Economic underwriting spread

Economic Underwriting Spread: Definition, Formula, Example, and FAQs

The economic underwriting spread is the difference between the price at which an investment bank or syndicate of underwriters buys securities from an issuing company and the higher price at which they sell those securities to the public in a primary market offering. This spread represents the gross profit margin earned by the underwriters for their services in facilitating the capital raising process. It is a fundamental concept within the broader field of Investment Banking, reflecting the compensation for the risk and effort involved in bringing new securities to market.

History and Origin

The concept of underwriting, and consequently the economic underwriting spread, has roots in the long history of financial intermediation. Early forms of investment banking emerged in the 19th century as merchant bankers financed infrastructure projects and underwrote government bonds. The industry evolved significantly in the early 20th century, particularly in the United States, as financial markets expanded and public stock ownership surged.¹⁵,¹⁴

A pivotal moment in the history of investment banking and its underwriting practices was the passage of the Glass-Steagall Act in 1933. Enacted in response to the Great Depression, this legislation aimed to restore public confidence in the banking sector by separating commercial banking from investment banking activities.¹³,¹² Among its key provisions, Glass-Steagall prohibited commercial banks from participating in securities underwriting, thereby formally delineating the roles of deposit-taking institutions and those involved in the issuance and distribution of securities.¹¹, While the Glass-Steagall Act was largely repealed by the Gramm-Leach-Bliley Act in 1999, which allowed for the re-integration of commercial and investment banking, the fundamental role of the underwriter and the economic underwriting spread remained central to the capital raising process.¹⁰

Key Takeaways

• The economic underwriting spread is the difference between the price underwriters pay for securities and the public offering price.
• It serves as compensation for the investment bank's services, including risk assumption, due diligence, and distribution.
• The size of the spread is influenced by factors such as the issuer's creditworthiness, market conditions, and the complexity of the offering.
• Regulatory bodies like FINRA and the SEC oversee underwriting practices and compensation to ensure fairness and transparency.

Formula and Calculation

The economic underwriting spread is calculated as the difference between the public offering price (POP) of a security and the price at which the underwriting syndicate purchases the securities from the issuer. In the context of an initial public offering (IPO)), this can be expressed as:

Where:

• Public Offering Price (POP) is the price per share at which the securities are offered to the investing public.
• Price Paid to Issuer is the price per share at which the underwriting firm or syndicate buys the securities directly from the company or entity issuing them.

This spread often comprises several components, including a manager's fee, an underwriting discount, and a selling-group concession, which are distributed among the various parties involved in the offering.⁹

Interpreting the Economic Underwriting Spread

Interpreting the economic underwriting spread involves understanding the factors that influence its size and what it signifies about an offering. A larger economic underwriting spread generally reflects higher perceived risk assessment associated with the offering, greater effort required for distribution, or less competition among underwriters. For instance, a small, unproven company conducting an IPO might have a wider spread due to the higher perceived risk and the increased marketing effort required to sell its shares. Conversely, a well-established company issuing additional shares might command a narrower spread.

The spread also compensates the syndicate members for their capital commitment and the potential risk of not being able to sell all the shares at the public offering price. It reflects the market's assessment of the issuer's quality and the demand for the securities.

Hypothetical Example

Consider "GreenTech Solutions Inc.," a company seeking to raise capital through an IPO. GreenTech plans to issue 10 million shares of new equity securities. They engage "Global Capital Partners," an investment bank, to underwrite the offering.

After extensive due diligence and market analysis, Global Capital Partners agrees to purchase the 10 million shares from GreenTech at $19.00 per share. Global Capital Partners then sets the public offering price for investors at $20.00 per share.

The economic underwriting spread per share is calculated as:

For the entire offering of 10 million shares, the total economic underwriting spread earned by Global Capital Partners for its capital raising services would be:

This $10 million represents Global Capital Partners' compensation for underwriting the IPO, covering their costs, risks, and profit.

Practical Applications

The economic underwriting spread is a critical component in various financial transactions where new securities are issued. Its most prominent application is in:

• Initial Public Offerings (IPOs) and Secondary Offerings: As illustrated, the spread is the primary means by which investment banks are compensated for underwriting new stock issuances. Similarly, in secondary offerings where existing shares are sold, an underwriting spread is charged.
• Debt Issuances: When corporations or governments issue debt securities (like bonds), underwriters purchase these from the issuer at a discount and sell them to investors at par or a premium, with the difference constituting the economic underwriting spread.
• Mergers & Acquisitions (M&A): While M&A advisory fees are distinct, if an M&A transaction involves the issuance of new securities to finance the deal, the underwriting portion of that financing will include an economic underwriting spread.

Regulatory bodies closely monitor underwriting spreads and associated compensation. For example, the Financial Industry Regulatory Authority (FINRA) has rules, such as FINRA Rule 5110 (Corporate Financing Rule), that govern underwriting terms and arrangements in public offerings to ensure they are fair and reasonable.⁸,⁷ The U.S. Securities and Exchange Commission (SEC) also has comprehensive regulations for regulatory compliance concerning the registration and sale of securities, which implicitly impacts how underwriting spreads are structured and disclosed.⁶,⁵,⁴ Investment banks, often acting as broker-dealer firms, must comply with these stringent requirements.

Limitations and Criticisms

While the economic underwriting spread is a necessary compensation for the significant services and risks undertaken by underwriters, it is not without its limitations and criticisms. One common critique revolves around the potential for conflicts of interest. An investment bank, acting as a financial intermediary, may have an incentive to maximize its economic underwriting spread, which could theoretically influence the pricing or timing of an offering in a way that is not optimally aligned with the issuer's long-term interests or the market's true valuation. Regulatory oversight aims to mitigate such conflicts.

Another limitation is that the size of the spread can be influenced by various financial markets conditions and issuer-specific factors, which may not always be transparent. Factors such as issue quality, term to maturity, issue size, and the degree of competition among underwriters can all affect the spread.³,² Furthermore, while the spread covers the underwriter's compensation, issuers also incur other substantial costs during a public offering, such as legal, accounting, printing, and regulatory registration fees, which are separate from the economic underwriting spread.¹

Economic Underwriting Spread vs. Underwriting Expenses

It is crucial to distinguish between the economic underwriting spread and underwriting expenses. While both relate to the costs and compensation involved in underwriting, they represent different financial concepts.

In essence, the economic underwriting spread is the compensation the underwriter earns for their services, whereas underwriting expenses are the costs the underwriter incurs to provide those services. A profitable underwriting engagement means the economic underwriting spread is greater than the underwriter's associated underwriting expenses.

FAQs

Q1: Is the economic underwriting spread always a fixed percentage?
A1: No, the economic underwriting spread is not always a fixed percentage. While it is often expressed as a percentage of the offering price, the actual dollar amount and percentage can vary significantly based on factors like the type of security, the size of the offering, market conditions, the perceived risk of the issuer, and competition among investment banks. It is typically negotiated between the issuer and the lead underwriter.

Q2: Who pays the economic underwriting spread?
A2: The economic underwriting spread is effectively borne by the issuing company. While the underwriters collect the difference, the issuer receives a net amount for their securities that is less than the price paid by public investors. It is the cost the issuer pays to the underwriting syndicate for their services and the assumption of risk.

Q3: What role does due diligence play in the underwriting spread?
A3: Due diligence is a crucial process performed by underwriters to thoroughly investigate the issuing company's financials, operations, and legal standing. The findings from due diligence directly impact the underwriter's assessment of risk, which in turn influences the size of the economic underwriting spread they will demand. A more complex or risky due diligence process may lead to a wider spread.