What is underwriting?

Underwriting is the process where a financial institution, such as an insurance company or investment bank, assumes the financial risk of issuing insurance policies, securities, or loans for a fee. In the context of securities, the underwriter evaluates the risks associated with a company’s stock or bond issuance and helps price and sell the securities to investors.

What is underwriting and how does it work in corporate finance?

Underwriting refers to the process of taking on financial risk in exchange for a fee. There are three primary types of underwriting: loan underwriting, insurance underwriting, and securities underwriting.

In corporate finance, underwriting primarily focuses on raising capital through equities or debt securities. Investment banks often act as underwriters who help clients secure funding through initial public offerings (IPOs), follow-on offerings, or bond sales. The underwriter’s role is to evaluate the risk of these securities, determine a fair market price, and in some cases, guarantee the sale of the securities by purchasing them upfront.

When underwriting a company’s IPO, for example, an investment bank will assess the company’s financial health, market conditions, and investor appetite to determine a suitable offering price. In some cases, underwriters agree to sell a minimum number of securities to meet the issuer's funding goals. Once the securities are underwritten, the bank either sells them directly to investors or through brokers. This process helps companies raise capital while earning a profit for underwriters through fees or price premiums.

Underwriters also help structure and finance mergers and acquisitions (M&A) deals.

What is the difference between equity underwriting and debt underwriting?

Equity underwriting and debt underwriting are the two primary types of securities underwriting, which facilitates the capital raising process for companies. Here’s how each of these processes work:

Equity securities underwriting

Equity underwriting involves raising capital by issuing shares of stock, which represent partial ownership in a company. When a privately-held company decides to offer shares to the public for the first time, it’s called an initial public offering (IPO). Equity underwriters support this process by evaluating the company’s financial health, determining the price of the shares, and selling the stocks to investors.

Equity underwriting can also involve secondary offerings or follow-on offerings, where an already public company issues additional shares to raise more capital. The underwriter’s role in this process is to price the offering fairly by assessing market conditions, investor interest, and the company’s growth prospects.

Debt securities underwriting

Debt underwriting involves raising capital through the issuance of debt securities, such as bonds. Debt securities are essentially loans made by investors to the issuing company, which agrees to pay periodic interest and repay the principal amount at maturity.

Companies often turn to investment banks for help when issuing bonds or other debt instruments, such as commercial paper, to raise funds for various purposes. For example, a company may need the funds to refinance existing debt or fund an acquisition.

The investment bank’s role in debt securities underwriting is to assess the creditworthiness of the company, determine the appropriate interest rate that reflects both market conditions and the issuer’s credit profile, and sell the bonds to investors. They’re also responsible for pricing the bonds in a way that meets market demand while minimizing the company’s borrowing costs.

What’s involved in the underwriting process?

Securities underwriting involves several stages, including:

1. Choosing an investment bank

The underwriting process begins when a corporation or entity looking to raise capital hires an investment bank, or group of banks, to manage the underwriting process. The chosen bank(s) will serve as the intermediary between the issuing company and the investors.

2. Due diligence and risk analysis

The next step is to conduct due diligence. The investment bank assigns a team of professionals to carefully review the issuing company’s financial health and operations. This process ensures that all financial data is accurate, transparent, and compliant with financial regulations (e.g. those set by the securities and exchange commission (SEC) in the U.S.). They also conduct a risk analysis to assess the potential risks of the offering and better understand how to price the securities.

3. Create marketing material & deliverables

The investment bank begins to design marketing materials to attract investors, including a presentation deck outlining the business’s strengths, potential risks, market positioning, and industry outlook. This is often created with an appealing narrative to present a convincing case to investors. If investor interest appears weak at this stage, the issuance could be paused or canceled.

4. Prepare SEC filings & securities pricing

After completing due diligence and compiling marketing materials, the investment bank works on structuring the deal. This involves deciding the type of securities to be issued (e.g. stocks or bonds), the number of securities, the estimated price range, and other transaction details.

When estimating an offer price, the underwriter aims to strike a balance between maximizing the client’s capital raise and ensuring that the securities are sold. This is especially important for equities issuances, where there’s often pressure to avoid an ‘IPO pop’ – when a company’s stock prices spike on the first day of trading. Such situations can result in missed value for both the issuer and the investors.

5. Choose underwriting type

There are different types of underwriting, with the most common being firm commitment underwriting. This involves the investment bank agreeing to buy the entire issuance of securities from the issuing company at an agreed-upon price, which is typically lower than the price at which the securities are sold to the public.

In exchange for the discounted price, the bank assumes the risk of selling all the securities. For large offerings, a syndicate of multiple investment banks is often formed to spread the risk. Firm commitment underwriting benefits the issuer because it means they achieve their capital raise target regardless of how many securities are sold.

In some cases, underwriters offer best efforts underwriting, where they agree to sell as many securities as possible without guaranteeing full subscription, acting only as an agent of the issuer in marketing the offering to investors.

6. Marketing phase or roadshow

Once the regulator gives approval for the issuance, the investment bank begins the marketing phase, often referred to as the roadshow. This involves pitching the offering to institutional investors and distributing a prospectus with detailed information about the securities, including pricing and how the issuing company plans to use the funds. Roadshows are designed to generate interest and encourage investors to commit to the offering.

7. Sale and distribution of securities

Once the marketing phase has completed, the investment bank officially distributes the securities to investors. Depending on the type of offering, securities may be sold to institutional investors before becoming available to the public through the secondary market. The investment bank’s role is to facilitate a smooth issuance process and maximize proceeds for the issuer.

8. Stabilization of the issued securities

After the securities are issued, the investment bank may continue to track their performance in the secondary market. In some cases, the bank may conduct short-term price stabilization activities to prevent excessive volatility during the early trading period. This is different to ongoing market-making, which involves continuously buying and selling securities to provide liquidity. Not all investment banks act as market makers, and such activities are strictly regulated and distinct from the underwriting process.

The relationship between underwriting and risk management in finance

Underwriting involves assuming and managing the risk associated with issuing securities, which makes it closely tied to risk management. When an investment bank underwrites a securities issuance, it often commits to purchasing the securities from the issuer at a predetermined price (for firm commitment underwriting – other types of underwriting don’t involve this commitment). This exposes the bank to market risk, as it may not be able to sell the securities at the expected price or volume. Effective risk evaluation and mitigation are therefore an important part of the underwriting process.

One of the key elements of risk management in underwriting is due diligence. Investment banks thoroughly analyze the issuer’s financial health, business model, and market conditions to identify potential risks. This process allows underwriters to price securities fairly, identify the risks upfront, and structure the transaction to mitigate adverse outcomes while complying with regulatory requirements.

When dealing with large or complex transactions, investment banks often form syndicates, where multiple institutions share the underwriting responsibilities. This helps to spread the risk across multiple parties, reducing the potential financial impact on any single institution and creating a more balanced risk profile for high-value issuances.

Beyond the initial underwriting phase, some investment banks engage in risk management by providing market making services. This involves providing liquidity and temporarily stabilizing the market to mitigate volatility risk.

How does securities underwriting facilitate capital market access?

Securities underwriting facilitates access to the capital markets by acting as a bridge between issuing companies and investors. Underwriters, like investment banks or investment houses, help companies and governments raise funds by pricing, marketing, and selling equity and debt securities to retail and institutional investors. This process allows issuers to access capital and provides investors with opportunities to invest in stocks or bonds.

This material is for informational purposes only and should not be considered as an investment recommendation or a personal recommendation.