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.
Underwriting Securities by Investment Banks
Investment banks are middlemen between companies that want to issue new securities and the buying public.
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 in order to price, underwrite, and then sell the new bonds.
Capital Raising and Initial Public Offerings (IPOs)
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, commit to purchasing the issue of 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 promotes the securities to investors in a process called a roadshow.
The company walks away with this new supply of capital, while the 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.”
Underwriting Example Scenario
Gillette wants to raise some money for a new project. One option is to issue more stock (through what’s called a secondary stock offering).
They’ll go to an investment bank like JPMorgan, which will price the new shares (remember, investment banks are experts at calculating what a business is worth).
JPMorgan will then underwrite the offering, meaning it guarantees that Gillette receives proceeds at $(share price * newly issued shares) less JPMorgan’s fees.
Then, JPMorgan will use its institutional salesforce to go out and 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 Gilette shares out of their own account, thereby making a market for the Gillette offering.