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Talking Finance: Underwriters bear risk

Talking Finance: Underwriters bear risk

In the third of his columns explaining financial terms,  Anthony Galliano, chief executive officer of Cambodian Investment Management, talks about investment banks and underwriting.

Corporations or governments that make the decision to sell ownership in their company through an initial public offering generally engage the services of an investment bank to assist in structuring the transaction and to raise capital.
 
Investment banks differ from commercial banks in that commercial banks take deposits from customers and use these deposits to provide financing to individuals and corporations through loans.  

Investment banks assist corporations and governments in raising capital by underwriting the issuance of securities.  

The services of investment banks include the promotion and trading of securities, known as the “sell-side” and distribution to individuals and institutions, known as the “buy-side”.

The investment bank will work with the company in deciding the amount of financing required, percentage of the company to be sold, the type of security to be offered, the offering price, and may assist with the filing and registration with the relevant exchange and regulatory body.  

Once this is achieved the company or government issuing the securities, the issuer, appoints an investment bank to underwrite the offering.

Underwriting is the process whereby an investment bank bears the risk of being able to sell the securities and the cost of holding them on its books, until they are sold.  

The most common form of the underwriting of securities is a firm commitment, also known as a bought deal. In this scenario the investment bank will buy the new securities for an agreed price and resell to the public at a mark-up.  

The company issuing the securities is guaranteed the funds whether the underwriter is able to sell the securities or not.  

For larger issues, a syndicate of underwriters may be formed involving several investment banks who share joint responsibility at an agreed ratio.  This is known as a syndicate underwriting. In this case a syndicate manager selects members, determines the allotment of shares for each member, and manages the overall process.  

The members may further have selling groups, consisting of other investment banks and broker-dealers. The underwriters sell the securities at a higher price than the issuer receives.   

This mark-up is known as an underwriting spread and is usually divided into a management fee for the syndicate manager and an underwriting allowance for the members of the syndicate, who can further compensate the selling group with a selling concession.

Another form of underwriting is a best-efforts underwriting.  

This usually occurs for issues which may be considered risky or difficult to sell.  

In this case the investment bank will not will not guarantee the sales of securities and the company bears the risk if the full issue is not sold, which would result in less monies being received.

Underwriters play a critical role in bringing securities to the market which involves a web of players before the securities are purchased by the end investor – a role with significant risk and compensation.

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