enough capital by offering the shares at an attractive enough price to the underwriters, a “bought deal” might be established by which the underwriters buy all the shares in one go and then sell them on at a profit to their clients. In this scenario, the underwriter is confident enough to sell all the shares and bear the risks.

Another option is that the underwriters will sell the shares on a best effort basis and charge a flat fee. The company might think that it can raise more capital, or the underwriters might not want to take the risk of purchasing all shares. In this scenario, the company will carry the risk of being stuck with unsold shares.

How can a company sell more shares, after it has entered the secondary market?

After the company’s shares have entered into the secondary market, and the company wants to sell more shares, it can do so through a “rights offering”. The company will offer the right for a limited amount of time to shareholders to purchase more shares at a usually discounted price. The shareholders can also sell their rights to buy the shares to a third party if the company allows it.

Another option is a private placement, where the company sells shares directly to large investors. With a private placement, these shares will not be traded on the stock market.

There are various reasons why a company wants to raise more capital. For example, it can be for growth reasons, such as taking over competitors, but it can also be due to dept reasons, if the company isn’t doing so well, or they might want to simply reduce debt in their books.

Can retail investors participate in the primary market?

It is complicated for retail investors to participate in the primary market, as companies at this point are interested in selling large parts of their shares in one go. You might stand a chance if you know the company’s owners or are a client of a large full-service provider such as an investment bank or hedge fund.

The other option is to invest in a mutual fund, or ETF, that focuses pre-IPO shares, but bear in mind, that this can be risky, as not all IPOs go well.

Therefore most retail investors purchase shares on the secondary capital markets.


What happens in the secondary capital market?

After the initial public offering, the shares sold will be traded on the secondary market, also called the “stock market”. These are NYSE, NASDAQ, and other stock exchanges around the world.

Once the shares are traded on the secondary market, the issuing company is no longer involved unless they buy back shares. The owners will buy and sell the shares of the company among each other.

In the secondary market, anyone can buy securities as long they are willing to pay the share’s asking price. Most retail investors will buy and sell their shares in coexistence with all the large investors, such as Mutual Funds, Hedge Funds, Insurance Companies, and other large financial institutions in the secondary market.

Retail investors usually acquire shares through a broker, as they are no direct stock exchange participants. The broker will charge a commission for executing the trade. In contrast to the primary market, where prices are set before going public, prices in the secondary market fluctuate with demand.

As the shares on the secondary market are traded daily, based on the demand, the security price will fluctuate.

The secondary market distinguishes between two categories: the auction and the dealer market. The auction market is an open outcry system, where buyers and sellers gather in one place and announce the prices they are ready to buy and sell their securities. The NYSE is one such example. In the dealer markets, trading takes place via electronic networks. Most retail investors trade through dealer markets.


Conclusion

  • New shares and bonds such as IPOs are issued on the primary capital market.
  • Companies wishing to raise capital will offer securities to large investors in the primary market at a fixed price.
  • Once a security has been traded on the primary market, it can be traded on the secondary market for smaller investors.
  • Exchanges like the NYSE, LSE, and Nasdaq are secondary markets.

Chris

Chris is an IT Project Portfolio Manager within the financial industry. Due to the nature of his role, he is engaged to study Financial Markets and is an active investor.

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