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Explain the secondary and primary markets for equity and the role each plays

CFA® Level I · Equity Investments · Equity Issuance and Trading · EQ.9.c

The idea

The primary market is where a company sells new shares and receives the money: an initial public offering the first time, a seasoned or follow-on offering afterwards, usually through underwriters who gauge demand and set the price. New shares dilute existing holders' percentage ownership. The secondary market is where investors then trade those shares among themselves, and the company receives nothing from those trades. Confusingly, "secondary offering" is used in two senses: it can mean a follow-on issue of new shares, but when it means existing holders selling a large block, it raises nothing for the issuer. The two markets depend on each other: investors pay more for new shares they know they can later sell, so a liquid secondary market lowers the cost of equity capital, and the prices it sets guide the pricing of new issues.

A practice question

From the question bank, with the reason each wrong option is wrong.

When a company sells shares to the public for the first time in an initial public offering, the proceeds go to:

  1. the issuing company — correct
  2. the stock exchangeWhy not: The exchange charges listing fees but does not receive the offering proceeds.
  3. secondary market buyersWhy not: Secondary market buyers pay for shares; in an IPO the seller receiving the money is the issuer.

An IPO is a primary market transaction: new shares are created and sold, and the money raised, less underwriting fees, goes to the company.

A harder one

A company whose shares already trade on an exchange sells 10 million newly created shares to raise capital. This is best described as a:

  1. secondary market tradeWhy not: New shares are created and the company receives the proceeds, which makes it a primary transaction.
  2. initial public offeringWhy not: The company is already listed; an IPO is the first sale of shares to the public.
  3. seasoned primary offering — correct

A seasoned (follow-on) offering is a primary market issue by a company that is already public. The capital raised goes to the company, and existing holders are diluted.

The hardest tier

A private equity firm sells a large block of its existing shares in Company F, a listed company, through an underwritten secondary offering. As a result, Company F:

  1. raises capital from the newly issued sharesWhy not: A secondary offering sells shares that already exist, so no new shares are issued and nothing is raised.
  2. dilutes its existing shareholders' ownershipWhy not: Dilution comes from creating new shares. The share count is unchanged; only the owners change.
  3. raises no capital and issues no shares — correct

Despite being underwritten like an issue, a secondary offering transfers existing shares from one holder to many. The proceeds go to the selling shareholder, not to the company.

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