Unit II Primary Markets Notes PDF

Unit II Primary Markets Introduction to Primary Market: Generally, the personal savings of the entrepreneur along with contributions from friends and relatives are pooled in to start new business ventures or to expand exi...

Unit II Primary Markets Introduction to Primary Market: Generally, the personal savings of the entrepreneur along with contributions from friends and relatives are pooled in to start new business ventures or to expand existing ones. However, this may not be feasible in the case of capital intensive or large projects as the entrepreneur (promoter) may not be able to bring in his share of contribution (equity), which may be sizable, even after availing term loan from Financial Institutions/Banks. Thus availability of capital is a major constraint for the setting up or expanding ventures on a large scale. Instead of depending upon a limited pool of savings of a small circle of friends and relatives, the promoter has the option of raising money from the public across the country/world by issuing) shares of the company. For this purpose, the promoter can invite investment to his or her venture by issuing offer document which gives full details about track record, the company, the nature of the project, the business model, etc. If the investor is comfortable with this proposed venture, he may invest and thus become a shareholder of the company. Through aggregation, even small amounts available with a very large number of individuals translate into usable capital for corporates. Primary market is a market wherein corporates issue new securities for raising funds generally for long term capital requirement. The companies that issue their shares are called issuers and the process of issuing shares to public is known as public issue. This entire process involves various intermediaries like Merchant Banker, Bankers to the Issue, Underwriters, and Registrars to the Issue etc.. All these intermediaries are registered with SEBI and are required to abide by the prescribed norms to protect the investor. The Primary Market is, hence, the market that provides a channel for the issuance of new securities by issuers (Government companies or corporates) to raise capital. The securities (financial instruments) may be issued at face value, or at a discount / premium in various forms such as equity, debt etc. They may be issued in the domestic and / or international market. Features of primary markets include:  The securities are issued by the company directly to the investors. 1 Ms. Sanjana S. Halarnkar @ MES College   The company receives the money and issues new securities to the investors.  The primary markets are used by companies for the purpose of setting up new ventures/ business or for expanding or modernizing the existing business  Primary market performs the crucial function of facilitating capital formation in the economy. Functions of New Issue Market/Primary Market: 1. Origination: It refers to the work of investigation analysis and processing of new project proposals. It starts before an issue is actually floated in the market. This function is done by merchant bankers who may be commercial banks, all India financial institutions or private firms. At present, financial institutions and private firms also perform this service is highly important the success of the issue depends, to a large extent on the efficiency of the market. The following things is being determined before origin of issue i.e.  Time of floating the new issue  Type of issue  Price 2. Underwriting: It is an agreement whereby the underwriter promises to subscribe to specified number of shares or debentures or a specified amount of stock in the event of public not subscribing to the issue. If the issue is fully subscribed, then there is no liability for the underwriter. If a part of share issues remains unsold, the underwriter will buy the shares. Thus, underwriting is a guarantee for marketability of shares. There are two types of underwriters in India - Institutional (LIC, UTI, IDBI, ICICI) and Non - institutional are brokers. 3. Distribution: It is the function of sale of securities to ultimate investors. This service is performed by specialized agencies like brokers and agents who maintain a regular direct contact with the ultimate investors. 2 Ms. Sanjana S. Halarnkar @ MES College  Issuer in Primary Market: An issuer is said to be a legal entity that develops, registers, and sells securities to raise funds for its operations. Issuers can be corporations, investment trusts, or domestic/foreign governments. Issuers mostly offer securities in the form of common and preferred stocks, bonds, debentures, notes, bills, and derivatives. Other issuers may collect funds from a pool of investors to issue mutual fund shares or exchange-traded funds (ETFs). Regulatory measures for Primary Market: SEBI has introduced various guidelines as regulatory measures for capital issues. They are as below: 1. Disclosure of All Material Facts is made Compulsory: SEBI has made it compulsory for companies do disclose all the facts and risk factors regarding the projects undertaken by the company. The basis on which the premium amount is calculated should also be disclosed by the company as per SEBI norms. SEBI also advises the code of ethics for advertising in media regarding the public issue. 2. Encouragement to Initial Public Offers: In order to encourage Initial Public Offers (IPO) in the primary market, SEBI has permitted companies to determine the par value of shares issued by them. SEBI has allowed issues of IPOs to go for “Book Building” – i.e. reserve and allot shares to individual investors. But the issuer will have to disclose the price, the issue size and the number of securities to be offered to the public. 3. Increase of Popularity to Private Placement Market: In recent years, private placement market has become popular with issuers because of stringent entry and disclosure norms for public issues. Besides low cost of issuance, ease of structuring investments and saving of time lag in issuance are the other causes responsible for the rapid growth of private placement market. 4. Underwriting has made Optional: To reduce the cost of issue in primary market, SEBI has made underwriting of issue optional. However, the condition that if an issue was not 3 Ms. Sanjana S. Halarnkar @ MES College  underwritten and was not able to collect 90% of the amount offered to the public, the entire amount collected would be refunded to the investor is still in force. 5. Issue of Due Diligence Certificate: The lead managers have to issue due diligence certificate, which has now been made part of the offer document. 6. Conditions regarding Application Size etc.: SEBI has raised the minimum application size and also the proportion of each issue allowed for firm allotment to institutions such as mutual funds. 7. Regulation of Merchant Banking: SEBI has brought Merchant banking under its regulatory framework. The merchant bankers are now to be authorized by SEBI. Merchant bankers, now have a greater degree of accountability in the offer document and issue process. 8. Imposition of Compulsory Deposit on Companies making Public Issues: In order to induce companies to exercise greater care and diligence for timely action in matters relating to the public issues of capital, SEBI has advised stock exchanges to collect from companies making public issues, a deposit of one per cent of the issue amount which could be forfeited in case of non-compliance of the provisions of the listing agreement and, non- dispatch of refund orders and share certificates by registered post within the prescribed time. 9. Reforms as to Mutual Funds: The Government has now permitted the setting up of private mutual funds and a few have already been set up. UTI has now been brought under the regulatory jurisdiction of SEBI. All mutual funds are allowed to apply for firm allotments in public issues. To improve the scope of investments by mutual funds, the latter are permitted to underwrite public issues. Further, SEBI has relaxed the guidelines for investment in money market instruments. Finally, SEBI has issued fresh guidelines for advertising by mutual funds. 10. Vetting of Offer Document: SEBI vets offer documents to make sure that the company listing the shares has made all disclosures in it. All the guidelines and regulatory measures of capital issues are meant to promote healthy and efficient functioning of the issue market (or the primary market). 4 Ms. Sanjana S. Halarnkar @ MES College Types of Investors: The primary market attracts a broad spectrum of investors. Different categories of investors buy shares in the primary market. They include retail investors, non-institutional investors, qualified institutional buyers (QIBs), employees of the issuing company, existing shareholders of the issuing company, etc. Investors are broadly categorized as:  Qualified institutional buyers  Non-institutional investors  Retail investors Qualified institutional buyers (QIBs): Mutual funds, banks, financial institutions like LIC and foreign investors come under this category. QIBs were not required to submit any money along with their bids and this led to some manipulative practices. SEBI recently changed the provisions and QIBs now have to pay a margin, not the full amount, at the time of bidding in the book building of an issue. The following are specified as QIBs by SEBI: Public financial institutions as defined in Section 4A of the Companies Act, 1956 Scheduled commercial banks Mutual funds Foreign institutional investors registered with SEBI Multilateral and bilateral development financial institutions Venture capital funds registered with SEBI Foreign venture capital investors registered with SEBI State Industrial Development Corporations Insurance companies registered with the Insurance Regulatory and Development Authority (IRDA) Provident funds with a minimum corpus of 25 crore Pension funds with a minimum corpus of 25 crore. Non-institutional investors: Resident Indian individuals, Hindu undivided families (HUF), companies, corporate bodies, non-resident Indians (NRIs), and societies and trusts whose applications in terms of value are worth more than 2 lakh fall under this category. At least 15 per cent of the total issue has to be reserved for non-institutional investors. 5 Ms. Sanjana S. Halarnkar @ MES College  Retail investors: They are defined in terms of the value of the primary issue applied to by them. This value should not exceed 2 lakh. According to the new guidelines, inclusion of PAN in application forms for public/rights issues has also been made mandatory, irrespective of the value of the application. Thirty-five per cent of the issue has to be reserved for them. Under this category, only individuals, both resident Indians and NRIs, along with HUFs are allowed to bid. Types of public issues: Initial public offering (IPO): For Unlisted Companies IPO is the first time a company goes public. When we say a company has gone public, it means it has offered its shares to the public at large and is ready to get listed at the stock exchanges of the country. We have two exchanges: Bombay Stock Exchange (BSE) and National Stock Exchange (NSE). The first time a company gets listed at BSE, NSE, or both and offers its shares to be publicly traded the offering is called an IPO. Advantages:  IPO allows companies to raise capital by selling shares. Moreover, companies don’t have to repay the capital raised through the issuance of IPO.  Companies can offer stock as an incentive, bonus, or as part of an employment contract. This is sometimes used to retain key people. In addition, equity can be used to purchase or acquire other businesses.  By getting listed on a stock exchange business receives wide media coverage enhancing company’s visibility and recognition of its products and services. Disadvantages:  Companies need to disclose critical information including financial information on a regular basis.  As public companies have directors who are meant to oversee management’s actions on behalf of shareholders, in some circumstances actions of management may be limited. 6 Ms. Sanjana S. Halarnkar @ MES College  Going public is an expensive and time consuming process. The legal, accounting and printing costs are significant and these costs will have to be paid regardless of whether an IPO is successful or not. FPO (Follow on Public Offer): For Listed Companies FPO is a follow up to the IPO as the name suggests. A follow on public offer is the issuance of shares after the company is listed on a stock exchange. In other words, an FPO is an additional issue whereas an IPO is an initial or first issue. A private company launches an Initial public offering (IPO) for additional funding. The company sells shares to outside investors so that it can gain access to funds for various purposes. This includes growth and expansion of the company. However, the company’s financial problems do not end with an IPO. Sometimes, a company may need additional capital to meet its goals. That’s the time such companies can opt to go for an Offer for Sale (OFS). How OFS works? In an OFS, promoters of a company dilute their stake by selling their shares on an exchange platform. Anyone including retail investors, companies, Foreign Institutional Investors (FIIs) and Qualified Institutional Buyers (QIBs) can bid on these shares. Offer for Sale: The shareholders can offer a portion of their shareholding to the public in consultation with the BOD (Board of Directors). The prospectus of a company is considered as its LOI (Letter of Offer). Also, the shareholders of the Company reimburse any expenses regarding the offer. Hence, any dividend paid or declared on these shares is paid to the transferee. In case of an offer for sale, the current promoters and anchor investors sell a part of their shareholdings via an IPO. In case of Government entities, most of the disinvestments are through 7 Ms. Sanjana S. Halarnkar @ MES College offer for sale. Thus, while the share capital does not grow, the share holding pattern undergoes a change. The offer for sale route may also be used by a closely held company to list in the stock exchange. What is a Private Placement? As the name suggests, a “private placement” is a private alternative to issuing, or selling, a publicly offered security as a means for raising capital. In a private placement, both the offering and sale of debt or equity securities is made between a business, or issuer, and a select number of investors. There may be as few as one investor for any issue. Difference between IPO & FPO: BASIS FOR COMPARISON IPO FPO Meaning IPO refers to an offer of securities FPO refers to an offer of securities made to the public for subscription for subscription to the public by a by the company for the first time publicly-traded enterprise Issuer Unlisted company Listed company Raising Capital Through the first time from public Through a subsequent public contribution Risk High Comparatively low Objective The main objective is raising capital The main objective is subsequent through public investment public investment Predictability Less predictable More predictable Profit Higher than FPO Lower than IPO 8 Ms. Sanjana S. Halarnkar @ MES College  Types Equity shares and Preferred shares Dilutive offering and Non-Dilutive offering Book building: What is Book Building? SEBI guidelines defines Book Building as "a process undertaken by which a demand for the securities proposed to be issued by a body corporate is elicited and built-up and the price for such securities is assessed for the determination of the quantum of such securities to be issued by means of a notice, circular, advertisement, document or information memoranda or offer document". Book Building is basically a process used in Initial Public Offer (IPO) for efficient price discovery. It is a mechanism where, during the period for which the IPO is open, bids are collected from investors at various prices, which are above or equal to the floor price. The offer price is determined after the bid closing date. As per SEBI guidelines, an issuer company can issue securities to the public though prospectus in the following manner:  100% of the net offer to the public through book building process  75% of the net offer to the public through book building process and 25% at the price determined through book building. The Fixed Price portion is conducted like a normal public issue after the Book Built portion, during which the issue price is determined. The concept of Book Building is relatively new in India. However it is a common practice in most developed countries. Book building Process:  The Issuer who is planning an offer nominates lead merchant banker(s) as 'book runners'.  The Issuer specifies the number of securities to be issued and the price band for the bids.  The Issuer also appoints syndicate members with whom orders are to be placed by the investors.  The syndicate members input the orders into an 'electronic book'. This process is called 'bidding' and is similar to open auction.  The book normally remains open for a period of 3 days.  Bids have to be entered within the specified price band.  Bids can be revised by the bidders before the book closes. 9 Ms. Sanjana S. Halarnkar @ MES College  On the close of the book building period, the book runners evaluate the bids on the basis of the demand at various price levels.  The book runners and the Issuer decide the final price at which the securities shall be issued.  Generally, the number of shares are fixed, the issue size gets frozen based on the final price per share.  Allocation of securities is made to the successful bidders. The rest get refund orders. Merchant Banking: “As per SEBI “merchant banker” means any person who is engaged in the business of issue management either by making arrangements regarding selling, buying or subscribing to securities or acting as manager, consultant, adviser or rendering corporate advisory service in relation to such issue management”  Merchant bank helps a business person to commence a business and raising finance. Furthermore, they help them to expand, modernizing, and restructuring the business. They also grant support in registering, buying, and selling shares at the stock exchange.  Merchant banking is a professional service provided by the merchant banks to their customers considering their financial needs, for adequate consideration in the form of fee. Merchant banks are banks that conduct fundraising, financial advising and loan services to large corporations.  These banks are experts in international trade, which makes them experts in dealing with large corporations and industries. Merchant banking provides funds to the multinational businesses and large business entities in the country which helps to boost the country’s economic strength.  Merchant banks do not provide services to the general public; their services are limited to business entities and large business corporations. Functions of merchant Banking Merchant banking functions in India is the same as merchant banks in UK and other European countries. The following are the functions of merchant bankers in India. 10 Ms. Sanjana S. Halarnkar @ MES College 1. Corporate counseling: Corporate counseling covers counseling in the form of project counseling, capital restructuring, project management, public issue management, loan syndication, working capital fixed deposit, lease financing, acceptance credit etc., The scope of corporate counseling is limited to giving suggestions and opinions to the client and help taking actions to solve their problems. It is provided to a corporate unit with a view to ensure better performance, maintain steady growth and create better image among investors. 2. Project counseling: Project counseling is a part of corporate counseling and relates to project finance. It broadly covers the study of the project, offering advisory assistance on the viability and procedural steps for its implementation. It provides assistance in following ways:  Identification of potential investment avenues.  A general view of the project ideas or project profiles.  Advising on procedural aspects of project implementation  Reviewing the technical feasibility of the project  Assisting in the preparation of project report  Assisting in obtaining approvals, licenses, grants, foreign collaboration etc., from government  Capital structuring  Arranging and negotiating foreign collaborations, amalgamations, mergers and takeovers. 3. Capital Structuring: Here the Capital Structure is worked out i.e., the capital required, raising of the capital, debt-equity ratio, issue of shares and debentures, working capital, fixed capital requirements, etc., 4. Portfolio Management: It refers to the effective management of Securities i.e., the merchant banker helps the investor in matters pertaining to investment decisions. Taxation and inflation are taken into account while advising on investment in different securities. The merchant banker also undertakes the function of buying and selling of securities on behalf of their client companies. Investments are done in such a way that it ensures maximum returns and minimum risks. 11 Ms. Sanjana S. Halarnkar @ MES College  5. Issue Management: Management of issues refers to effective marketing of corporate securities viz., equity shares, preference shares and debentures or bonds by offering them to public. Merchant banks act as intermediary whose main job is to transfer capital from those who own it to those who need it. The issue function may be broadly divided in to pre issue and post issue management. a. Issue through prospectus, offer for sale and private placement. b. Marketing and underwriting c. pricing of issues 6. Credit Syndication: Merchant Banks help corporate clients to raise syndicated loans from commercials banks. Merchant banks helps in identifying which financial institution should be approached for term loans. The merchant bankers follow certain steps before assisting the clients approach the appropriate financial institutions. a. Merchant banker first makes an appraisal of the project to satisfy that it is viable b. He ensures that the project adheres to the guidelines for financing industrial projects. c. It helps in designing capital structure, determining the promoter’s contribution and arriving at a figure of approximate amount of term loan to be raised. d. After verifications of the project, the Merchant Banker arranges for a preliminary meeting with financial institution. e. If the financial institution agrees to consider the proposal, the application is filled and submitted along with other documents. 7. Working Capital: The Companies are given Working Capital finance, depending upon their earning capacities in relation to the interest rate prevailing in the market. 8. Venture Capital: Venture Capital is a kind of capital requirement which carries more risks and hence only few institutions come forward to finance. The merchant banker looks in to the technical competency of the entrepreneur for venture capital finance. 9. Fixed Deposit: Merchant bankers assist the companies to raise finance by way of fixed deposits from the public. However such companies should fulfill credit rating requirements. Merchant banking in India: Merchant banking in India began in 1967 by National Grind lays; later, Citi Bank started it in 1970. In the year 1972, SBI became the first commercial bank to set up a distinct division for merchant banking. Then it was followed by ICICI in 1973, and then various banks started these services such as PNB, Bank of India, UCO Bank, etc. 12 Ms. Sanjana S. Halarnkar @ MES College It was in 1973 when FERA (Foreign Exchange Regulation Act) came into existence that helped increase merchant banking activities in India. After that, various banks such as IDBI and IFCI entered the market. Role in Issue Management:  Issue management refers to managing issues of corporate securities like equity shares, preference shares and debentures or bonds. It involves marketing of capital issues, of existing companies including rights issues and dilution of shares by letter of offer. Management of issue also involves other issues. The decisions concerning size and timing of the public issue in the light of the market conditions are advised by the merchant bankers.  Marketing of capital issues, of existing companies including rights issues and dilution of shares by letter of offer are assisted by the merchant banks.  Merchant banks also advise the issuing company whether to go for a fresh issue, additional issue, bonus issue, right issue or combination of these.  The public issues are managed by the involvement of various agencies i.e., under writers, brokers, bankers, advertising agencies, printers, auditors, legal advisers, registrar to the issue and merchant bankers providing specialized services to make the issue a success.  Merchant bank is the agency at the apex level, who plans, coordinates and controls the entire issue activity and directs different agencies to contribute to the successful marketing of securities.  Issue managers in capital market parlance are known as Merchant Bankers or Lead Managers. Classification of Merchant Bankers:  The SEBI has classified ‘merchant bankers’ under four categories for the purpose of registration:  Category I Merchant Bankers: These merchant bankers can act as issue manager, advisor, consultant, underwriter and portfolio manager. 13 Ms. Sanjana S. Halarnkar @ MES College  1. Category II Merchant Bankers: Such merchant bankers can act as advisor, consultant, underwriter and portfolio manager. They cannot act as issue manager of their own but can act co-manager. 2. Category III Merchant Bankers: They are allowed to act as underwriter, advisor and consultant only. They can either undertake issue management of their own nor they act as co-manager. They cannot undertake the activities of portfolio management also. 3. Category IV Merchant Bankers: A category IV merchant banker can merely act as consultant or advisor to an issue of capital. Regulations for Merchant Banking in India: SEBI was established in 1992 as a regulatory body for protecting the interests of investors in the securities market. They made a few rules and guidelines for merchant bankers so that there is no monopoly, plus the interest of the customers is not harmed. They are called Securities Exchange Board of India (SEBI) Regulations, 1992. These guidelines are amended regularly as per the dynamic market conditions:  Merchant banker not to associate with any business other than that of the securities market.  Every merchant banker shall keep and maintain the books of account, records and documents such as (a) a copy of balance sheet as at the end of the each accounting period; (b) a copy of profit and loss account for that period; (c)a copy of the auditor’s report on the accounts for that period; (d) a statement of financial position  Every merchant banker acting as an underwriter shall also maintain the detail records.  The merchant banker shall preserve the books of account and other records and documents maintained under regulation 14 for a minimum period of five years.  Lead merchant banker not to associate with a merchant banker without registration. 14 Ms. Sanjana S. Halarnkar @ MES College