underwriter

What It Is

In the securities industry an underwriter is a company, usually an investment bank, that helps companies introduce their new securities to the market.

In the insurance business, an underwriter is a company liable for insured losses in return for a fee (premium).

How It Works

When a company wants to issue stock, bonds, or other publicly traded securities, it hires an underwriter to manage what is often a long and complex process.

To begin the offering process, the underwriter and the issuer first determine the kind of offering the issuer needs. Sometimes the issuer wants to sell shares via an initial public offering (IPO) cash proceeds return to the issuing company as capital to fund its projects.  Other offerings, such as secondary offerings, funnel the proceeds to a shareholder who is selling some or all of his or her shares. Split offerings occur when a portion of the offering go to the company while the rest of the proceeds goes to an existing shareholder. Shelf offerings allow the issuer to sell shares over a two-year period.

After determining the offering structure, the underwriter usually assembles what is called a syndicate to get help manage the minutiae (and risk) of large offerings. A syndicate is a group of investment banks and brokerage firms that commit to sell a certain percentage of the offering. (This is called a guaranteed offering because the underwriters agree to pay the issuer for 100% of the shares, even if all the shares can't be sold). With riskier issues, underwriters often act on a "best efforts" basis, in which case they sell as many shares as they can and return the unsold shares back to the issuing firm.

After the syndicate is assembled, the issuer files a prospectus. The Securities Act of 1933 requires the prospectus to fully disclose all material information about the issuer, including a description of the issuer's business, the name and addresses of key company officers, the salaries and business histories of each officer, the ownership positions of each officer, the company's capitalization, an explanation of how it will use the proceeds from the offering, and descriptions of any legal proceedings the company is involved in.

With prospectus in hand, the underwriter then proceeds to market the securities. This usually involves a road show, which is a series of presentations made by the underwriter and the issuer's key executives to institutions (pension plans, mutual fund managers, etc.) across the country. The presentation gives potential buyers the chance to ask questions from the management team. If the buyers like the offering, they make a non-binding commitment to purchase, called a subscription. Because there may not be a firm offering price at the time, purchasers usually subscribe for a certain number of shares. This process lets the underwriter gauge the demand for the offering (called indications of interest) and determine whether the contemplated price is fair.

Determining the final offering price is one of the underwriter's most important responsibilities. First, the price determines the size of the capital proceeds. Second, an accurate price estimate makes it easier for the underwriter to sell the securities. Thus, the issuer and the underwriter work closely together to determine the price. Once an agreement is reached on price and the SEC has made the registration statement effective, the underwriter calls the subscribers to confirm their orders. If the demand is particularly high, the underwriter and issuer might raise the price and reconfirm this with all the subscribers.

Once the underwriter is sure it will sell all of the shares in the offering, it closes the offering. Then it purchases all the shares from the company (if the offering is a guaranteed offering), and the issuer receives the proceeds minus the underwriting fees. The underwriters then sell the shares to the subscribers at the offering price. If any subscribers have withdrawn their bids, then the underwriters simply sell the shares to someone else or own the shares themselves. It is important to note that the underwriters credit the shares into all subscriber accounts (and withdraw the cash) simultaneously so that no subscriber gets a head start.

Although the underwriter influences the initial price of the securities, once the subscribers begin selling, the free-market forces of supply and demand dictate the price. Underwriters usually maintain a secondary market in the securities they issue, which means they agree to purchase or sell securities out of their own inventories in order to keep the price of the securities from swinging wildly.

Why It Matters

Underwriters bring a company's securities to market. In so doing, investors become more aware about the company.  Issuers compensate underwriters by paying a spread, which is the difference between what the issuer receives per share and what the underwriter sells the shares for. For example, if Company XYZ shares had a public offering price of $10 per share, XYZ Company might only receive $9 per share if the underwriter takes a $1 per share fee. The $1 spread compensates the underwriter and syndicate for three things: negotiating and managing the offering, assuming the risk of buying the securities if nobody else will, and managing the sale of the shares. Making a market in the securities also generates commission revenue for underwriters.

As we mentioned earlier, underwriters take on considerable risk. Not only must they advise a client about matters large and small throughout the process, they relieve the issuer of the risk of trying to sell all the shares at the offer price. Underwriters often mitigate this risk by forming a syndicate whose members each share a portion of the shares in return for a portion of the fee.

Underwriters work hard to determine the "right" price for an offering, but sometimes they leave money on the table. For example, if Company XYZ prices its 10 million share IPO at $15 per share but the shares trade at $30 two days after the IPO, this suggests that the underwriter probably underestimated the demand for the issue. As a result, Company XYZ received $150 million (less underwriting fees) when it could have possibly fetched $300 million.  Thus, the issuing company must also follow a robust due diligence process on their end in order to optimize their capital raising efforts.

Source: Investing Answers