“Going public” marks a milestone in a company’s growth. The primary market is the first place where the company's securities are sold. The major players of the primary market are large institutional investors, and the market requirements are stringent. Therefore, the company as an investment potential is evaluated on multiple levels. The primary issue is traded in the secondary market by individual investors. Failure to generate interest in the primary market is translated as poor investment potential.
The primary market can be defined as the first opportunity to purchase a company's securities. The primary market is typically only open to large institutional investors.
Understanding the Primary Market
Primary market is the market for newly issued financial assets. It is also known as the “issue market.” There are different kinds of primary markets based on the nature of the asset sold such as the primary bond market, the primary equity market or the primary mortgage market. In the equity market the most common form by which security is issued is through “initial public offering” (IPO). Underwriters play an important role in determining the pricing of an IPO. Large institutional firms are the major players of the primary market.
Defining Capital Generation
Primary markets enable firms to raise capital through the sale of financial assets. Businesses are able to access potential investors that are outside its immediate influence. Businesses have to meet stringent market standards to issue securities at the primary market. The added scrutiny makes the issue more attractive to potential investors, and the company is able to raise the capital with lower costs. The company can also continue to raise more capital for future investments through multiple issues because it is not restricted to a single set of investors.
Exploring Asset Liquidity
Primary markets also help in making the financial assets more liquid. Investors in privately held companies are tied to the fortunes of the company. The primary market investors, on the other hand, are able to easily trade their investments in the secondary market. This liquidity makes investors less wary and enables companies to raise more capital easily. Indirectly, this translates to more investment in businesses and better job creation.
Evaluating Risk Reduction
Risk reduction through diversification is another important part of the role that primary markets play in finance. An IPO has a large number of financial intermediaries investing in the IPO. Therefore, the risk of failed investment is shared, thereby reducing the overall risk of an investing firm. On the other hand, the issuing firm is not dependent on a single investor but has access to multiple sources, so the risk of not finding an investor is also reduced. The institutional investors can also choose to invest in a portfolio of multiple IPOs, thereby reducing their risk through diversification.
Exploring Cost Reduction
Stringent market regulations ensure that to sell at the primary market, businesses should meet financial and legal parameters. Businesses should also provide full disclosure of their financial structure through a prospectus that is available to all potential investors. Due to this, investors can accurately estimate whether the IPO price is fair. The primary market thus reduces “information costs” – the costs incurred in assessing the investment merit of the asset. The primary market also reduces “search costs” – the costs associated with time and money spent in locating potential investors and counterparty for trade.