Underwriter, Functions, Advantages of Underwriting

An underwriter is a financial institution or individual that guarantees the purchase of any unsold shares in a public offering, such as an Initial Public Offering (IPO) or a Rights Issue. Underwriters play a key role in ensuring that the company raising funds will meet its capital-raising goals, even if the public does not fully subscribe to the offering. They assess the risk, determine pricing, and market the securities. In return for assuming this risk, underwriters are paid a commission, which compensates them for their services and financial commitment to the issue.

Functions of Underwriter:

• Risk Assessment

One of the primary functions of an underwriter is to assess the risk involved in a public offering. Before agreeing to underwrite an issue, the underwriter evaluates the financial health, market conditions, and business prospects of the issuing company. This assessment helps the underwriter determine the likelihood of the offering being successful and identify any potential risks that might affect the sale of shares. Based on this evaluation, they decide whether to underwrite the issue and the terms of underwriting.

• Pricing of Securities

Underwriters play a crucial role in determining the price at which securities are offered to the public. This involves market research, understanding investor demand, and analyzing the company’s financial position. The underwriter sets the issue price to balance the issuer’s goal of raising capital and attracting investor interest. An accurately priced issue ensures that it is neither underpriced (leading to a loss of capital for the issuer) nor overpriced (leading to poor investor demand).

• Marketing and Promotion

Marketing and promotion of the offering is another key function of the underwriter. They are responsible for creating an awareness campaign and ensuring that potential investors are well-informed about the company’s offering. This involves roadshows, presentations, and other promotional activities to generate interest. Underwriters leverage their relationships with institutional and retail investors to ensure the offering is adequately subscribed. Effective marketing directly impacts the success of the offering by creating demand and enhancing visibility.

• Managing Subscription Process

The underwriter is responsible for managing the subscription process during an offering. This includes handling investor applications, collecting payments, and ensuring the shares are allocated correctly. The underwriter coordinates with stock exchanges and regulatory bodies to comply with all procedural requirements. They must ensure that the subscription is conducted smoothly, and that any oversubscription or undersubscription is dealt with effectively, including the allotment of shares to investors as per the rules and regulations.

• Underwriting Commitment

Underwriters provide a guarantee to the issuing company that they will purchase any unsold shares in the event that the public does not fully subscribe to the offering. This is referred to as the underwriting commitment. If the offering is undersubscribed, the underwriter steps in and buys the remaining shares at the agreed-upon price. This commitment ensures that the issuer will raise the desired amount of capital, even if there is low investor interest in the offering.

• Due Diligence

Underwriters are responsible for performing due diligence to ensure that the issuing company’s financials and disclosures are accurate and compliant with regulatory requirements. This includes verifying financial statements, business operations, and legal standing. Due diligence is crucial in protecting investors and ensuring that the information provided in the offer document is truthful and transparent. A thorough due diligence process reduces the risk of legal disputes and protects both the underwriter and the issuer from potential liabilities.

• Stabilization of Market Price

After the securities are issued, the underwriter may be involved in stabilizing the price of the securities in the secondary market. This involves buying and selling shares to prevent excessive price fluctuations immediately after the offering. The underwriter’s role is to ensure that the market price of the shares remains stable and does not fall below the issue price. This helps maintain investor confidence and prevents volatility that could harm the issuer’s reputation and the investors’ interests.

Advantages of Underwriting:

• Capital Guarantee

Underwriting ensures that the company raising capital will receive the full amount of money it requires, even if the public does not fully subscribe to the offering. This capital guarantee helps reduce uncertainty for the issuer, providing confidence that the financial objectives of the offering will be met, regardless of investor demand.

• Expert Guidance

Underwriters bring in-depth market knowledge and expertise, helping the issuing company set the right price for the securities and strategize on how to attract investors. Their experience in market conditions, pricing, and risk management ensures the offering is attractive, thereby maximizing the chances of success for both the company and investors.

• Enhanced Market Credibility

Having a reputable underwriter associated with an issue enhances the company’s credibility in the market. Investors often feel more confident in subscribing to an offering that has been underwritten by well-known financial institutions. This can help increase investor interest and trust, potentially leading to higher subscriptions and a successful offering.

• Risk Mitigation for Issuers

By assuming the risk of underwriting, underwriters protect the issuer from potential losses if the offering is undersubscribed. This is especially important during volatile market conditions where public interest may be lower than expected. The issuer is assured of receiving the required funds, even if the shares do not sell as anticipated.

• Investor Protection

Underwriters perform due diligence to ensure that the information provided in the offer document is accurate, complete, and compliant with regulatory standards. This protects investors by ensuring they have access to reliable and truthful information when making investment decisions. It reduces the likelihood of fraud or misinformation, fostering a safer investment environment.

• Market Liquidity

By underwriting the offering, financial institutions contribute to the liquidity of the stock market. They help ensure that shares are not only sold initially but that they are also available for subsequent trading. This liquidity helps maintain the efficiency and stability of the market, providing investors with opportunities to buy or sell securities as needed.

Disadvantages of Underwriting:

• High Costs

Underwriting involves substantial fees, including commissions paid to the underwriters, as well as legal, administrative, and marketing expenses. These costs can be significant, especially for large public offerings. For smaller companies or those with limited capital, these expenses may be prohibitive and could diminish the funds raised through the offering.

• Underwriter Risk

Underwriters assume a significant amount of financial risk, especially when market conditions are unfavorable. If the public does not subscribe to the offering as expected, the underwriter is left with unsold shares. This risk may lead to financial losses, particularly if the market price of the shares falls below the issue price, impacting the underwriter’s profitability.

• Potential for Overpricing

Underwriters, in their role, set the issue price, which may sometimes be overestimated based on market conditions or overly optimistic projections. Overpricing can lead to poor investor demand, resulting in undersubscription. An improperly priced issue may also harm the company’s reputation, as investors may feel the offering was not accurately valued.

• Conflicts of Interest

In some cases, underwriters may have conflicts of interest. They might prioritize their financial gain over the interests of the issuer or investors. For instance, underwriters may push for a higher issue price or aggressively market the shares to boost their commission, which can negatively affect the long-term success of the company and its stock performance.

• Limited Control for Issuer

Once an underwriter is hired, the company may lose a degree of control over the terms of the offering. The underwriter typically takes the lead in setting the price, timing, and other key aspects of the issue. This can be problematic if the issuer’s vision does not align with the underwriter’s strategies or market approach.

• Increased Regulatory Scrutiny

Underwritten offerings are subject to strict regulatory scrutiny, particularly regarding the due diligence process and disclosure requirements. While this ensures transparency, the complexity and compliance costs can be burdensome for the issuer. Regulatory bodies, such as SEBI in India or the SEC in the U.S., monitor the underwriting process closely, increasing the time and effort needed to complete the offering.