The Internal Capital Market and Investor Governance of Capital Allocation

Part I of this book covered the credit and ‘external‘ capital markets. The governance mechanism for the external capital market revolves around the need for the company to persuade potential investors in an IPO that they will, in fact, earn not less than the required market return for a project or company in its particular risk class. However, the main source of financing for new investment projects in companies subsequent to an IPO is not the external capital markets but the so-called internal capital market. The reason is that after undertaking an IPO on the primary capital market most companies never again raise equity on the public markets. Secondary offerings, i.e. an offering of additional shares sometime after the initial offering (meaning a second, primary offering and nothing to do with the secondary market), are relatively rare. In fact, most equity financing for new projects or expansion of existing ones comes from retained profits. Only banks which have eaten through their equity capital have had to access the equity market for additional funds. Companies may of course access the debt markets on a continuing basis both to re-finance their maturing debt (rollover) and to maintain the debt/equity ratio as equity increases due to retained earnings.