Concessions

Concessions, in the realm of Corporate Finance, refer to the fees or discounts paid by a company (the issuer) to the underwriters for their services in facilitating a securities offering. These fees compensate the syndicate of financial institutions for the risks and efforts involved in distributing new securities to investors. Concessions are a critical component of the total cost associated with bringing new stocks or bonds to the financial markets.

History and Origin

The concept of concessions emerged alongside the development of organized securities markets and the practice of underwriting new issues. As companies sought to raise capital from a broader base of investors, the role of intermediaries became essential. Early forms of underwriting involved direct purchases of new issues by a few wealthy individuals or institutions. However, as capital needs grew, a more formalized system evolved where investment banks guaranteed the sale of an entire issue.

This guarantee, known as a firm commitment underwriting, required compensation for the risk assumed by the banks. The compensation, or spread, included the profit margin for the lead underwriter and portions allocated to other syndicate members as concessions for their sales efforts. The practice became more standardized with the growth of modern capital markets and regulatory frameworks. For instance, former SEC Chairman Arthur Levitt highlighted the evolution of underwriting practices and the critical role of these fees in the IPO market's development and integrity.³²

Key Takeaways

• Concessions are fees or discounts paid to underwriters and selling group members in a securities offering.
• They compensate financial intermediaries for their role in distributing new securities and assuming market risk.
• Concessions are a major component of the total costs incurred by issuers in a public offering.
• The size of concessions can vary based on market conditions, the issuer's risk profile, and the type of security being offered.
• These fees are disclosed in the offering's prospectus.

Formula and Calculation

Concessions are typically expressed as a percentage of the public offering price per security. The total underwriting spread, or gross spread, is the difference between the price at which the underwriting investment bank purchases the securities from the issuer and the public offering price. This gross spread is then divided among the syndicate members, with different components for the managing underwriter, syndicate members, and selling group members.

The formula for the total concession per share can be represented as:

This total concession is then distributed among the syndicate, often broken down into:

• Manager's Fee: Compensation for originating and managing the offering.
• Underwriting Fee: Compensation for assuming the risk of purchasing the securities from the issuer.
• Selling Concession: Compensation for selling the securities to investors. This is the portion typically passed on to selling group members who do not underwrite the issue but participate in its distribution.

For example, if a security is offered to the public at $100 per share, and the underwriting syndicate purchases it from the issuer at $97 per share, the total concession (gross spread) is $3 per share. This $3 is then allocated internally.

Interpreting the Concessions

The size of the concessions reflects several factors, including the perceived risk of the offering, the demand for the securities, and the amount of effort required for distribution. Higher concessions might be offered for riskier issues or those requiring more marketing to attract retail investors and institutional investors. Conversely, highly anticipated offerings with strong demand may command lower concessions.

Concessions also signify the underwriter's commitment and the value they place on their role in ensuring a successful sale. A significant concession implies that the underwriter is taking on more risk or expending greater effort to place the securities effectively. The transparency of these fees, typically detailed in the prospectus, allows investors and market participants to assess the cost structure of a public offering.

Hypothetical Example

Consider "TechInnovate Inc." planning its Initial Public Offering (IPO) to raise capital. TechInnovate wants to issue 10 million shares of equity at a public offering price of $20 per share.

An investment bank, "Global Capital Markets," agrees to underwrite the offering. They agree to purchase the shares from TechInnovate at $19.00 per share. The difference of $1.00 per share represents the total concession (or gross spread).

Global Capital Markets then forms a syndicate with other banks to distribute the shares. The $1.00 per share concession is broken down as follows:

• Manager's Fee: $0.20 per share (for Global Capital Markets' role in leading the IPO).
• Underwriting Fee: $0.30 per share (shared among Global Capital Markets and other syndicate members for bearing the risk).
• Selling Concession: $0.50 per share (paid to all firms, including those in the selling group, for each share they successfully sell to investors).

If an investor purchases a share at $20, TechInnovate receives $19, and the remaining $1 is distributed as concessions among the various intermediaries involved in the public offering.

Practical Applications

Concessions are primarily observed in securities offerings, particularly Initial Public Offerings and subsequent offerings of equity or debt. They are the core compensation mechanism for investment banks and their syndicates involved in underwriting. These fees incentivize the extensive due diligence and marketing efforts required to ensure a successful placement of securities in the market.

In the U.S., the detailed breakdown of underwriting discounts and commissions, including concessions, is a mandatory disclosure in SEC filings such as the prospectus. The U.S. Securities and Exchange Commission (SEC) provides guidance on how to create clear disclosure documents, which include these financial details.³¹ The structure of these fees is integral to the economics of investment banking, as explored in academic research focusing on the compensation and incentives within the underwriting process.³⁰

Limitations and Criticisms

While concessions are a fundamental aspect of the capital-raising process, they have faced scrutiny and criticism. One common critique revolves around the standardization and perceived rigidity of underwriting fees, particularly the 7% "IPO tax" often cited for middle-market IPOs. Critics argue that technological advancements and increased competition should lead to lower fees, yet the standard percentage has remained relatively static for certain types of offerings.²⁹

Another limitation stems from potential conflicts of interest. The fixed nature of concessions might disincentivize underwriters from negotiating the best possible price for the issuer, as their compensation is tied to the volume sold rather than the final trading performance of the stock. Market conditions can significantly impact the profitability of concessions for investment banks, especially during periods of market downturns when dealmaking slows, leading to a sharp reduction in investment banking fees.²⁸ This volatility underscores the risk assumed by underwriters and the potential for reduced returns on their capital and effort.

Concessions vs. Underwriting Fees

While often used interchangeably in general discussion, "concessions" and "underwriting fees" represent distinct components of the total compensation structure in a securities offering.

| Feature | Concessions Concessions are essentially what a group of underwriters and selling agents earn from helping a company sell its new securities to the public. It's the profit margin they get for handling the sale, typically expressed as the difference between the price they pay the issuer and the price at the public offering.^{1234567891011121314151617181920212223242526}