What are Primary Market and Secondary markets?

 (This post explains Initial Public Offer- Private Placement- Qualified institutional placement (QIP) -Preferential Issue – Rights and Bonus Issues, stock exchange, secondary market, and over-the-counter market)

Types of Capital Issues in the Primary Market

The primary market, also known as the new issue market, is that segment of the capital market where securities are issued to investors for the first time. The most common types of primary market issues include  Initial Public Offer, Private Placement, Qualified institutional placement (QIP), Preferential Issue, Rights, and Bonus Issues,

Initial Public Offer (IPO):

An Initial Public Offer (IPO) is the selling of securities to the public in the primary market where in the first time the general public can buy shares in a company that goes “public”. It is the largest source of funds with long or indefinite maturity for the company. An IPO is an important step in the growth of a business. It provides a company access to funds through the public capital market.

Private Placement:

In Private Placements, the promoters sell a company’s shares to several pre-selected investors. Generally, these investors include friends and family, accredited investors, and institutional investors. The process takes place privately, hence the name ‘Private Placements’. The advantages of private placement are faster access to capital since it avoids the lengthy public offering process, less regulatory compliance, and the ability to target specific investors who can add strategic value.

Qualified institutional placement (QIP):

Qualified institutional placement is another kind of private placement where a listed company issues securities in the form of equity shares or partly or wholly convertible debentures to qualified institutional buyers. Some of the Qualified Institutional Buyers (QIBs) are –Foreign Institutional Investors registered with the Securities and Exchange Board of India, Foreign Venture Capital Investors, Alternate Investment Funds, Mutual Funds, Public Financial Institutions, and Insurers, Scheduled Commercial Banks, and Pension Funds.

It is a common method of private placement where the company does not dilute its management stake and also does not need to repeat elaborate paperwork as it did during its IPO.

Preferential Issue:

Preferential Issue is a way of raising funds by issuing equity shares or convertible securities by listed or unlisted companies to a select group of investors including individuals, venture capitalists, companies, etc. on a preferential basis but does not include rights issue, public offer, or sweat equity shares. Preference shares or preferred stocks come with a preferential right when it comes to the distribution of dividends or during the liquidation of a company. It means, in both situations, preference shareholders are given more priority than other shareholders. The difference between private placements and preferential issues is that Private placement is typically used to raise capital from a small number of high-net-worth individuals or institutional investors, while preferential allotment is typically used by companies to raise capital from existing shareholders.

A company may issue preference shares which are liable to be redeemed within a period not exceeding twenty years from the date of their issue under section 55 of the Companies Act 2013. The company should be authorized by its articles. They also have a right to participate in the premium at the time of redemption. These shares do not carry voting rights. For infrastructure projects, a company may issue preference shares for a period exceeding 20 years but not exceeding 30 years (Specified in Schedule VI). However, subject to redemption of a minimum 10% of such preference shares per year from the twenty-first year onwards or earlier, on a proportionate basis, at the option of the preference shareholders.

Rights and Bonus Issues

Right Issues: Under the rights and bonus issue, a company issues securities to existing investors by offering them to purchase more securities at a predetermined price (in case of rights issue) or avail allotment of additional free shares (in case of bonus issue). For rights issues, investors retain the choice of buying stocks at discounted prices within a stipulated period. Rights issue enhances control of existing shareholders of the company, and also there are no costs involved in the issuance of these kinds of shares.

Bonus Shares: Instead of increasing the dividend payout, the companies offer to distribute additional shares to the shareholders. These additional shares allotted free of cost to the shareholder at a specific ratio are known as Bonus Shares. For example; the company may decide to give out two bonus shares for one share currently held. It means, existing shareholders receive additional shares at a ratio of 2:1.

Secondary Market:

Secondary markets are primarily of two types – Stock exchanges and over-the-counter markets. The secondary market facilitates the buying and selling of previously issued securities like stocks, bonds, options, and futures contracts. Some of the entities that are functional in a secondary market include –Retail investors, advisory service providers, Banks, NBFCs, Mutual funds, insurers, and brokers.

‘Over- the Counter Market’ is a decentralized market where securities are traded between parties without the involvement of an exchange. Notably, OTC markets trade unlisted stocks, which are unavailable in mainstream stock exchanges. Examples of over-the-counter stocks and securities include derivatives (especially non-standardized), foreign currency, ADRs, and new issues.

The capital market is divided into Primary Market and Secondary Market. The primary market is where securities are created, while the secondary market is where those securities are traded by investors. Read ‘What a capital market is’.