Underwriting in Investment Banking – A Comprehensive Exposition
Whenever we use the word underwriting, a whirlpool of fear grips our nervous system. This is because of the element of risk involved in it. The whole concept of Investment Banking is about risk-taking. If you are sure of what you are doing, you know the process and you know the market rhythm, your fear of risk will be minimized. This is where the underwriter dodges in to evaluate risk. This article will accentuate the overall aspects of Underwriting in Investment Banking. Let us learn how underwriting is a useful pillar in Investment Banking.
Underwriting as the word states means to write underneath. It is derived from the English word “underwritten” which means “write at the foot of”. Are you aware of what purpose this concept of underwriting was incepted? Are you aware of the origin of underwriting? Want to know? Please read this interesting article further.
Birth of Underwriting
The origin of underwriting is a very interesting fact. All began at a coffee shop. Around 1680, Edward Lloyd started a coffee shop in London’s Tower Street. It was named Lloyd’s Coffee House. Soon this coffee house became popular. It became an engaging place for sailors, ship owners, merchants, and bankers. People used to discuss over here regarding various news topics about the ships and other intellectual discussions gained ground, But the most prominent was the talk about the ships and maritime auctions.
Seeing the current discussions and analyzing the situation the bankers started gathering premiums in exchange for the risks of ships for the announced routes. The ships were listed by providing the details of their destination, cargo, crew and weather. Seeing the listed ships, the bankers used to write their names under the ships for identification. This is how the word “underwriting” came into existence and people started using it.
As the origin of the term underwriting has been discussed, now let us see the definition of the word underwriting to make our concept more transparent.
Underwriting means that a person is taking risks out of their wish. Not only an individual it can be an institution also. So, if put together in simple terms underwriting means a process where a company or a person risks themselves in exchange for something.
In investment banking underwriting is a means of raising funds from the investor to the investee. The investment bank acts as a middleman between both parties. An example can help to understand the situation in a better way.
In this scenario, let us assume that AB is a company that requires money for a project, FG is the investment bank and LM is the investor. Say, AB wants monetary benefit for a project. They want to do it by raising capital. So, they contacted FG Investment Bank. Now FG, will go through the data of AB company, check the properties, and check the financial statements and financial position. Then they will assess the risk. After assessing the risk, they will price new shares in the market. Then they look out for the investors who are willing to invest in the project. LM company finalizes the deal. They are the investors. FG investment bank while assessing the risk has underwritten the documents, that AB company will receive so and so amount. This is how the underwriting process works.
Underwriting in investment banking is all about assessing the risk. To raise capital, the bank should inflate the IPOs. This is where the risk is associated. The investment banks underwrite the securities. This acts as a guarantee for the firms, that the investment bank will help in raising the amount. Then who bears the risk? The investment banks of course. This is the reason why investment banks charge heavy amounts at the time of the underwriting process.
As we have got the idea of what underwriting is and what it all deals with, now let us take a peek at the process of underwriting. This will help to know better how the underwriting is processed in investment banks.
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Process Flow of Underwriting in Investment Banking
The underwriting in investment banking is a key element. It is one of the most vital services provided by the investment banks. The process flow of the underwriting section helps us to know the initiatives the banks take for the smooth functioning of the business. It also helps us determine the amount of time it takes to process underwriting work. Below mentioned are the steps.
- Choosing the investment bank: The very first step that the company should take is that they would take guidance from which investment bank. There are many investment banks and many types of investment banks. So, an entity or individual can check from which bank they are going to raise the capital.
- Risk Measurement: After the company seeks aid from the investment bank the bank goes through the project for which the capital will be raised, the company details, financial position of the company and other details as required. By doing this, the bank analyses the risk and sets the price for the shares or stocks.
- Marketing and Securities Valuation: The third step is the most important. That is marketing and pricing. The bank prepares its marketing team to pitch the investors for the projects. After this, comes the valuation. The investment bank structures the deal, and they strategize which securities to use like shares, stocks or other financial instruments. They also decide the pricing or share value, how to be issued and other details of the financial transaction.
- Underwriting: The bank and the company decide which type of underwriting they are going to select. Based on it the risk is determined, if they are going to spread the risk or the bank is only going to buy entire securities and pay the company the decided price.
- Approach to investors: After all the above aspects are set, the banks start marketing the shares to the investors and details about the project are also provided. They convince the investors to aid in raising the funds.
- Selling and Monitoring the Securities: Once the investor is ready, they sell the securities. Then they guide, the investment banks to monitor the performance of the securities in the market.
This is the full process of underwriting in investment banking. It involves a deep knowledge and hard work of the underwriters and other team members to make a deal successful. Saying this, are you guessing the job role of underwriters or who are underwriters? Yes! We will discuss it later in this article.
Underwriting Consulting Services
This involves the stages taken by the investment bank or the underwriter after the issuing company signs up with the investment bank to raise capital through underwriting. The advisory services of underwriting are as follows:
- Planning: In this stage, the underwriter studies the type of investment made. They check the investor’s interest in the required field and their demand.
- Timing Demand: Time is always a necessary factor in the field of underwriting. The underwriter takes a close watch on the market demand, what the investor needs, investors demand, similar entities that are going for shares, and the position of the company. These aspects are necessary to judge.
- Issue Structure: This is the last step. This aspect discusses how to organize the issue that will be beneficial for the company and investment banking to deal with.
Types of Underwriting
After the borrower company selects the investment bank, the bank takes the steps forward. The main assurance the bank provides to the company determines the types of underwriting. Following are the three main types of underwriting in investment banking.
In this type of underwriting, the underwriter is not blameworthy for the financial deal. This means when the deal is made between the company and the bank, the bank assures to sell all or most of the security issuance at an agreed price. But if they are not able to do so after their best efforts, the underwriter is not responsible for any deal. This is the most appreciated type of underwriting.
As the name suggests, the firm commitment means commitment by the firm. In this sort of underwriting, the investment bank buys the entire issue at a definite price. So, the borrower company need not have to share the risk for unsold issues. If the issues are not sold the investment bank is responsible for it.
This is the last type of underwriting process. Here, if all the issues are not sold out entirely, the deal stands null and void. As the deal is void, the bank also does not receive any compensation.
Now we know in detail about underwriting, types of underwriting and the process of underwriting in investment banking. Can you tell me who does all these underwriting jobs? An underwriter. Is that enough? No, let us see who an underwriter is and what is the role of an underwriter.
Who is an Underwriter
After going through this article we can guess that an underwriter is an individual who is responsible for underwriting jobs.
The definition of underwriter is the person or individual who measures the risk involved for the investor. The underwriter works for an investment bank. The underwriter mainly focuses on quantifying and evaluating the risk involved for the investor. They also see to it that all the securities are sold out, if not then the underwriter is responsible for the loss incurred by the organization.
So to perform this activity in an orderly and efficient way, the underwriter goes through many of the financial documents of the borrower company. After going through all the details underwriter informs the company about how much risk is involved and how much price is to be set for the issues. It is a hard job, there is too much labour to be given for the job to be done. They require deep knowledge and understanding of market situations and analysis part. They need to have deep knowledge of all the current rules and regulations regarding investment banking.
Types of the Underwriter
Underwriters are the risk evaluators. They are the people who evaluate the risk. Usually, there are 4 types of underwriters.
In this case, the underwriters are responsible for the risk involved while providing a loan to an applicant. See this instance, a person is applying for a car loan. Then the underwriter checks the risk for the car loan.
The function of a mortgage underwriter is similar to a loan underwriter. For example, a person wants to get a house loan. The mortgage underwriter measures the risk involved through it and then confirms if the applicant is eligible for the house loan or not.
The insurance underwriters assess the risk of the applicants whoever is applying for insurance. It may be car insurance, health insurance, home insurance and life insurance. They check if the applicant is eligible to qualify for the policy or not. If not, they provide the applicant with the insurance for which they qualify. They make the contracts profitable for the insurer.
Underwriting in investment banking makes a house for securities underwriters. These underwriters deal with shares. They assess the risks involved from the borrower entity and decide the price of the shares. If all the securities are not sold at the said price sometimes the investment bank is responsible for the due loss. So, in this scenario, these underwriters are different from other types of underwriters. The risks involved for these underwriters are more than the others.
These were the types of underwriters bifurcated based on the activities or functions they perform. In all situations, the key job of the underwriter is to evaluate risk, to assess it, and to measure it. Evaluating risk is the key factor for the survival of investment banks. Not only in underwriting, in investment banks risk is a crucial subject matter, and analyzing it is its most challenging job performance.
Roles of the Underwriter
As we have seen the underwriters hold a significant place in investment banks, are you aware of the various functions that they are associated with? Below are the roles of the underwriter.
We are well aware that the key role of the underwriter is to assume the risk. The risk that is related to the securities. The success or failure of this can make the investment bank as well as the issuing company suffer.
The next in the series is the underwriter’s aid in the preparation of the prospectus. This prospectus termed as Draft Red Herring Prospectus is prepared when the issuing company decides to for IPO. This prospectus is a norm that is maintained by SEBI (Securities and Exchange Board of India). Here the issuing company has to fill in the financial and other details.
The next job that comes along with this is they provide a guarantee of the selling of as much as shares as possible.
The last aspect is that they offer guidance in regulatory compliance. They assist the entities with the various norms regarding SEBI and others as such.
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Impact of Underwriting on Investment Banking
As per this article, we have discussed in full the overview of underwriting and underwriters. Will it not be beneficial for us to know how underwriting is impacting investment banking?
Underwriting in investment banking is an important subject of concern. We all know that investment banks work on raising capital from investors through shares, stocks, and other financial tools. It makes it move according to the market situation. The market is the nerve of investment banking. So, we can blindly say that investment banks are surrounded by risk. Where risk prevails, there is more money.
The work of underwriting is mainly to asses this risk. The impact of underwriting in investment banking is more important than other spheres of underwriting because, in investment banking, the underwriters deal with shares or IPOs.
When an entity approaches an investment bank to raise capital through underwriting, the underwriters start on with their job. The underwriters check on all the financial details about the company and measure the risks. In some types of underwriting the underwriters buy all the shares and are responsible for selling all the shares for a decided price. So, we can see that the underwriter not only decides the quantity of risk involved in a project but also based on his review the prices of IPOs are shared.
By seeing the above aspects, we can say that underwriting is hugely impacting investment banks. As we have read based on the decision of underwriters the shares price is decided. So, the underwriter has to be careful for the investor, investee, and investment banks. If the IPOs are not sold out with the fixed amount, then the investment banks bear losses.
Underwriters set the prices and create a market for securities too. This also impacts the investment banks. If the price of the securities does not get a proper valuation, then the banks suffer losses. In the underwriting process, the investment banks draw profit from the entity that is willing to raise capital. The investment bank receives its shares of profit from the entity by selling the securities. During this underwriting process, investment banks take a heavy amount in their accounts. Thus the investment bank fetches a lot of benefits from its underwriting service.
These are some of the aspects that impact investment banking. These features make underwriting an important process of investment banking.
Well, it is time to end the article. As a note of ending it can be said that underwriting in investment banking is an important process. This is the process that helps investment banks to gain hefty amounts from their clients. This interesting process of underwriting is a bit complex but once you catch the rhythm, know the market, gain lots of information about companies, and have ample knowledge and experience in the field then the sky is your limit in this arena. Underwriting is all about assessing the risk and taking risks in exchange for money. There are many types of underwriting each with various functionality. A career as an underwriter will also help you in earning a lot of money. The job role will demand analyzing risk, data research, data study, market study, and self-belief. These factors will help you in setting your career. The underwriting process involves a lot of challenges but is surely a very interesting subject to deal with. Enjoy reading the article!!
Frequently Asked Questions (FAQs)
1. Is underwriting in investment banking different from underwriting in insurance?
Underwriting in investment banking does differ from underwriting in insurance. Underwriting in insurance involves insurance like car, house, health and life insurance. However, the underwriting in investment banking involves IPOs. They have more responsibilities and more risks are involved in their profile.
2. Do underwriters earn commission?
Yes, the underwriters earn commissions from their deals. They are eligible for commissions and premiums as they assess the risk and underwrites for the issuing company. Underwriting acts are a great relief for the companies as they know that the investment bank will help them to raise the money and in some cases take the full responsibility to take the risk.
3. Is an underwriter a good career option?
As India is the fifth largest economy, many investment banks and business houses are counting on India as its next hub. The number of investment banks is increasing, which will provide more scope for many people aspiring to enter the financial world. As per Glassdoor, the average salary for an underwriter is Rs.741889 per year.
4. What are the academic checkpoints needed to be an underwriter?
Underwriting in investment banks involves a lot of academic checkpoints. The candidate has to earn a degree in bachelors in a related field or anything. But the aspirer should be aware of maths, economics, finance and the business.