Investment Banks and Underwriting

The primary function of investment banks is to help their clients raise equity capital. This is often done by initial public offerings. This is where investment banks provide their biggest service i.e., underwriting. Most people have a basic understanding of underwriting. They know that when an investment bank underwrites a share issue, they guarantee to the issuer that their issue will be subscribed to at a certain price. However, there is much more to underwriting. In this article, we will have a closer look at what underwriting means from the point of view of the investment banker.

Different Types of Underwriting

There are various types of underwriting commitments that investment bankers can make to their clients. Let’s have a look at some of the most frequently used agreement types.

  • Firm Commitment Basis: This is a type of underwriting arrangement which is most commonly known to the public. As per this arrangement, the investment bank simply buys the entire issue from the issuer at a given price. Post the purchase, they try to sell the issue at a higher price to the investors. However, the responsibility of the entire issue lies with the investment banker. This means that if, for any reason, if they are unable to sell the shares, they are supposed to hold on to the shares themselves. Needless to say that this creates a lot of risk for investment bankers. Hence, they are careful about who they sign such deals with. Also, they charge a high compensation for making such deals.

  • Best Effort Basis: Most investment banking deals happen on the best effort basis. This means that the investment banker is legally bound to use their entire network in order to try and sell the securities of the issuing company. However, if, for any reason, the securities are not sold out, the investment banker would not be under any obligation to hold on to the securities. They can simply be returned to the issuing company.

  • All or None Basis: Another arrangement between investment banks and clients is called all or none basis. Under this arrangement, investment banks try to sell all the securities at a particular price point. However, if they fail in making such a sale, they return the entire lot to the issuer. As the name suggests, either 100% of the sale is made, or no security is sold.

Factors Considered by Investment Bankers Before Underwriting

Investment bankers are often taking significant risks when they decide to underwrite any public issue. This is why they often consider several important factors before deciding whether or not to underwrite an issue.

  • Market Timing: The timing of the market is the most important factor. It is a known fact that most public issues are timed to coincide with the bull phase of the market. The bull phase of the market is known for frantic buying. Hence, if the public issue happens during this phase, investment bankers find it considerably easy to offload the shares. This is the reason why almost no public issues have happened since the coronavirus pandemic has led the market to collapse.

  • Public Opinion: Public opinion about an industry is also an important factor that investment banks consider during the underwriting process. This is because there are times when the general media is flush with good news about an industry, and there are other times when an industry is getting negative publicity. For instance, tech companies were getting a lot of positive publicity during the dot com bubble. Similarly, housing companies were getting a lot of positive publicity prior to the 2008 mortgage debacle. During that time, investment bankers were very positive about underwriting the issues of these companies.

  • Size of Float: Investment bankers also tend to consider the size of the free float that is being offered to the market for sale. If the majority stake in the company is being sold, then it is probably not a good sign. Hence, investment bankers avoid aggressive underwriting commitments on such issues. On the other hand, if only a small percentage of the total shares of the company are being sold at a fair valuation, then investment bankers feel confident enough to risk their money as well as reputation on such an issue.

  • Type of Investor Focus: There are some IPO’s which are focused on the retail investors, whereas at the same time, there are other issues that are focused on the institutional investors. Investment bankers have to take into account the cash position of these investment communities before they underwrite the issue. For instance, investment bankers will not underwrite a retail-focused issue during periods of high unemployment. Similarly, they will not underwrite an institutional focussed issue during periods when the financial industry is on the back foot.

The bottom line is that underwriting is a core part of the investment banking profession. It is also a complex activity wherein a lot of financial skill and acumen is required to predict the future performance of an issue. This is the reason why investment bankers are highly compensated for these activities.

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Investment Banking