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Securities Markets and the Role of Investment Bankers
Business Essentials · Chapter 22: Securities Markets and Capital RaisingSection 22.1 · lesson 95 of 10513 min · free with a free account
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In this lesson
How savings reach businesses, and who stands in between.
- Describe what securities markets do
- Distinguish primary from secondary markets
- Explain the 4 functions of an investment bank
- Describe the regulatory framework and its philosophy
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Securities Markets and Capital Raising
Securities Markets and the Role of Investment Bankers
A company's share price doubles. How much of that money does the company receive? The answer is none, and this section explains why. This is educational content about how securities markets work. It isn't investment, financial, tax, or legal advice. It doesn't evaluate or recommend any security. Real decisions call for a qualified, licensed professional. We'll look at what securities markets do, and the difference between primary and secondary markets. We'll meet the securities themselves, the venues, and the participants. We'll examine the four functions of an investment bank, and the conflicts they can create. And we'll close with the regulatory framework, and the philosophy underneath it.
The Function
Moving Savings In, and Letting Investors Out
Securities markets are where financial instruments are issued and traded. Those instruments represent ownership claims, or lending claims, on a business. Their economic function is to channel savings to businesses. Individuals and institutions with money to invest get connected to businesses that need capital to operate and grow. Arranging that through one-to-one negotiation, between every saver and every business, would be far harder. Markets also provide something a private deal rarely can. An exit. An investor can sell the stake to someone else, without the business repaying anything. That exit is what makes long-term equity investment possible at all. Few investors would commit capital indefinitely, if their only way out was persuading the business to buy them back. So the two kinds of market depend on each other. Investors buy newly issued shares largely because a liquid market exists to sell them later. Take away that exit, and far fewer investors would provide capital in the first place.
Figure 22.1.1
Where the Money Goes
This figure traces the flow of funds in each market. The primary market is where securities are issued for the first time. A business sells new shares or bonds directly to investors, and the business receives the proceeds. The secondary market is where existing securities change hands after that first issue. One investor sells to another, and the cash passes between the two of them. The business receives nothing from that trade. That holds however large the trade is, and however many times it happens. So here's the counter-intuitive consequence. A company's shares can trade actively, and rise substantially, for years. And not a single additional dollar reaches the business. It was paid once, at issuance. Every trade since has been between investors.
The Securities
What a Security Represents
Securities fall into categories, defined by what they represent. Equity securities, which we met in the debt and equity comparison, represent ownership. The holder gets a residual claim on assets and earnings, after obligations to others are met. There's no promise of repayment of any specific amount. Debt securities represent a lending relationship. The holder has a fixed claim, typically to scheduled interest, and repayment of a stated amount at a stated time. That claim holds regardless of how the business performs. The next section develops it further. Hybrid securities combine features of both. Derivatives are different again. Their value derives from an underlying security or asset. They aren't a direct claim on a business at all. This course names hybrids and derivatives as categories, without developing them further.
Trading Venues
Exchanges and Over-the-Counter Markets
Securities trade through two broad structures. An exchange is a centralized marketplace, with defined rules, and a structured process for matching buyers and sellers. A security has to meet listing requirements to trade there. Exchanges historically ran from a physical trading floor. Today they operate substantially through electronic systems. An over-the-counter market has no single central location. Trading happens through a network of dealers, connected electronically, typically with less stringent listing requirements. Both connect buyers and sellers. They differ mainly in structure, and in what a security must meet to trade. Those differences matter when a business decides where its securities will trade. Listing on an exchange means meeting stated financial and governance thresholds. In return, it offers greater visibility, generally deeper investor demand, and the credibility of meeting those standards. Over-the-counter trading can suit a smaller or newer public company that can't yet meet exchange standards. The cost is usually less visibility, and a smaller, less active base of investors. Which venue is realistically available depends on the business, its investment bank, and its legal counsel.
Participants
Who Makes the Markets Work
Several kinds of participant make these markets function. Issuers are the businesses that create and sell securities, to raise capital. Individual investors are private people, buying and selling on their own account. Institutional investors include pension funds, insurance companies, and investment funds. They manage pooled capital for many underlying individuals, and typically trade in much larger volumes. Intermediaries connect issuers and investors. They include investment banks, and brokers who execute trades on behalf of clients. Market makers are firms that stand ready to buy and sell a particular security, continuously. That provides liquidity. A buyer or seller can usually find a counterparty right away, without waiting for one to appear on its own.
Investment Banks
4 Functions, and What Underwriting Commits
Investment banks perform four principal functions for businesses raising capital, or considering major transactions. First, they advise on whether and how to raise capital, drawing on the debt, equity, and sourcing options from the last chapter. The decision itself stays with the business and its own advisers. Second, they underwrite an issue. Third, they distribute securities, using their networks to place a new issue with buyers. Fourth, they advise on combinations, meaning mergers and acquisitions. Underwriting deserves a precise look, because the two forms commit the bank to very different things. In a firm commitment underwriting, the bank buys the entire issue from the business, at an agreed price. It then resells it to investors. So the bank bears the risk of not reselling for as much, or at all. In a best efforts underwriting, the bank commits only to try to sell the securities for the business. It doesn't buy the issue, so the risk of an incomplete sale stays with the business. The choice reflects, among other things, how confident the bank is, and how much risk each side will bear.
Table 22.1.1
Who Pays, and Where Interests Diverge
Every one of these functions is paid for by the business. And each carries a possible conflict of interest. An adviser who may also underwrite the same deal has an interest in recommending one. Underwriting fees come out of the proceeds, and the bank may favor pricing that suits its own risk. In distribution, the bank's investor relationships may come ahead of getting the issuer the highest price. And when advising on combinations, a fee tied to completion can reward recommending a deal over advising against it. These conflicts are structural. They are not evidence of any specific wrongdoing. There are two serious positions on what they mean in practice. One holds that a bank playing several roles on one deal inevitably compromises its advice, since underwriting pay depends on the deal proceeding. The other holds that reputation and repeat business discipline banks, since a bank known for self-serving advice loses clients. It adds that one relationship can cost a business less than several. This course takes no position on which effect dominates. The practical point is narrower. Know which function you're paying for, and what interest the bank has in its advice.
Regulation
The Regulatory Framework
In the United States, the principal regulator is the Securities and Exchange Commission. It's a federal agency that oversees offerings, exchanges, and market participants, and enforces disclosure and conduct rules. State securities regulators play a role too, particularly for smaller or more local offerings. That fits the general pattern. Federal law sets a floor, and state law can add to it. The framework rests on three requirements. Registration and disclosure means a business offering securities to the public files detailed information first. Exemptions exist for certain smaller or more limited offerings. Their terms should be confirmed with qualified securities counsel. Periodic reporting means a public company regularly discloses its financial condition, and material developments. And insider trading is prohibited. Trading on material, non-public information, obtained through a position of trust or confidence, is illegal. Allowing it would let people with privileged access profit systematically, at the expense of ordinary investors. That would undermine confidence in the fairness of the markets. This section states the principle, not its detailed application.
The Philosophy
Disclosure Is Not Endorsement
Underneath all of this sits one regulatory philosophy, the disclosure principle. The law generally requires that material information be disclosed. Material means information a reasonable investor would consider important to a decision. What the law doesn't do is judge whether an investment is a good one. An accepted filing says nothing about whether the business is well managed, growing, or likely to perform well. It says only that the required information is available, so investors can use their own judgment. That mirrors the point about audits from the accounting chapter. A required process completed correctly is not a favorable verdict on the business. You'll also hear about market indices. An index is a sample of securities, combined by a stated method, and used as a reference point for a market or segment. And one boundary is worth stating plainly. This chapter describes mechanisms. It doesn't advise anyone on what to do with money.
Worked Application
Following Halden Instruments' Shares
Let's follow one security from issuance onward, with a fictional business called Halden Instruments. Halden decides to raise capital by issuing new shares to the public, for the first time. Its investment bank advises on the structure, and agrees to a firm commitment underwriting. So the bank buys the whole block of new shares, and takes on the risk of reselling them. When the shares are first sold to investors, Halden receives the proceeds, net of the bank's fee. That primary market transaction is now complete. The business has raised its capital. From then on, every trade happens in the secondary market. Say an institution sells part of its holding to an individual the next month, with a market maker standing ready. Halden isn't a party to that trade in any financial sense. It gets no proceeds, and doesn't approve it. That stays true whether the price has risen or fallen, and across millions of trades over the years. Months later, Halden needs more capital for an acquisition, and makes a follow-on offering of new shares. That's a primary market event again. New shares are created and sold, and Halden receives the proceeds. So the distinction isn't about the company. It's about whether a transaction creates a new security, or transfers an existing one.
Case Vignette
The Rising Share Price That Brought No Cash
Anselm founded a specialty electronics company. This is a composite case, constructed for instruction. The company went public several years ago, and its shares have since risen considerably. Planning an expansion, Anselm is surprised to find the rising price hasn't brought in any new funds. At first he assumes the finance team is tracking cash incorrectly. Nothing is wrong. Since the offering, the shares have traded entirely between investors. The company was paid once, at issuance, and no later trade has touched its accounts. A rising price can still matter, indirectly, in three genuine ways. It can make a future equity issue easier to price and place, since investors have shown demand at that level. It can serve as more valuable currency in a share-for-share acquisition. And lenders may treat a strong, actively traded price as one signal, among several, of financial health. But none of these puts cash directly into the business, the way a primary issue does. So Anselm's expansion needs a fresh capital-raising decision of its own. That could be a new equity issue, bond financing, or another source from this chapter or the last.
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