What is the Equity Capital Market?

What is the Equity Capital Market?

If you hear the words “Equity Capital Markets (ECM)”, you might immediately think of initial public offerings (IPOs) and companies raising billions of dollars in huge stock-market debuts.

But there’s a lot more to the group than breaking records and making headlines in the process.

Like other capital markets teams at banks, ECM groups can be described as a cross between investment banking and sales & trading.

If you’re in this group, you’ll spend most of your time advising companies that want to raise equity capital.

“Raising equity capital” means that the company sells a percentage of ownership in itself in exchange for cash – as opposed to raising debt, where the company maintains its ownership but must pay interest on the funds it raises.

There’s a surprising amount of controversy online about this group, from how “good” it is to what the true exit opportunities are.

introduction of Equity Capital Markets (ECMs)

The equity capital market (ECM) is broader than just the stock market because it covers a wider range of financial instruments and activities. These include the marketing and distribution and allocation of issues, initial public offerings (IPOs), private placements, derivatives trading, and book building. The main participants in the ECM are investment banks, broker-dealers, retail investors, venture capitalists, private equity firms, and angel investors.

Together with the bond market, the ECM channels money provided by savers and depository institutions to investors. As part of the capital markets, the ECM, leads, in theory, to the efficient allocation of resources within a market economy.

Instruments Traded in the Equity Capital Market

Equity capital is raised by selling a part of a claim/right to a company’s assets in exchange for money. Thus, the value of the company’s current assets and business define the value of its equity capital. The following instruments are traded on the equity capital market:

Common Shares

Common stock shares represent ownership capital, and holders of common shares/stock are paid dividends out of the company’s profits. Common shareholders have a residual claim to the company’s income and assets. They are entitled to a claim in the company’s profits only after the preferred shareholders and bondholders have been paid.

The earnings available to common shareholders (EAS) are given by the following formula:

Earnings Available To Shareholders (EAS) = Profit after Tax – Preferred Dividend

Note: Profit after Tax = Operating profits (/Earnings before Interest and Tax) – Tax

The variability in the returns of shareholders depends on the company’s debt-to-equity ratio. The higher the proportion of debt financing, the fewer the number of shares with claims to the company’s profits. If the profits exceed the interest payments, the excess profit is distributed to shareholders.

However, if the interest payments exceed the profits, the loss is distributed to shareholders. The higher the debt-to-equity ratio, the higher will be the variability in the payment of dividends (and vice versa).

However, common shareholders have no legal right to be paid a dividend. Thus, the dividend paid depends on the discretion of management. Similarly, in the event of liquidation, the shareholder’s claim to the company’s asset ranks after that of creditors and preferred shareholders.

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Thus, common shareholders face a higher degree of risk than other creditors of the company but also have the prospect of higher returns.

Private Equity

Equity investments made through private placements are known as private equity. Private equity is raised by private limited enterprises and partnerships, as they cannot trade their shares publicly. Typically, start-up and/or small/medium-sized companies raise capital through this route from institutional investors and/or wealthy individuals because:

  • They have limited access to bank capital due to the unwillingness of banks to lend to an enterprise with no proven track record; or,
  • They have limited access to public equity on account of not having a large and active shareholder base.
  • Venture capital funds, leveraged buyouts, and private equity funds represent the most important sources of private equity (click to find out about a career in private equity).

American Depository Receipts (ADR)

An ADR is a certificate of ownership issued in the name of a foreign company by an American bank, against the foreign shares deposited in the bank by the said foreign company. The certificates are tradeable and represent ownership of shares in a foreign company.

ADRs promote the trading of foreign shares in America by admitting the shares of foreign companies into a well-developed stocked market. They often represent a combination of many foreign shares (for instance, lots of 100 shares). ADRs and their associated dividends are denominated in US dollars.

Equity Capital Markets Interviews

In some cases, students intern in ECM and then accept full-time offers; in others, they are brought in via a placement or “sell-day” process.

Some Analysts also find their way into the group via lateral hiring, and sometimes bankers from industry coverage groups join because they’re seeking a better work/life balance.

The recruiting process and interview questions for ECM teams are quite similar to what you would receive in investment banking interviews anywhere else.

Expect questions on accounting, equity value and enterprise value, valuation approaches, DCF analysis, and transaction modeling.

For the basics, please see our tutorial on how to calculate Enterprise Value.

Questions on M&A deals and leveraged buyouts are a bit less likely since you do not work on them in ECM, but almost anything is fair game in entry-level interviews.

The main difference is that you need to show more of an interest in the markets – be able to discuss recent equity issues and trends, how indices are performing, and how IPOs and follow-ons have done recently in your region of interest.

You can follow our deal discussion examples to plan out what you’ll say for these questions.

To learn more about recent IPO filings, Renaissance Capital’s “Commentary & News” section is helpful.

It’s tougher to find information about follow-on offerings and convertible bonds, but sometimes the NY Times DealBook has good coverage.

If you’re interviewing for a convertible bonds role, you should also familiarize yourself with calls, puts, and the basics of how to value convertible bonds and create payoff diagrams.

The textbook Options, Futures, and Other Derivatives by John C. Hull can be a useful reference; we also cover convertible bond accounting and valuation in our IB Interview Guide and Financial Modeling Mastery course.

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Your response to the “Walk me through your resume” question will be similar to what you would say for other groups, but you should emphasize how you like both markets and deals, so equity capital markets is the perfect combination, given your past experience, current interest, and future career goals.

For more details, please view the investment banking recruitment section of this site.

Functions of an Equity Capital Market

The equity capital market acts as a platform for the following functions:

  • Marketing of issues
  • Distribution of issues
  • Allocating new issues
  • Initial Public Offerings (IPOs)
  • Private placements
  • Trading derivatives
  • Accelerated book-building

Structure of the Equity Capital Market

The equity capital market can be divided into two parts:

Primary Equity Market

Allows companies to raise capital from the market for the first time. It is further divided into two parts:

  1. Private Placement Market

The private placement market allows companies to raise private equity through unquoted shares. It provides a platform where companies can sell their securities to investors directly. In this market, companies do not need to register securities with the Securities and Exchange Commission (SEC), as they are not subject to the same regulatory requirements as listed securities.

Typically, the private placement market is illiquid and risky. As a result, investors in this market demand a premium as compensation for their risk-taking and the lack of liquidity in the market.

  1. Primary Public Market

The primary public market deals with two activities:

  • Initial Public Offerings (IPO): An IPO refers to the process by which a company issues equity publically for the first time and becomes listed on the stock exchange.
  • Seasoned Equity Offering (SEO)/Secondary Public Offering (SPO): An SEO/SPO is the process by which a company that is already listed on the stock exchange issues new/additional equity.

When a firm issues stock on the stock exchange, it may do so without creating new shares, i.e., it may exchange unquoted stock for quoted stock. In such a case, the initial investor receives the proceeds earned by selling the newly quoted shares. However, if the company creates new shares for the issue, the proceeds from the sale of those shares are credited to the company. Furthermore, investment banks are major players in the primary public market because both IPOs and SEOs/SPOs require their underwriting services.

Secondary Equity Market

The secondary equity market provides a platform for the sale and purchase of existing shares. No new capital is created in the secondary equity market. The holder of the security, and not the issuer of the traded security, receives proceeds from the sale of the security in question. The secondary equity market can be further divided into two parts:

  1. Stock Exchanges

A stock exchange is a central trading location where the shares of companies listed on the stock exchange are traded. Each stock exchange has its own criteria for listing a company on its exchange. The most commonly used criteria are:

  • Minimum earnings
  • Market capitalization
  • Net Tangible Assets
  • Number of shares held publicly
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2. Over-The-Counter (OTC) Markets

The OTC market is a network of dealers who facilitate the trading of stocks bilaterally between two parties without a stock exchange acting as an intermediary. The OTC markets are not centralized and organized. Thus, they are easier to manipulate than stock exchanges.

Equity Capital Markets Exit Opportunities

And now we reach the major downside of ECM teams: The exit opportunities.

The most common exits are moving to an industry group (healthcare, technology, consumer/retail, etc.), going into investor relations (IR) at a normal company, or joining a hedge fund or other buy-side firm in an IR or fundraising role.

Outside of those, it would be tough to win roles such as equity research or investment analysis at hedge funds because of the types of projects you work on as an ECM professional.

It’s not impossible to win roles in private equity or corporate development, but it is extremely difficult, and you’ll have trouble getting headhunters interested if you’re coming from capital markets.

You do work on deals, but much of your work is different and doesn’t apply to acquisitions of entire companies.

So, if you want to go that route, you’ll have to do much of the legwork yourself or move to a different group first.

If you want to make a long-term career out of banking, you could argue that ECM is a fine group since you’ll have a better lifestyle and you’ll still earn a lot.

But if you’re laser-focused on the private equity career path, this is not the group for you.

Advantages of Equity Capital Market

Raising capital in the equity market provides a company with the following advantages:

  • Reduction of credit risk: The higher the proportion of equity in the company’s capital structure, the lesser the amount of debt it has to raise. As a result, credit risk is reduced.
  • Greater flexibility: A lower debt to equity ratio allows greater flexibility in the firm’s operation. This is because shareholders are less risk-averse than debt holders, given that the former stand to gain more if the company makes a large profit (in the form of greater dividends) and face limited losses if the company does poorly (because of limited liability).
  • Signaling Effect: Issuing equity also signals that the company is doing well financially.

Disadvantages of Equity Capital Market

A company faces the following disadvantages by raising capital in the equity market:

  • Dividend payments are not tax-deductible: Unlike interest on debt, dividend payments are not tax-deductible.
  • The company is subject to greater scrutiny: Investors in the equity market rely very heavily on the company’s financial statements to make their investment decisions. Thus, the company and its financial statements are subject to more stringent disclosure norms and scrutiny.
  • Shareholder dependence: Maintaining a low debt-to-equity ratio means that a larger number of shareholders have a claim to the company’s profits. As a result, the company may have to reduce its retained earnings, even if it results in lower profits in the long run, to pay a competitive dividend to the shareholders in the short run.