Meaning Of Primary Markets And Its Characteristics

Table of Contents

Primary Markets

Primary market is a market for issue of new instruments or financial claims. This is the reason for Primary Markets to also be known as the “New Issues Markets”. The market facilitates generation of fresh capital by issuing securities such as equity shares, preference shares, debentures, Government Securities, Corporate Bonds, etc.

Funds are mobilized in the primary markets by the Central and State Governments and Public Sector Enterprises, Banks, Financial Institutions and Non-Government Public Limited Companies (Private Sector). These entities issue new securities periodically, to raise funds in order to meet their financial requirements. These new issues are floated through a Prospectus, Rights, and Private Placement – Qualified Institutional Placement (QIP).

Primarily, issues made by an Indian company can be classified as Public, Rights, Bonus and Private Placement. White right issues by a listed company and public issues involve a detailed procedure, bonus issues and private placements are relatively simpler.

Public Issue
1. Initial Public Offer (IPO)
2. Further Public Offer (FPO)
Rights Issue
Bonus Issue
Private Placement
Preferential Issue
Qualified Institutional Placement

When an issue / offer of securities is made to new investors for becoming part of shareholders family of the issuer, it is called a public issue. Public issue can be further classified into Initial Public Offer (IPO) and Further Public Offer (FPO). When an unlisted company makes either a fresh issue of securities or offers its existing securities for sale or both for the first time to the public, it is called an Initial Public Offering or an IPO. This enables listing and trading of the issuer’s securities in the Stock Exchanges. When an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, it is called a Further Public Offer (FPO) or Follow on offer. When an issue of securities is made by an issuer to its shareholders existing as on a particular date fixed by the issuer (i.e., record date), it is called a rights issue. The rights are offered in a particular ratio to the number of securities held as on the record date. When an issuer makes an issue of securities to its existing shareholders as on a record date, without any consideration from them, it is called an bonus issue. The shares are issued out of the Company’s free reserve or share premium account in a particular ratio to the number of securities held on a record date. When an issuer makes an issue of securities to a select group of persons not exceeding 49, and which is neither a rights issue nor a public issue, it is called a private placement. Private placement of shares or convertible securities by listed issuer can be of two types, namely, Preferential allotment and Qualified Institutional Placement (QIP). When a listed issuer issues shares or convertible securities, to a select group of persons, it is called a preferential allotment. The issuer is required to comply with various SEBI guidelines which inter alia include pricing, disclosures in the notice, lock in, etc. in addition to the requirements specified in the Company Act. Alternatively, when a listed issuer issues equity shares or securities convertible in to equity shares to Qualified Institutional Buyers, it is called a QIP.

SEBI has laid down the general conditions for entities to undertake public and rights issues. This is available in the SEBI Issue of Capital and Disclosure Requirements (Regulations) 2009. No issuer shall make a public issue or rights issue of specified securities.

If the issuer, any of its promoters, promoter group or directors or persons in control of the issuer are debarred from accessing the capital market by the Board.
If any of the promoters, directors or persons in control of the issuer was or also is a promoter, director or person in control of any other company which is debarred from accessing the capital market under any order or directions made by the Board.
If the issuer of convertible debt instruments is in the list of wilful defaulters published by the Reserve Bank of India or it is in default of payment of interest or repayment of principal amount in respect of debt instruments issued by it to the public, if any, for a period of more than six months.
Unless it has made an application to one or more recognized stock exchanges for listing of specified securities on such stock exchanges and has chosen one of them as the designated stock exchange: Provided that in case of an initial public offer, the issuer shall make an application for listing of the specified securities in at least one recognized stock exchange having nationwide trading terminals.
Unless it has entered into an agreement with a depository for dematerialization of specified securities already issued or proposed to be issued.
Unless all existing partly paid-up equity shares of the issuer have either been fully paid up or forfeited.
Unless firm arrangements of finance through verifiable means towards 75% of the stated means of finance, excluding the amount to be raised through the proposed public issue or rights issue or through existing identifiable internal accruals have been made.

Raising capital in Primary Markets itself can be broadly classified into 3 stages, namely, Pre-Issuance, Issuance and Post Issuance stage. A brief overview of these stage is given below. This would provide the larger picture as to the activities leading to the Primary Market Issue.

Pre-Issuance

The Memorandum of Association (MoU) and Articles of Association (AoA) of the company are filed with the Stock Exchanges for their comment / feedback / suggestions. Draft offer document is filed with the SEBI for its comments / feedback / suggestions. Draft over document is also filed with the Stock Exchanges requesting permission from the Exchange to use the Exchange’s name in its offer document. Detailed report on the company is prepared on the basis of the draft offer document and material documents/information filed with the Exchange and placed before the listing Committee of the Exchange which then decides whether the request of the company is to be accepted or rejected.

If the request is accepted, the company is issued the in-principle approval granting permission to use the Exchange’s name in its offer document. The SEBI gives its comments on the draft offer document. The changes, if any, as suggested by the SEBI in its offer document are incorporated. The company then fixes the period for which its public issue would remain open to investors for subscription.

Issuance And Post Issuance

In the case of a book-building issue the company receives bids for subscription at different prices falling within the price band. In the case of a fixed price issue, subscription is received at the issue price fixed by the company.

After the issue closes, in the case of a book-building issue, the company fixes the issue price in consultation with the lead manager to the issue. In the case of a fixed price issue, the allotment of securities should be made within 30 days from the date of closure of the issue, whereas in the case of a book-building issue/rights issue, the allotment is to be made within 15 days from the date of closure of the issue. In case there is over-subscription, the basis of allotment is finalized by the company in consultation with the Designated Stock Exchange. The company, lead manager and the registrars to the issue are responsible for ensuring that the basis of allotment is in accordance with the prescribed rules and regulations. Thereafter, the company must ensure that all step for completion of the necessary formalities for listing and commencement of trading on all the Stock Exchange are taken within 7 working days from the finalization of the basis.

Issues are offered to the public through a prospectus and the public can subscribe directly to the offer made by any of the prior mentioned entities. Section 67 of the Companies (Amendment) Act (2000), specifies that when the offer or invitation to subscribe for shares or debentures is made to 50 or more persons, then such an offer or invitation shall be deemed to be a public offering and shall have to comply with all the provisions of the Act as well as the SEBI guidelines applicable to public offerings. Public issues are open to the general public and media publicity is provided by the issuer of securities, to attract the attention of the investors. The issuer entitles a registered Merchant Banker to oversee the development of the Prospectus and ensure that all regulatory guidelines have been adhered to, in the pre-issue, issue and post-issue phases. Alternatively, if the issuer provides an offer only for specific select individuals or entities, e.g., institutions, hedge funds, foreign institutional investors, etc., then such an offer is usually referred to as a private placement.

Need For Capital

The capital sourced from the primary markets may be used by the issuers for development of existing or new business – modernization, expansion or diversification.

Expansion: Investment in fixed assets resulting in increase in the installed capacity of its existing products.

Diversification: Creation of production capacity of items not being now manufactured by the unit, without reducing the installed capacity of existing items.

Modernization: Technological up-gradation of the production process of the unit.

Characteristics Of Primary Markets

Primary Markets enable efficient allocation of resources between companies seeking funds and investors having surplus funds. The existence of regulatory mechanism ensures that all participants in the primary markets are on a level platform, to ensure fairness and integrity. This increases confidence in the entire market. Primary market participants such as issuing company, merchant bankers, underwriters, brokers and investors need to adhere to regulatory compliance requirements. This also avoids manipulation in the market. The pricing of shares is also transparent, due to the processes such as book building method followed in the market.

Following is a brief discussion on each of these features of the Primary Markets in India.

Allocation Of Resources Between Companies And Investors

The flow of funds moves investors (lenders) to corporate (borrowers) directly or indirectly (through financial institutions). Thus, Primary markets play a significant role in the allocation of the economy’s savings in efficient production of goods and services. Economic development and growth of an economy can be achieved through savings and investment. The pace of economic development depends upon the rate of long term investment and capital formation in a country. Primary market also enables savings of funds (by investors) to transmit into long term investments by deficit units (by corporate).

Existence Of Regulatory Mechanism

Primary markets should be governed by a strong regulatory mechanism to protect the investors, to stabilize the internal management of financial institutions, and to create / strengthen the structure of the financial markets. Investors should be protected from malpractices and fraud in the primary markets. The regulations also ensure institutions, the freedom of operation to improve the efficiency and provide innovative financial instruments and processes that benefit the investors and other participants. The regulations must aim to ensure the soundness and safety of financial institutions and market. Thus, existence of regulations enhance credibility and confidence among market participants.

Factors Affecting Primary Markets

There are various factors that affect the growth and performance of the Primary markets.

Impact Of Secondary Markets

Historically, it has been observed that the secondary market fuels growth in the primary markets. Growth in Primary markets is measured in terms of the number of companies raising funds as well as the quantum of funds raised. As secondary markets developed and attracted new investors from India and abroad (FII), the liquidity in the secondary market has improved. As secondary market provide exit opportunities to primary market investors, a liquid secondary market usually assists the growth and development of primary markets.

But if a company’s stock price in secondary market decreases below the Issue Price, the investors’ confidence in the primary market is affected and demand for new issues decreases. The calendar year 2008 witnessed these factors. In fact, as many as 50 new companies have either cancelled or postponed their new issues in 2008-2009. This is in anticipation of vibrant economic growth in the country, which would in turn result in demand for such securities.

Issue price is defined as the price at which shares are allotted to investors in the primary markets. Listed price is the price at which the stock starts trading in the secondary markets.

Economic Requirements For Funds

Mobilization of funds in the primary market is a reflection of requirement of funds by various companies. Requirement of funds depends upon the business opportunities in terms of modernization, expansion and diversification. Thus, Primary Markets affect the economy of the country and economic development affects the growth of Primary Markets. This is a cyclical effect.

Investors Risk-Return Appetite

Investors have two options for investments namely, Primary and Secondary markets. In the Primary markets, the return generated by investor depend upon the issue price and the listed price. Upon listing on the stock exchange, if the stock commences trading below the issue price, then it generates negative returns.

For example, let us consider the case of a company, 20 Microns Limited, whose shares were issued in the primary market at Rs. 55 per share. On 15th May 2009, it was trading at Rs. 20.05. Thus, if an investor purchased these shares in the primary market at the issue price, and sells the share on 15th May 2009, he incurs a negative return. If most of the stocks are traded below the issue price, it creates a barrier for new investors to invest in new companies in the primary market.

Let us consider another company, Alkali Metals Limited which issued its equity shares in the primary market at Rs. 103 per share. On 15th May 2009, the shares were trading at Rs. 267.10. Thus, if an investor purchases these shares in the primary markets and sells it, he generates positive returns.

If most of the stocks are traded below the issue price, it may attract new investors to invest in new companies in the primary market but at the same time, may not instill confidence among companies which are planning primary market issue – due to possibility of failure of the new issues and increase in underwriting expenses.

To summarize, the ultimate success of the IPO is broadly based on the following factors:

Reasonable first day performance in terms of subscriptions after the launch of the IPO is critical for the success of the IPO. There have nevertheless been instances when the IPO subscription increases as the IPO closing date approaches.
Distribution to institutions, corporate bodies, retail investors: The success of the IPO is also proportional to the market reach. Greater is the number of participants targeted in the market activities, greater is the probability of the subscription.
Stable Core holding: Investors are also concerned about the stability of the company after equity issue.
The cancellation of the subscription should be minimal. This will ensure minimal flow-back of funds, in case of cancelled applications.
Strong market performance after listing is dependent on the economics conditions in general and the overall market performance in particular. Trading volume/investor confidence in secondary market is critical for IPO’s success.

Performance of New Issues

Equity Analysts periodically report the performance of newly listed companies on regular basis. It has been observed that except for few, almost all issues are trading much. Hence, investors may not be keen in investing in the primary markets, due to possibility of the listing price being lower than the issue price. But as the situation improves, i.e., stocks start trading above the issue price, investor risk – return appetite will improve – they may tend to take risk to generate positive returns.

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