Underwriting commitments

We first discussed underwriting commitments in the Municipal bond unit. Some of this will feel familiar, but here we’ll apply the same ideas to primary offerings more broadly.

When a security is sold in the primary market, underwriters typically use one of two underwriting commitments: firm or best efforts. An underwriting commitment describes who is financially responsible if some of the offering doesn’t sell.

Firm underwriting commitments make the underwriter liable for any unsold shares. In a firm commitment, the investment bank buys the entire issue from the issuer and then resells it to investors. Offerings can be large - thousands of bonds or millions of shares of stock. If investor demand is weak, the underwriter may sell only part of the issue and must hold the remaining securities.

A firm underwriting is also known as a principal or dealer transaction. A principal (dealer) transaction occurs when a customer buys a security from a firm’s inventory. In a firm commitment, the investment bank owns the securities it’s selling, so the securities are part of its inventory. The firm profits if it buys from the issuer at a lower price and resells to investors at a higher price (a markup).

A best efforts underwriting commitment means the investment bank agrees to use its best efforts to sell the offering, but it doesn’t guarantee that all securities will be sold. Any unsold units or shares are returned to the issuer. Because the underwriter isn’t taking unsold securities onto its books, best efforts is less risky for the underwriter, and underwriting compensation is typically lower.

A best efforts underwriting is also known as an agency transaction. An agency transaction occurs when a financial firm acts as a middleman, bringing buyers and sellers together rather than selling from its own inventory. In a best efforts offering, the investment bank is acting as the link between the issuer and the investing public.

There are a few different versions of best efforts underwriting commitments. A mini-max underwriting sets both a minimum and a maximum number of shares to be sold. For example, an issuer may offer 1 million shares but require that at least 750,000 be sold for the offering to proceed. If the minimum isn’t met, the offering is canceled and investors who placed orders receive their money back.

There’s also an all or none underwriting commitment. The underwriter must sell all of the securities for the offering to proceed. If an issuer has 1 million shares to sell, all 1 million must be sold. Otherwise, the offering is canceled and investors who placed orders receive their money back.

Firm underwriting commitments are riskier for underwriters, so underwriting fees are typically higher. Best efforts underwriting commitments shift the risk of unsold securities back to the issuer, so the underwriter’s compensation is typically lower.