The issuance of new securities like stocks and bonds is a complex process that requires the expertise and capital of investment banks. As underwriters, investment banks play a critical role in facilitating new securities offerings and ensuring successful fundraising for companies. There are several key requirements and risks that investment banks undertake when underwriting new securities.
Investment banks purchase the entire securities issue from the issuer
One of the main requirements of underwriting new securities is that the investment bank commits to purchasing the entire issue from the company at an agreed price. This is known as firm commitment underwriting. By taking on the obligation to buy all the newly issued securities, the investment bank provides certainty to the issuer over the amount of capital that will be raised. However, this also exposes the investment bank to the risk of being unable to sell all the securities to investors. If underwriter demand is less than expected, the investment bank may end up holding unsold securities and facing losses.
Investment banks assess investor demand to price the offering
A key part of underwriting new securities is determining the price and yield at which the issue will be offered to investors. The investment bank gauges investor appetite for the securities through various methods like roadshows, surveys and book building. Based on this assessment of demand, it decides on the pricing that will maximize proceeds for the issuer while ensuring full subscription by investors. Misjudging demand can lead to securities being underpriced and losing potential issuer revenue or overpriced and left unsold.
Investment banks distribute and sell the securities
Underwriting securities requires investment banks to take on the responsibility of selling and distributing the new issue to investors. This includes activities like marketing the securities, identifying potential buyers, taking and confirming orders, allocating shares/bonds and completing the settlement process. The underwriter syndicate mobilizes its salesforce and trading desks to ensure adequate placement of the issue. Failure to sell all issued securities will mean the underwriter having to hold remaining inventory and take losses.
Investment banks provide aftermarket support and stabilization
Even after a successful offer, underwriters have an obligation to support orderly trading and stability of the securities price in the aftermarket. This stabilisation process can involve activities like short selling and repurchasing shares to counter excessive volatility and large price declines immediately following the IPO. While stabilisation is restricted to a limited period, underwriters may still face further losses if prices drop substantially later on.
Underwriting new securities issuance requires investment banks to take on significant pricing and distribution risks. From purchasing the entire issue to gauging demand, setting the offer price, selling shares, and providing aftermarket support, investment banks play an indispensable role in enabling companies to successfully raise funds through securities offerings.