Underwriting commitments

We first discussed underwriting commitments in the Municipal bond unit. Part of this may feel like a review, but we’ll broaden our view beyond municipal bonds.

When a security is sold in the primary market, underwriters take on one of two underwriting commitments: firm or best efforts. An underwriting commitment refers to the liability of the underwriter.

Firm underwriting commitments make the underwriter liable for any unsold shares. The investment bank purchases the security from the issuer and sells it to investors. Many times, thousands of bonds or millions of shares of stock are involved. If there’s not much demand for an issue, the underwriter may only sell a portion of the securities. They are stuck with unsold units or shares in a firm underwriting.

A firm underwriting is also known as a principal or dealer transaction. When a customer is sold a security from the inventory of a financial firm, a principal (dealer) transaction occurred. With a firm underwriting, the investment bank sells a security that they own and is considered its inventory. The firm makes money if they buy the security at a low price and re-sell it at a marked-up price. This is exactly how dealers inside and outside of finance operate.

A best efforts underwriting commitment is exactly what it sounds like. The investment bank is doing its best to sell the security, but any unsold units or shares go back to the issuer. Best efforts are less risky for underwriters, but they’ll collect less underwriting fees (less risk, less return).

A best efforts underwriting is also known as an agency transaction. When a financial firm acts as a middleman and connects buyers and sellers, an agency transaction occurred. With a best efforts underwriting, the investment bank is connecting the issuer with the investing public. This is exactly how agents (a.k.a. brokers) inside and outside of finance operate.

There are a few different versions of best efforts underwriting commitments. A mini-max underwriting is one that specifies a minimum and maximum amount of shares. For example, an issuer may have 1 million shares available to sell but requires the underwriter to sell at least 750,000 for the sale to go through. If 750,000 shares cannot be sold, the sale is canceled and money is returned to investors who purchased units or shares.

Also, there’s an all or none underwriting commitment. The underwriter must sell all of the securities in order for the sale to go through. If an issuer has 1 million shares to sell, all 1 million would need to be sold. Otherwise, the sale is canceled and money is returned to investors who purchased units or shares.

Firm underwriting commitments are riskier for underwriters, therefore their underwriting fees are higher. The underwriter doesn’t want to be stuck with unsold shares, but it’s part of the deal (and why they’re paid more for this type of underwriting). Best efforts underwriting commitments are less risky for underwriters. They won’t be stuck with unsold shares, but they’ll make less money on the underwriting.