Underwriting Business

Companies and states regularly need money, for example for new factories or roads. One way to raise this money is by selling securities. A security is a certificate that grants the buyer a claim: either a share in the company or the right to repayment of a loan with interest. The initial issuing and selling of such securities is called the underwriting business. Almost always, those seeking funds bring in one or more banks to organize the sale. The banks earn a fee that they charge for this work.

Why companies need banks for this

A company could theoretically sell shares itself. In practice, this fails for three reasons: it doesn’t know the major buyers, it cannot assess the right price, and it doesn’t know the regulations. Banks have all of this. They have been in contact for years with pension funds, fund companies, and insurers—in other words, with the investors who move large sums.

For the economy as a whole, the underwriting business is a central channel for money. Without functioning new issues, companies would have to finance themselves almost exclusively through bank loans. That would be more expensive and would slow down large investments. States also depend on it: Germany finances its debt through regularly issued bonds, that is, credit securities with a fixed term.

For the banks themselves, this business is an important source of revenue. In an IPO, fees are often between two and seven percent of the amount raised. For an issue of over one billion euros, this quickly amounts to double-digit millions. That is why investment banks compete fiercely for such mandates.

From price negotiation to allocation

It begins with due diligence. The bank examines the company’s books and estimates what the market would pay. Afterward, a prospectus is created, an extensive document with figures, risks, and plans. Regulatory authorities must approve this prospectus before sales may begin.

Then comes price discovery. In the usual procedure, bookbuilding, the bank names a price range. Interested investors indicate how many shares they would take and at what price. From these indications, a book is built, from which the final price emerges. If demand is high, the price is at the upper end of the range.

An important question is who bears the risk. In a firm commitment underwriting, the bank buys all the securities itself and resells them. If it gets stuck with them, that is its loss. In a pure best-efforts arrangement, it only seeks buyers and bears no liability. Firm commitment underwriting is safer for the company and therefore more expensive.

IPOs and bonds in the news

The best-known form is the IPO, short for Initial Public Offering. In this, a company sells shares to the general public for the first time. When the news reports that a chipmaker went public at 50 dollars per share, an underwriting deal was behind it. The often-cited price jump on the first day of trading merely shows that the issue price was lower than what buyers were willing to pay.

Less spectacular, but much larger in volume, is the bond market. Almost daily, corporations and states issue new bonds. Reports such as 'The federal government places a ten-year bond worth four billion euros' describe exactly such transactions. Green bonds, whose proceeds are tied to climate projects, also arise this way.

A common misconception: anyone who buys a share on the stock exchange does not give the company any money. The underwriting business happens only once, on the so-called primary market. After that, the securities merely change hands between investors. The company receives no further cent from it.