Underwriting, Functions, Types, Limitations

Underwriting in the context of financial markets refers to the process where a financial institution, such as a merchant bank or an insurance company, guarantees the purchase of securities (stocks or bonds) from a company issuing them. The underwriter agrees to buy any unsold shares during a public offering, thereby ensuring that the issuer raises the desired amount of funds. Underwriting also involves assessing the risk of the offering and determining the appropriate price. It provides confidence to both the issuer and investors, ensuring the success of an issue even if market demand falls short.

Functions of Underwriting:

• Risk Assessment

One of the primary functions of underwriting is assessing the risk associated with a financial offering. Underwriters evaluate the financial health, business model, and potential risks of the issuing company. This includes scrutinizing the company’s balance sheet, cash flow, management, and market environment. By analyzing these factors, underwriters determine the viability of the offering, which helps in setting the price of the securities and assessing the overall risk involved. This risk assessment is critical for pricing and setting the terms of the offering.

• Pricing of Securities

Underwriters are responsible for determining the appropriate price at which the securities will be offered to the public. Based on market conditions, the demand for the offering, and the company’s financial performance, underwriters recommend a price range that is attractive to investors while ensuring that the issuer achieves its fundraising goals. The pricing function is essential because an overly high or low price can lead to under-subscription or poor investor sentiment, which could harm the success of the offering.

• Distribution and Marketing

Underwriters also take on the responsibility of marketing and distributing the securities to potential investors. This process involves conducting roadshows, meeting with institutional investors, and creating promotional materials that provide detailed information about the company and its offering. The goal is to generate interest in the offering and secure the commitment of investors, which helps ensure that the securities are fully subscribed. The distribution function also includes determining the allocation of securities among different categories of investors, such as retail, institutional, and high-net-worth individuals.

• Guaranteeing the Sale of Securities

One of the most critical functions of underwriting is providing a guarantee to the issuer that the securities will be sold. In a firm commitment underwriting agreement, the underwriter agrees to purchase any unsold shares from the public offering. This guarantee reduces the risk for the issuer, ensuring that they will raise the targeted capital even if market demand does not meet expectations. In case of a best-efforts underwriting, the underwriter does not guarantee the sale but makes an effort to sell the securities.

• Regulatory Compliance and Documentation

Underwriters play a key role in ensuring that the company complies with regulatory requirements set by authorities like the Securities and Exchange Board of India (SEBI) or the Securities and Exchange Commission (SEC). This involves preparing and submitting necessary documents, such as the prospectus or offer document, for approval. They assist in adhering to rules about disclosure, transparency, and investor protection. Proper documentation ensures the legitimacy of the offering and fosters investor confidence.

• Stabilization and Market Making

After the securities are issued and listed on the stock exchanges, underwriters may engage in stabilization activities to support the market price of the securities. If the market price falls below the issue price, the underwriter may step in to purchase shares, ensuring that the price does not drop too much. This function helps maintain investor confidence and stabilizes the securities in the initial trading phase. Market-making involves buying and selling the securities to provide liquidity and reduce price volatility.

• Post-Issue Monitoring

Following the completion of the issue, underwriters are often involved in monitoring the performance of the securities. This includes ensuring that the issuing company meets its ongoing disclosure obligations, addressing investor concerns, and assisting the company with any future offerings. The underwriters’ post-issue support helps maintain market confidence in the company’s securities, as well as ensures that regulatory compliance is upheld.

Types of Underwriting:

• Firm Commitment Underwriting

Firm commitment underwriting is one of the most common and popular forms of underwriting. In this arrangement, the underwriter agrees to purchase the entire issue of securities from the issuer at a set price, regardless of whether or not the securities are sold to investors. The underwriter takes on the full financial risk associated with the offering and is responsible for selling the securities to the public at a price that ensures a profit for both the issuer and the underwriter. If the underwriter cannot sell the securities at the offered price, they may have to absorb the loss.

• Best Efforts Underwriting

Best efforts underwriting is another type of underwriting where the underwriter does not guarantee the sale of the entire issue. Instead, the underwriter agrees to make its best effort to sell as many securities as possible at the agreed-upon offering price. If the securities are not fully subscribed, the issuer does not receive the full amount of the capital intended to be raised. The underwriter assumes less risk in this arrangement compared to firm commitment underwriting, as it does not bear the full responsibility for any unsold securities.

• All-or-None Underwriting

In all-or-none underwriting, the underwriter agrees to sell the entire issue of securities. If the securities cannot be sold in their entirety, the entire offering is canceled, and no securities are sold. This type of underwriting is generally used for smaller offerings, where the issuer needs the entire capital amount to be raised for the project to proceed. If even a small portion of the securities cannot be sold, the offer fails, and the issuer does not receive any capital.

• Standby Underwriting

Standby underwriting is a hybrid of firm commitment and best efforts underwriting. In this arrangement, the underwriter agrees to purchase any unsold securities during the offering period. The issuer typically uses standby underwriting in rights issues or secondary offerings where existing shareholders have the right to purchase new shares. If the shareholders do not take up the offer, the underwriter purchases the remaining unsold securities, ensuring that the issuer raises the targeted capital. Standby underwriting provides an additional layer of security to the issuer, ensuring that the full offering is subscribed to.

• Syndicate Underwriting

Syndicate underwriting involves a group of underwriters who pool their resources together to handle a large public offering. The lead underwriter coordinates the process, while other underwriters in the syndicate contribute capital, sell securities, and share the financial risk. Syndicate underwriting is commonly used for large issues where the risk and the capital requirements are too high for a single underwriter to handle alone. The lead underwriter typically receives a larger portion of the underwriting fee for their role in managing the syndicate.

• Shelf Underwriting

Shelf underwriting allows issuers to register a large number of securities with the regulatory authorities but issue them in smaller amounts over time. The issuer can “shelve” the securities and then issue them when market conditions are favorable. The underwriter agrees to help with the issuance and sale of these securities whenever the issuer decides to offer them. Shelf underwriting provides flexibility to the issuer, allowing them to raise funds as needed without having to go through the entire registration process again.

Limitations of Underwriting:

• Market Risk

One of the most significant limitations of underwriting is market risk. Despite the underwriter’s efforts in pricing and assessing the offering, the market conditions can fluctuate unpredictably. If the market sentiment turns negative after the offering is priced, the underwriters may find it challenging to sell the securities at the agreed price, leading to a potential loss. Underwriters may have to purchase unsold securities at a loss, which increases their exposure to market volatility.

• Overvaluation of Securities

In some cases, underwriters may overestimate the value of a company’s securities. If the securities are priced too high, it may lead to weak demand during the offering. This overvaluation can also result in poor post-issue performance, as investors may sell the securities after the offering, causing the price to fall. Underwriters may struggle to stabilize the price and maintain investor confidence, leading to reputational damage and financial losses.

• Limited Control over Issuer’s Performance

Underwriters cannot control the performance of the company issuing the securities. Even if an underwriter conducts thorough due diligence, the company’s future performance can still be impacted by internal or external factors, such as management decisions, market changes, or economic conditions. If the issuing company fails to meet its projections or experiences financial difficulties, it can affect the security’s value, leading to a loss for both investors and underwriters.

• Regulatory and Compliance Risks

The underwriting process involves meeting various regulatory requirements, such as filing documents with securities regulators and ensuring transparency in disclosure. However, there is a risk of non-compliance or delay in approvals, which can affect the timeline of the offering. Non-compliance with regulatory requirements can result in fines, legal issues, or the suspension of the offering. These regulatory risks pose limitations to the underwriting process, especially in markets with strict regulations.

• Underpricing and Opportunity Cost

In some situations, underwriters may choose to underprice securities to ensure a successful offering and guarantee investor interest. While this strategy helps in achieving full subscription, it may lead to an opportunity cost, as the issuing company may not raise the maximum amount of capital it could have. The underpricing may also benefit investors more than the company or the underwriters, who may miss out on the potential upside of higher pricing.

• Conflicts of Interest

Underwriters may face conflicts of interest during the underwriting process. For example, they may prioritize their own financial interests or the interests of large institutional investors over the issuer or smaller investors. The underwriter’s decision to price securities in a way that benefits their own portfolio or their institutional clients may result in an unfair advantage and dissatisfaction among smaller retail investors. These conflicts can lead to legal challenges and reputational risks.

• Reputation Risk

The underwriting process carries a significant reputation risk. If an offering fails or the securities perform poorly in the market, underwriters may face reputational damage. A failed IPO, for example, can harm the underwriter’s standing in the market and may affect its future business prospects. Investors often associate a failed offering with underwriter incompetence or poor risk management, which can undermine investor trust in future offerings handled by the same underwriters.