One More Go Round: Secondaries, Tracking Stock and the Fed Funds Rate

Memo to Peter Wen, professor of history at the University of Michigan, who writes in with a bevy of questions on secondary offerings: "Inktomi (INKT) files for a public offering of 3.3 million shares. What does this mean for the person who's already invested in the stock? Where does this stock come from? Is it just money that is created out of thin air? By a basic supply-and-demand point of view it seems that adding a flood of new shares would dilute the value of the outstanding shares. What it also seems like is that top management is getting free money at the expense of existing shareholders. But this is a valid financial practice, and might be read as a developing company needing more capital to grow. How should offerings like these be interpreted?"

First of all, you're right about dilution. Whenever a company issues new stock, the value of the previously existing shares decreases. There's nothing mysterious about this process -- as you say, it's just a matter of supply and demand. Secondary offerings increase supply without directly increasing demand. (For the mechanics of a secondary offering, see a column I wrote a few weeks ago on the subject.)

In a sense, the additional stock in such an offering is created out of thin air; all a company needs to do is register the shares and sell them. Of course, anyone who has taken part in a roadshow would probably argue that there's quite a bit of sweat, or at least tireless salesmanship, involved. And as for managers using secondaries to line their own pockets, that's not hard to find out -- just look at the company's public filings and see how many of the shares are new and how many are existing shares owned by insiders. You'll have to decide for yourself whether you have a fundamental problem with pocket-lining.

Secondaries, like everything, involve trade-offs. You may not like the prospect of share dilution. But if you're a shareholder of a company like Inktomi, the success of your investment hinges on that company's ability to grow -- it is a growth stock, after all. Add the fact that interest rates are low but not going any lower, plus strong demand for both corporate debt and equity right now, and it's not hard to see why so many companies are going back to the well lately.

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Memo to John De Palma, who wonders what the federal funds rate is and how it relates to the 30-year Treasury bond: The fed funds rate is so named because it refers to the excess reserve that banks keep at a Federal Reserve bank in their district. The rate itself is the interest rate that banks charge when they lend excess reserves overnight to banks that need the extra cash to meet their reserve requirement.

Unlike the discount rate, which is the set interest rate that the Fed charges its member banks for loans, the fed funds rate changes each day in response to market pressures. For that reason, it's considered a better gauge of the overall interest-rate environment than the discount rate -- such a good gauge, in fact, that people who want to know how traders think the Fed is going to behave should keep a close eye on the fed funds futures traded on the CME.

How does the fed funds rate relate to the 30-year Treasury bond? Directly. Like the discount rate, the fed funds rate describes the interest environment for a very short period -- overnight. As the most basic market-set interest rates, it's a benchmark for all other interest rates, which will follow the fed funds rate like petrol follows oil and consumer prices follow producer prices.

Memo to L. Talerico, who writes: "When an announcement of a stock being acquired comes out, usually the stock ticks up to or near the sale price. If you purchase it and are filled at the sale price, can you sell the stock?"

You betcha. The arbitrage you're talking about happens very quickly, usually in a matter of hours, sometimes in minutes. But acquisitions can take months to close, and in the meantime, the to-be-acquired stock continues to trade. When the deal closes, you'll know it. The stock will be delisted, and your account will be filled with whatever currency -- stock or cash -- the acquirer is using.

Memo to Chris Wong, who wonders if tracking-stock holders can go after the parent company's assets if the "tracking company" goes out of business:

Holders of tracking stock, for those who don't know, have no voting control over the assets that their stock tracks. Their equity is in the parent company rather than the tracked assets, which remain legally part of the parent. (See a previous column for more on the subject.)

Because of that ownership structure, tracking-stock holders can't go after the parent company in the event that the "tracking company" falters. Just like shareholders can't demand recompense from General Motors (GM) if its Chevrolet division goes under.

The tracking-stock holder's claim is on the parent. But get in line -- bondholders have precedence over equity holders. In fact, if the parent company in this scenario ever got into financial trouble, creditors (bondholders) could go after the tracking firm's assets.

Memo to all this column's loyal readers: I'm gonna give it to you straight. It's over. This is the last MonEmailbag that will ever grace TheStreet.com. Keep your eyes peeled for our redesigned weekend edition -- it's imminent.

Stop with the damn blubbering, already.

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