What is Underwriting?
Underwriting is the process in which an investment bank, on behalf of a client, raises capital from institutional investors in the form of debt or equity.
The client in need of capital raising – most often a corporate – hires the firm to negotiate the terms appropriately and manage the process.
What are the Different Types of Underwriting Transactions?
One of the core functions in investment banking is to serve as the middleman between companies (i.e. the clients) that want to issue new securities and the general public.
In particular, the two types of capital sources that investment banks can help their clients raise are equity and debt securities:
- Equity Securities Underwriting → The corporation raises capital by issuing shares in itself – which represent partial ownership in its equity – to the general public. The first time a privately-held company decides to issue its shares in the open markets is referred to as an initial public offering (IPO).
- Debt Securities Underwriting → The corporation raises capital by issuing debt securities, which are contractual obligations to pay periodic interest over the course of the borrowing, as well as the repayment of the debt principal in full at maturity. For instance, a corporation could retain an investment bank to raise capital through commercial paper (CP) or corporate bond issuances.
When a company wants to issue, say, new bonds to get funds to retire an older bond or to pay for an acquisition or new project, the company hires an investment bank.
The investment bank then determines the value and riskiness of the business to price, underwrite, and then sell the new bonds.
What is the Function of an Investment Bank in Underwriting?
Investment banks also underwrite other securities (like stocks) through an initial public offering (IPO) or any subsequent secondary (vs. initial) public offering.
When an investment bank underwrites stock or bond issues, it also ensures that the buying public – primarily institutional investors, such as mutual funds or pension funds – commits to purchasing stocks or bonds before it actually hits the market.
In this sense, investment banks are intermediaries between the issuers of securities and the investing public.
In practice, several investment banks will buy the new issue of securities from the issuing company for a negotiated price, and promote the securities to investors in a process called a roadshow.
The company walks away with this new supply of capital, while investment banks form a syndicate (group of banks) and resell the issue to their customer base (mainly institutional investors) and the investing public.
Investment banks can facilitate this trading of securities by buying and selling the securities out of their own account and profiting from the spread between the bid and the ask price.
This is called “making a market” in a security, and this role falls under “Sales & Trading.”
What is the Underwriting Process?
The general underwriting process in investment banking is as follows.
- Selection of Investment Bank → To initial the process of raising capital, the corporation (or entity seeking to raise capital) must select and hire an investment bank – or group of investment banks – to kick off the underwriting.
- Due Diligence and Risk Analysis → Once an investment bank is hired on the mandate, the banking professionals closely examine the risks associated with the proposed issuance and perform in-depth due diligence to ensure the client’s financial data and operational details surrounding the issuer is accurate and transparent to abide by SEC regulations.
- Create Marketing Material and Deliverables→ In anticipation of the pitches to institutional investors, the investment bank must analyze the merits and risks of the business model, market positioning, and industry trends to put together a compelling presentation deck with a “storytelling” aspect to improve the likelihood of a favorable outcome, i.e. most or all shares are sold. If investor interest seems poor, the issuance could be abruptly halted.
- Prepare SEC Filings and Securities Pricing → After performing due diligence on the client, the investment bank works on structuring the deal, which involves determining the type of securities to be issued (stocks, bonds, etc.), the volume of the issuance, the price range, and other details of the transaction. Using the research compiled to date, the investment bank must estimate the offer price for the securities, where an appropriate balance is struck between obtaining the highest valuation on behalf of the client and ensuring all securities are sold (or as close to as possible). The trade-off receives much scrutiny, especially for equity issuances, because of the potential conflict of interest and the “IPO Pop” frequently seen in the markets on the first day of trading, with one of the more vocal critics being prominent venture capitalist (VC), Bill Gurley.
- Underwriting Type → In “firm commitment” underwriting, an investment bank agrees to purchase the entire issuance of securities from the client at a predetermined price. The price is lower than the price at which securities will be sold to the public. Because of the risk undertaken by the investment bank, there is substantial risk involved in such underwriting transactions, because the issuer reaches their capital raise target regardless of whether the bank sells all the securities to the public or not. For larger-sized issuances, a syndicate is common, where the risk is “spread” across several investment banks.
- Marketing Phase (“Roadshow”) → The investment bank markets the securities issuance, assuming receipt of regulatory approval from the SEC (i.e. the S-1 for an IPO), to predominately institutional investors, such as pension funds. The prospectus must be prepared to offer detailed information regarding the issuer and the securities (e.g. the expected “use” of funds, pricing) and then distribute them to potential investors to convince them to formally commit to participate in the upcoming issuance.
- Sale and Distribution of Securities → Once the marketing phase has concluded and the date of issuance has arrived, the investment bank formally starts to issue the securities to institutional investors, and later on, the public markets will soon trade the shares.
- Stabilization of the Issued Securities: Finally, after the securities have been issued, the investment bank could continue to monitor the performance of the securities in the secondary markets. While more relevant to equity issuances, the investment bank can actively stabilize the price of the shares via “market making,” where the bank purchases and sells securities to ensure liquidity and price stability, i.e. reduce market volatility.
What is an Example of Underwriting in Investment Banking?
Suppose Gillette wants to raise money to fund a new project. One option to raise capital is to issue more stock in a transaction referred to as a secondary stock offering.
Gillette will go to an investment bank like JPMorgan, which will price the new shares based on what the firm estimates the business to be worth, and the current state of the capital markets (i.e. the ease of raising capital), among other factors.
JPMorgan will then underwrite the offering, meaning the firm guarantees Gillette receives proceeds at $(share price * newly issued shares) less JPMorgan’s fees.
Then, JPMorgan will use its institutional sales force to get Fidelity and many other institutional investors to buy chunks of shares from the offering.
JPMorgan’s traders will facilitate the buying and selling of these new shares by buying and selling Gillette shares out of their own account, creating a market for the Gillette offering.
J.P. Morgan Investment Bank: Capital Markets Groups Example
Equity Capital Markets and Debt Capital Markets (Source: JPMorgan)