Investment Banking Underwriting

8/4/2019 Investment Banking Underwriting

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Underwriting

By Prof. Samie



Underwriting - Definition

• In the Indian Context underwriting is defined by SEBI as – “ as an agreement with or without conditions tosubscribe to the securities of a corporate body when theexisting shareholders of such corporate body or the

public do not subscribe to the securities offered to them.” • Underwriting is always in connection with a proposed

issue of securities by a corporate body.

• Underwriting is a service that consists of a contingentobligation to subscribe to an agreed number of securitiesin an issue if such securities are not subscribed to by theintended investors.

• Underwriting is primarily a fee-based service.



Sub-Underwriting

• Sub-underwriting is used by an underwriter to spread therisk assumed in underwriting an issue of shares.

• Sub-underwriting is a process under which anunderwriter appoints another person to underwrite his orher underwriting obligation.

• In the third largest rights issue ever by HSBC, GoldmanSachs and JPMorgan underwrote 2.6 billion pounds ofthe 12.9 billion pound issue. Co-bookrunners BNP

Paribas, Credit Suisse and RBS Hoare Govettunderwrote1.6 billion pounds each.

• Over 5 billion pounds had been pledged in sub-underwriting.



Underwriting Commission

• The underwriters compensation for the servicesrendered is the fee that is paid by the issuer company.

• This fee which is known as underwriting commission, ispaid as a percentage of the value of underwriting.

• Underwriting commission is payable irrespective ofwhether the underwriter ultimately has any requirementto purchase the underwritten securities or not.

• Underwriting commission should not confused with

brokerage that is paid to a stock broker for dealing inshares or for procuring subscriptions.



The Underwriting Process



Devolvement

• A devolvement occurs when the undersubscription of a security issue forces theunderwriting investment bank to purchaseunsold securities during an offering.

• In India, a pubic offer or issue devolves when itfails to attract 90% of the offer size.

• Devolvement is often an indication that themarket currently has negative sentiments toward

the issue.• This negative sentiment can have a significantimpact on subsequent demand.



The Devolvement Notice

• The issuer company shall within 30 days after the date ofclosure of the subscription communicate in writing to theunderwriter, the total number of securities remainingunsubscribed, and the number of securities being taken upby the underwriter.

• The company shall make available to the underwriter themanner of computation of devolvement and also furnish acertificate in support of such computation from thecompany’s auditors.

• The underwriter shall within 30 days after the receipt of the

devolvement notice, make or procure the applications tosubscribe to the securities and submit them along with therequire payment.

• In the event of failure of the underwriter fulfill his obligationsthe company can look into legal action against the

underwriter and claim damages.



The Underwriting Agreement

• The underwriting agreement is a document thatestablishes the contract between the underwriter and theissuer company.

• It forms a part of material contracts for the issue and

requires to be approved by the concerned stockexchange apart from being filed with ROC as part ofprospectus registration.

• The SEBI evolved a model underwriting agreementwhich is recommendatory and should be followed to theextent possible by all the underwriters.



Model Agreement

• The model agreement lists out the following mainclauses:

– Amount being underwritten

– Provision for sub-underwriting

– Computation of devolvement

– Procedure for effecting or discharge of underwritingobligations

– Right to receive commission within statutory

stipulation – Statutory declaration



Hindalco Rights Issue

• Hindalco Industries Ltd. informed NSE vide its letterdated October 15, 2008, that: "The Issue period of theproposed rights issue of 525.8mn equity shares ofHindalco pursuant to the filing of the letter of offer datedSeptember 13, 2008 with the stock exchanges closed on

October 10, 2008.• As per the provisional data provided by the Registrar,

Hindalco had received a subscription of 55.967% of theIssue size, being 294.2mn equity shares in the Issue.

• As per regulations in India, this rights had devolved and

the underwriters were bought into play.



Hindalco Devolvement

• Pursuant to the underwriting agreement entered into bythe Hindalco with ABN AMRO Asia Equities (India)Limited, ABN AMRO Securities (India) Private Limited,Citigroup Global Markets India Private Limited, DeutscheEquities India Private Limited, DSP Merrill Lynch Limited,

State Bank of India (together referred to as the"Underwriters"), dated September 12, 2008, theCommittee of the Board of the Company in its meetingapproved the issuance of a devolvement notice datedOctober 15, 2008 to the Underwriters.

• The notice required the Underwriters to subscribe orprocure subscription for equity shares aggregating to178.9mn at the price of Rs. 96 per equity share, for anamount of Rs. 1717.88 crores



IFCI Sub-Underwriting

• IFCI had sub-underwritten Hindalco rights issue and thesub-underwriting contract was struck when the scrip ofthe company was 30 per cent above their current marketprices.

• The Rs 5,000-crore Hindalco rights issue was priced atRs 96 per share and the scrip traded at around Rs 65 atthe time of the conclusion of the rights issue.

• IFCI had an agreement with Citibank to sub-underwriteRs 150 crore of Hindalco’s rights issue.

• Citibank charged underwriting fees of 3 per cent andpaid IFCI 1.35 per cent, investment banking sourcessaid.



The case of Wockhardt Hospitals

• After a jittery start in late January, Wockhardt HospitalsLtd’s IPO eventually succumbed to the volatility in thestock markets. The hospitals major officially withdrew itsIPO due to feeble response from investors.

• Wockhardt Hospitals’ IPO was subscribed 0.20 times,receiving 4.9mn bids, on the day of the IPO’s closing.

• A company statement, however, said that WockhardtHospitals had indeed decided not to proceed with itsproposed IPO of 25.08mn equity shares constituting24.06 per cent of the proposed post-issue paid-up equity

share capital of the company. “The decision not toproceed with the IPO was made in light of continuedglobal and domestic market volatility and poor marketsentiments and the resultant effect on the subscriptionlevels in the IPO.”



• Wockhardt had slashed its price band from Rs280-310 toRs225-360 for its Rs800 crore issue that opened on 31January.

• It was slated to close on 5 February but was extended bytwo days to 7 February.

• It finally had to be shelved as it could sell only 20% ofthe 25 million shares that it floated.

• Citibank and Kotak were the book running leadmanagers for the issue.




• In India, there is no “hard” underwriters to public issues

who buy the unsubscribed portion of an issue.

• However, the merchant bankers do “soft” underwriting.

• They are responsible for putting in money if investors,after bidding for shares, do not pay up on allotment.

• The clause as per disclosure and investment protection(DIP) guidelines where if the book was not built 75%,price remained undiscovered and hence underwriters didnot oblige and the underwriters did not shell out a singlerupee.




Assessment of an issue for UW

• The critical risk factors in underwriting business are : – Devolvement probability

– Devolvement quantum

– Capital loss from devolved securities

• In order to mitigate this risk, the critical success factorsfor an underwriter are capital adequacy and the capacityto procure subscriptions.

• The capacity to procure depends upon the distributionnetwork and investor base of an underwriter and the

marketability of an issue.• While underwriters build an expansive network of

brokers, sub-brokers and marketing agents over a periodof time, the have to carefully assess the marketability ofevery issue that they underwrite.



Assessment for UW

• Assessment of an issue for underwriting should alwaysbe made from an investor’s perspective since the issueis successful only when it finds favor with investors.

• Institutional investors generally look at medium termgrowth while retail investors tend to look at short-termprofit booking within the first three to six months.

• Institutional investors are driven more by fundamentalsof the issue and are therefore keen to wait forappreciation in the market price over a longer timeframe.

• The success of the issue depends on a lot of factorsincluding – industry, pricing of an issue, fundamentals ofthe issue, past track record, soundness of the businessplan, financial performance, level of brand visibility.



• Retail investors are driven more by profit motive andarbitrage opportunities than by fundamentals.

• Therefore what matters more to retail investors isaffordability and possibility of price appreciation.

• Keeping the mind-set of investors in perspective, theunderwriter should look at the potential of the issue tomeet these expectations and their own distributionstrengths to reach these investors.

• Many underwriters develop a strong and loyal investorbase that can support significant number of issues.

Assessment for UW



• There are broadly two types of underwriting –

– Firm underwriting

– Best effort underwriting

• In firm underwriting, the underwriter enters into apurchase agreement with the issuer and the purchaseprice is fixed a day before or usually on the morning ofthe date on which the registration statement becomeseffective.

• By this time, the underwriters would have completed theroad shows and marketing and would have practicallypre-sold the issue to investors although technically,investor bids cannot be accepted until registrationstatement becomes effective.

Types of UW



• In best effort underwriting, which is very uncommon inthe US as well as Indian market, the underwriting ismore on the lines of an agency function as is the casewith brokerage houses in India.

• The investment banks would make best efforts to sell thestock and whatever is not sold is not issued by thecompany.

• Therefore, in this model there is not contract forpurchase and sale by the underwrite and there is only an

agreement to market the securities.

Types of UW



Safety Net

• Safety Net is a mechanism whereby an issuer companyenter into an understanding with its merchant bankers orunderwriters or any other financial intermediary toprovide a limited period facility to investors subscribing to

the issue.• The arrangement would be to provide the investors with

a buyback facility for the securities subscribed by them inthe public issue at the issue price.

• For example, if an investor has been allotted 100

securities in a pubic issue at a price of Rs. 60 per share,if a safety net has been offered by the company theinvestor may choose to sell all or any of those securitiesto the Safety Net provider for a price of Rs. 60 persecurity



Safety Net

• SEBI has imposed certain regulations on the operationof a safety net keeping view the need for such facility tobe provided only for small investors. The followingregulations apply to safety net arrangements:

– Any safety net scheme or buyback arrangement of the sharesshall be finalized by issuer company with the lead merchantbanker in advance and disclosed in the prospectus.

– Such buyback or safety net arrangement shall be made availableonly to all original residents individual allotte.

– Such buyback or safety net facility shall be limited up to a

maximum of 1000 securities per allotte and the offer shall bevalid at least for a period of six months.

– The financial capacity of the person making available buyback orsafety net facility shall be disclosed in the draft prospectus



Safety Net

• Safety Net is an additional protection that may be madeavailable by an issuer company to small investorsentirely at its option.

• Issuer company usually do this as a marketing factor forthe issue.

• Providing a safety net in a high price issue may alsosend a signal to prospective investors about theconfidence of the company in its pricing and post issue

performance of the scrip.

• Safety Net was used in some public issues in earlieryears such as Infotech Enterprises Limited and IDBI.



Bought Out Deals

• Bought Out deals were a common occurance in the IPOin the early 90’s in India during which several companieswent public through a BOD and a subsequent offer forsale to the public.

• BOD is an alternative to a straight IPO where by acompany places certain amount of stock with aninvestment bank with the understanding that it wouldtake the company public by making a secondary offerwithin an agreed time frame.

• The bought out deal refers to the fact that the investment

bank buys the entire stock meant to be issued to thepublic from the issuer company.

• Usually, within 9 to 12 months the investment bankmakes an offer for sale to the public thereby listing thecompany.



Bought Out Deals

• The risk in a BOD is similar but not exactly the same asthat in firm underwriting.

• In a firm underwriting, the risk is in terms of beingsaddled with stock that would be listed but not having

demand with investors.• In a BOD, the risk is in terms of being saddled with

unlisted stock in case the issue cannot be made due toadverse market trends setting after a bought deal isdone.

• Divi’s lab is good example of a bought out deal in India.

• The first bought out deal ever was done US by CSFB forGMAC.

Investment Banking Underwriting

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