What is underwriting process in banking?
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Getting a piece of a hot IPO is very difficult. To understand why, we need to know how an IPO is done, a process known as underwriting. Show When a company wants to go public, the first thing it does is hire an investment bank. A company could theoretically sell its shares on its own, but realistically, an investment bank is required - it's just the way Wall Street and Bay Street work. Underwriting is the process of raising money by either debt or equity (in this case we are referring to equity). You can think of underwriters (brokerage firms) as middlemen between companies and the investing public. In Canada, Desjardins and the major chartered banks are the biggest underwriters. The company and the investment bank will first meet to negotiate the deal. Items usually discussed include the amount of money a company will raise, the type of securities to be issued, and all the details in the underwriting agreement. The deal can be structured in a variety of ways. For example, in a "firm commitment," the underwriter guarantees that a certain amount will be raised by buying the entire offer and then reselling to the public. In a "best efforts" agreement, however, the underwriter sells securities for the company but doesn't guarantee the amount raised. Also, investment banks are hesitant to shoulder all the risk of an offering. Instead, they form a syndicate of underwriters. One underwriter leads the syndicate and the others sell a part of the issue. It is also common for the syndicate to use a selling group. Members of the selling group express their interest to the syndicate and have no guarantee that their request will be filled. Expressions of interest are subject to rejection or allotment, in whole or in part, and the right is reserved to close the subscription books at any time without notice by the lead of the issue Once all sides agree to a deal, the investment bank puts together a registration statement to be filed with the provincial regulators. This document contains information about the offering as well as company info such as financial statements, management background, any legal problems, where the money is to be used, and insider holdings. The regulator then requires a "cooling off period," in which they investigate and make sure all material information has been disclosed. Once the regulator approves the offering, a date (the effective date) is set when the stock will be offered to the public. During the cooling off period the underwriter puts together what is known as the red herring. This is an initial prospectus containing all the information about the company except for the offer price and the effective date, which aren't known at that time. With the red herring in hand, the underwriter and company attempt to build up interest for the issue. They go on a road show where the big institutional investors are courted. This time is also called the marketing period. As the effective date approaches, the underwriter and company sit down and decide on the price. This isn't an easy decision: it depends on the company, the success of the road show, and most importantly, current market conditions (of course, it's in both parties' interest to get as much as possible). Finally, the securities are sold on the stock market and the money is collected from investors. A company that is already listed on an exchange can, for various reasons, issue more shares through another public offering. Since shares were already issued shares through an IPO, this procedure is referred to as a "secondary offering". It is also frequently referred to as a "new issue". A company that distributes a secondary offering issues new shares that are added to those already in circulation. For the investor, this type of issue is accessible through the same mechanism as an IPO however the period in which one can place an expression of interest may be quite short. As the company in question is already listed, investors have several sources of information (internet site, news releases and the company's financial statements) to help them make an informed decision. Overview of capital raising process What is Underwriting?In investment banking, underwriting is the process where a bank raises capital for a client (corporation, institution, or government) from investors in the form of equity or debt securities. This article aims to provide readers with a better understanding of the capital raising or underwriting process in corporate finance from an investment banker’s perspective. There are two main functions in corporate finance: M&A Advisory and Underwriting. M&A advisory includes assisting in negotiating, structuring, and performing a valuation of a merger or an acquisition associated with a deal. This service is usually provided by the advisory side of an investment bank, transaction advisor, or in-house by the corporate development group. On the underwriting side, the process includes the sale of stocks or bonds to investors in the form of Initial Public Offerings (IPOs) or follow-on offerings. In corporate finance, jobs exist on the sell side with investment banks providing M&A or capital raising advisory services, or on the corporate side with in-house corporate development groups. Finally, jobs also exist in public accounting firms providing support services for these types of transactions. To learn more about each job in detail, see our Career Map. Underwriting Advisory ServicesThere are three main phases of underwriting advisory services: planning, assessing the timing and demand for the issue, and issue structure, respectively. 1. PlanningIt is important to identify the investor themes in the planning phase, understand the rationale for the investment, and get a preliminary view of investor demand or interest in this type of offering. 2. Timing and DemandThe timing and demand of an offering are crucial to a successful capital raising. Here are some factors that influence the assessment of the timing and demand of an offering.
3. Issue StructureDeciding the structure of an offering is the final phase of underwriting advisory services. Here are some factors that influence the issue structure:
Types of Underwriting CommitmentWhen an underwriter enters into a contract with a company to help raise capital, there are three main types of commitments made by the investment bank: firm commitment, best efforts, and all-or-none. 1. Firm CommitmentIn the case of a firm commitment, the underwriter agrees to buy the entire issue at a certain price. If the underwriter fails to sell the entire issue, the underwriter must take full financial responsibility for any unsold shares. 2. Best EffortsThe best efforts basis is the most common form of commitment out of the three listed. Although the underwriter commits in good faith to sell as much of the issue at the agreed price as possible, there is no financial or legal responsibility imposed on the underwriter for any unsold shares or deal performance. 3. All-or-noneFinally, in an all-or-none commitment, unless the entire issue is sold at the offering price, the deal is voided, and the underwriter will not receive any compensation. Summary of the underwriting processThere are three main stages in the underwriting or capital raising process: planning, assessing the timing and demand, and issue structure. The planning stage involves the identification of investor themes, understanding of investment rationale and an estimate of expected investor demand or interest. In the timing and demand phase, the underwriter must evaluate the current market conditions, investor appetite, investor experience, precedents, and benchmark offerings, and current news flow to determine the best timing and demand of an offering. Finally, the underwriter must decide the issue structure based on the focus on either institutional or retail investors and a domestic versus an international issue. There are three main types of commitment by the underwriter: firm commitment, best efforts, and all-or-none. In a firm commitment, the underwriter fully commits to the offering by buying the entire issue and taking financial responsibilities for any unsold shares. The most common form of commitment – best efforts or marketed deal – imposes no financial responsibility on the underwriter, regardless of the performance of the deal. The underwriter is not liable for any unsold shares. Finally, in an all-or-none commitment, the underwriter will not be compensated at all unless the entire issue is sold at the offering price. Additional ResourcesThank you for reading CFI’s guide to Underwriting. To further your knowledge and understanding of investment banking, CFI offers the following resources.
What is underwriting in banking?Definition: Underwriting is one of the most important functions in the financial world wherein an individual or an institution undertakes the risk associated with a venture, an investment, or a loan in lieu of a premium. Underwriters are found in banking, insurance, and stock markets.
What is the basic function of underwriting?Underwriting helps to set fair borrowing rates for loans, establish appropriate premiums, and create a market for securities by accurately pricing investment risk.
What are types of underwriting?There are three kinds of underwriting, namely loans, securities, and insurance. Underwriting is a crucial process in the financial world because it helps investors make profitable investment decisions.
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