Underwriting Services and the New Issues Market

George J. Papaioannou, Ahmet K. Karagozoglu

• Publisher: Academic Press
• Year: 2017
• ISBN:
  9780128032831
• Topic: Business
• Subtopic: Investments & Securities
• Index: Business

Underwriting Services and the New Issues Market integrates practice, theory and evidence from the global underwriting industry to present a comprehensive description and analysis of underwriting practices. After covering the regulation and mechanics of the underwriting process, it considers economic topics such as underwriting costs and compensation, the pricing of new issues, the stock price and operating performance of issuing firms, the evaluation of new issue decisions, and an analysis of the many choices issuers face in structuring new issues.

Unlike other books, it systematically develops a critical perspective about underwriting practices, both in the U.S. and international markets, and with a level of detail unavailable elsewhere and an approach that reveals how financial institutions deliver underwriting services. Underwriting Services and the New Issues Market delivers an innovative and long overdue look at security issuance.

Foreword by Frank Fabozzi

• Covers underwriting contracts and arrangements on pricing and costs
• Focuses on the financial consequences of the issuance decision for the firm
• Describes and evaluates decisions regarding the features and structure of new security offerings.

1

The Underwriting Business

Functions, Organization, and Structure

Abstract

Underwriting is defined as the intermediation service in the capital raising process that takes place in the new issues markets. This chapter describes the services underwriting firms provide to issuers and the functions these firms perform in the new issues markets. The chapter discusses the competencies and skills underwriting firms must develop and possess in order to compete successfully and how investment banks develop these competencies by running multifaceted operations in the primary and secondary capital markets. The chapter also examines the complementarities and synergies as well as conflicts of interest these operations engender as underwriting firms strive to balance their own interests with those of issuers and investors. Furthermore, the chapter reviews the structure of the underwriting industry, describes the factors that impact the structure of underwriting markets and reports information that sheds light on the structure of the industry in the United States and internationally.

Keywords

Underwriting; underwriting functions; underwriting competencies; supporting operations; industry structure; underwriting market competition; commercial banks; securities firms; domestic and international competition; IPO; SEO; investment banking

This chapter describes the underwriting business, the firms that provide underwriting services, how these firms organize the underwriting business within the broader scope of their operations, and how they compete in the market for underwriting services.

Functions and Organization

What Underwriters Do

Corporations as well as other entities (e.g., municipalities, universities, etc.) need to raise new capital for various purposes by selling financial claims, like stocks or bonds. Because these issuers come to the market only periodically they lack the expertise required to ensure the new securities are appropriately priced and successfully placed with investors. To overcome these disadvantages, issuers retain financial institutions that operate as investment banks to assist with the pricing, marketing, and placement of their new issues. In full-service underwriting arrangements, the intermediary also assumes the risk of placing the issue. It is this risk bearing service, akin to an insurance policy, that gives the name “underwriting” to these business arrangements and by extension to this business activity. In return, issuers pay underwriting firms a fee to compensate them for the range of services they receive. Underwriting of new issues is part of the activities that take place in the primary capital markets. This is the segment of the financial markets that facilitates the raising of new capital through the sale of financial claims, like stocks and bonds.

The Underwriting Firms

The firms that engage in the provision of underwriting services are called investment banks. Most investment banks are much more than just underwriting firms. They also run various other securities businesses, including brokerage, trading, wealth management, and corporate advisory services. They may operate as independent investment banks (e.g., Goldman Sachs and Morgan Stanley) or as divisions of other financial institutions, banks or insurance companies (e.g., Merrill Lynch is part of the Bank of America).

The Functions of Underwriters

As intermediaries in the capital raising process, underwriting firms perform several valuable functions that help issuers offer new securities at higher prices and lower cost than otherwise.

Valuation and Pricing

In many instances, a firm approaches the public capital markets for the first time. This is the case of a firm selling stock in an initial public offering (IPO) or the case of a firm issuing a bond for the first time. In these cases, there is no prior history to serve as a guide about the value of the firm. Even in instances when an issuer has publicly traded securities but lacks wide recognition and active trading of its securities there may not be full agreement on the value of the firm’s securities. By operating in the capital markets and engaging in repeat new issue deals, underwriting firms acquire the expertise to collect the appropriate information and arrive at a more credible estimate of value than the issuing firm. Arriving at an appropriate value is not, however, sufficient for the successful placement of a new issue. Even more important is to set the right price at which the new securities will be accepted by investors—i.e., the offer price. Informational frictions between sellers (issuer and underwriter) and buyers (investors) can cause the latter to be reluctant to pay the full value of the security for fear of overpaying—a condition called adverse selection. Valuing and pricing a new issue may also require that regular investors be engaged in the production of information relevant to the price discovery process. It is the function of the underwriter to organize this information production by incentivizing investors and finding efficient methods of compensation, as, for example, though price discounts.

Certification

The ability of underwriters to convince the market about the fairness of the offer prices of new issues depends on the underwriter’s reputation and track record. Since the underwriter’s revenue stream depends on repeat business, underwriters have an incentive to maintain a reputation as credible intermediaries. This is how they build reputation capital. The greater this capital is the greater the certification power of the underwriter. Thus, as certifiers of new issue values, underwriters facilitate the placement of new securities into the capital markets and contribute to the financing of new investments.

Marketing

Underwriting firms have extensive contacts and networks of retail and institutional clients to whom they can pitch the new securities. Through person-to-person contacts or group presentations in the so-called roadshows, underwriters can communicate vital information that helps investors to become informed about the new issue.

Distribution

The distribution of new offers is the culmination of the pricing and marketing activities of the underwriting process. Distribution includes both the sale of the new securities as well as the scope of investor clienteles to whom the new securities will be sold. The sale of new issues requires human capital, especially an experienced salesforce, and tangible assets ranging from brick-and-mortar facilities to information and computer technology resources. Investor networks are valuable in securing the sale of new securities to investor clienteles favored by the issuer or dictated by the conditions of the market.

Valuable Competencies in Underwriting

To perform the above functions efficiently and to succeed in the underwriting business, underwriting firms must possess several competencies.

Ability to Originate Deals

This is the most important competitive advantage an underwriting firm must possess. Receiving mandates to serve as the lead manager of new issues is critical in maximizing revenues from new issue deals and building reputation. Since the lead manager is engaged in all services under the underwriting contract and also retains the lion’s share in the allocation of the offers, he/she receives the bulk of the underwriter compensation. As lead manager, the underwriter also selects the comanagers and other syndicate members thus establishing the conditions of reciprocal invitations to participate in other deals. Investment banks develop the origination advantage by cultivating and maintaining relationships with many prospective issuers. Such contacts and networks are built on reputation and a wide-ranging scope of operations that can be of use to issuers (e.g., providing services in M&A deals and other corporate finance decisions and transactions).

Ability to Design and Price New Issues

Capital markets expertise enables successful underwriters to advice issuers on the appropriate type of new securities to offer (e.g., stocks or bonds) and design the terms of new securities so that they are compatible with market conditions and dynamics, investor appetite, and other institutional arrangements. This kind of expertise is most important in the case of bond issues. Debt instruments can have many different features in terms of maturity, callability, and convertibility to mention a few. Part of the ability to advise on financial instruments is also the ability to assess their relative risk-return appeal to different investor clienteles.

Ability to Place Securities

Underwriting starts with origination and ends with placement. Successful placement of the new issue under the terms of issuance (i.e., offer price and quantity offered) is the necessary outcome to prove the underwriter’s competence in organizing and executing the new issue mandate. Without access to investor capital even a firm strong ...

Table of contents

• Cover image
• Title page
• Table of Contents
• Copyright
• Dedication
• Foreword
• Preface
• 1. The Underwriting Business: Functions, Organization, and Structure
• 2. The New Issues Markets
• 3. Regulation of the New Issues Market in the United States
• 4. The Mechanics of the Issuance Process
• 5. Aftermarket Underwriting Activities
• 6. Underwriting Costs and Compensation
• 7. Alternative Offering Methods in New Issues Markets
• 8. Assessing the Price Performance of New Issues
• 9. Theories of New Issue Pricing
• 10. The Price and Operating Performance of Initial Public Offerings
• 11. The Price and Operating Performance of Seasoned Equity Offers, Debt Offers and Other Offerings
• 12. The Empirical Evidence on Underwriting Spreads
• 13. International Offers: Mechanics and Performance
• 14. The Decision to Issue Securities
• 15. Structuring Securities Offerings
• 16. New Issue Decisions: The Underwriter, Syndicate, Auditor, and Legal Counsel
• References
• Index