Deals & Acquisitions
Jan 9, 2024
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This guide explains what underwriting is and the role of investment banks in the underwriting process. We will also look at the fees that investment banks charge for underwriting services. Here are some key takeaways about the underwriting process for raising capital:
The most important function of an investment bank is their role in raising capital. Generally, investment banks tend to work with larger corporations, organizations, and governments.
The term “underwriting” refers to the process of raising capital for clients in the form of debt and equity securities.
When businesses (or other organizations) want to expand, but don’t have the ability to pay for that growth out of cash flow, they look to raise outside capital. They can choose to do so with either debt or equity.
Often, large and mid-sized businesses choose to raise large amounts of capital by issuing securities to the public. Here, we’ll look at how investment banks help to facilitate that process. In order to understand this process, we need to understand the difference between the primary market and the secondary market.
When a business issues new securities for the first time, it does so through an initial public offering (IPO). Through this IPO the business will issue either bonds (debt) or shares of stock (equity) to the public.
The first time that a business issues any shares or bonds to the public is called an initial public offering. Often bond IPO’s are just called new issues and the term most often refers to the initial public offering of shares of stock. Any additional time that a business issues new securities to the public, for the first time is called a follow-on offering.
Both of these types of transactions happen in the primary market. Here, investment banks facilitate the issuance and sale of these securities (stocks or bonds) to public markets.
In exchange for money the corporations issue these debt or equity securities to mostly institutional investors. Both IPO’s and follow-on offerings help the business raise capital. The business makes money when investors purchase these shares. Fundamentally, when businesses issue debt securities (bonds) they are effectively borrowing money. When they issue stock, they are selling ownership stake in the company.
For clarity purposes we’ll also talk about the secondary market. The secondary market is where institutional investors and portfolio managers go to trade (purchase or sell) existing securities. It’s important to note that the corporation that originally issued these stocks or bonds in the primary market doesn’t profit from their trading on the secondary market. In the secondary market money is made and lost between the investors trading these securities on the open market. To learn more about the primary market vs secondary market, we recommend our guide: Primary vs Secondary Market.
For clarity regarding the underwriting process, the distinction between the primary and secondary market has to do with whether or not the bank is helping the company raise money. Investment banks provide advisory services for both the primary and secondary markets, but the primary market is where businesses raise capital through the issuance of debt and equity securities.
Now that we understand what underwriting is, we’ll look at the role that investment banks play in the underwriting process. To start, here’s an infographic illustrating the role that investment banks play in the underwriting process.
Investment banks support securities issuances as an underwriter and by providing access to their network of investors. In the primary market, these investors are normally comprised of financial institutions and portfolio managers.
In other words, investment banks help corporations raise money through the issuance of securities and by finding institutional investors to buy those securities in the primary market.
Now that we understand what underwriting is and the role that investment banks play in the underwriting process, we’ll move on to talk about how investment banks organize these services by department.
Investment banks typically organize their capital markets side into three departments, debt capital markets (DCM), equity capital markets (ECM), and research.
This section will focus on DCM and ECM, for more on research and other investment banking services, we recommend our guide: Intro To Investment Banking.
Here is an infographic showing the difference between debt capital markets and equity capital markets:
First, we’ll look at debt capital markets and then move onto equity capital markets.
As the name suggests, debt capital markets is the department that focuses on raising capital through the issuance of debt (fixed income securities). Here, the investment bank helps corporations, governments, and organizations raise capital through issuing bonds to the public.
The type of bond that the organization uses to raise capital depends on a few factors.
First, government bonds are bonds that are issued by the country in order to support the government’s spending obligations. Municipal bonds are bonds issued by states, cities, counties, or other governmental entities to fund day-to-day obligations as well as to build schools, highways, or sewer systems. Emerging markets bonds usually refer to bonds that are issued by countries with developing economies, although they can also refer to corporations located in those countries.
Now that we understand the role that investment banks have in helping governments raise capital through bonds, we’ll return our focus to corporations.
When corporations issue bonds, the strength of the company’s financials will determine whether the bonds are classified as investment grade or high-yield bonds. Companies that have manageable levels of debt, strong debt paying records, and good earnings potential receive better credit ratings.
Investment grade bonds are issued and backed by corporations with strong financials and a long track record of success. High-yield bonds are issued by businesses that are either considered to be a higher credit risk or by businesses without a long financial history to reference.
When we’re talking about investment grade, we’re talking about the quality of the company’s credit. Standard and Poor’s and Moody’s issue credit ratings for bonds. If the bond is rated at BBB or higher, then it is considered investment grade. Bonds under BB are referred to as “junk bonds” indicating that they are more of a speculative investment due to the higher risk of default. In practice, junk bonds are referred to as high-yield bonds. Due to the fact that they offer higher interest rates in order to compensate investors for the higher risk they are taking with this investment.
Now that we’ve looked at debt capital markets, we’ll move onto equity capital markets. Equity capital markets is the department in an investment bank that helps corporations raise money by issuing shares of stock to the public.
When a business issues shares of stock for the first time, it is called an initial public offering. When that company issues additional new shares of stock for sale to the public, it is called a follow-on offering. Additionally, corporations can raise capital through private placements. There are two main types of private placements. A rights issue is when a company wants to issue additional shares to existing shareholders but may choose to offer them at a discounted price compared to the new market price of the shares. Preferential allotments are when a company decides to issue new shares to a few individuals that are, again, potentially offered at a discounted price compared to the market price.
There are two types of underwriting agreements, firm commitment agreements and best efforts agreements.
With a firm commitment, the investment bank basically commits to buying the entire security issuance at a specific price. In these agreements, the investment bank takes on all of the risk that the issue is undersubscribed. So, if they can’t find a buyer for all of the shares that a company wants to issue, then the bank is obligated to purchase the remaining shares. Firm commitment agreements put all of the risk on the investment bank and take as much risk as possible off of the corporation. However, investment banks can include a market-out clause, which can allow them to get out of the agreement if something unexpected affects the quality of the securities. Although, the primary reason that a corporation would want a firm commitment is to mitigate risk, so these market-out clauses in practice would only pertain to more extreme circumstances.
Best-efforts underwriting agreements can be broken down into two types. First, we have an all-or-none agreement. Here, the entire issue must be subscribed and sold within a specified amount of time. If it is undersubscribed, then the deal is canceled, no new securities are issued by the corporation, and the investment bank is not paid. Additionally, we have mini-max agreements where a pre-specified minimum must be sold in the specified time period, or the deal is canceled, and the money is returned to the investors.
In practice, firm commitment agreements are less common than best-efforts agreements.
Underwriting is a valuable service to corporations, as it shifts all or some of the risk of the issue onto the investment bank. Because of this, corporations pay investment banks fees. Usually, these fees are a percentage of the capital the corporation effectively raises.
For equity securities issuances, investment banks charge between 4 and 7 percent of the issuance as a fee, in addition to offering costs, which will typically be between $1 and $3 million. These offering costs are related to registration, accounting, and legal services.
For debt securities issues, the fee charged is based on the type of debt being issued. Investment grade, government, and municipal bonds are usually issued at a fee of 1 to 2 percent of the issue. With high-yield and higher risk bond issuances, those fees can go up to 5 percent. For debt issuances investment banks also charge fees for offering costs.
