Underwriting fees

What Are Underwriting Fees?

Underwriting fees are the compensation charged by financial institutions, typically investment banks, for their role in facilitating the issuance of new securities to investors. These fees fall under the broader category of investment banking services within capital markets. They represent the cost incurred by an issuer, such as a corporation or government entity, for services like risk assessment, pricing, marketing, and distribution of an offering. Underwriting fees compensate the underwriters for assuming the financial risk of buying the securities from the issuer and reselling them to the public, or for their best efforts in finding buyers.

History and Origin

The term "underwriting" originated in the 17th century within the Lloyd's of London insurance market. Financial backers, who accepted a portion of the risk for a venture (historically, sea voyages with the associated risks of shipwreck), would literally write their names "under" the risk information on a slip. This established the concept of accepting financial risk for a fee.¹⁴ Over time, this practice evolved and expanded into other financial sectors, notably investment banking, where institutions began to "underwrite" new issuances of financial instruments. By guaranteeing the sale of new stocks or bonds, investment banks adopted the underwriter's role, ensuring a company could raise capital while taking on the risk of selling the securities themselves.

Key Takeaways

• Underwriting fees are the primary compensation investment banks receive for managing and distributing new securities offerings.
• These fees are typically calculated as a percentage of the total proceeds of the offering, known as the "underwriting spread."
• The fees compensate underwriters for services like pricing, due diligence, marketing, and assuming the risk of unsold securities.
• Factors such as offering size, issuer reputation, market conditions, and the complexity of the deal influence the level of underwriting fees.
• Underwriting fees are a significant cost for companies undertaking a public offering, impacting the net capital raised.

Formula and Calculation

Underwriting fees are typically expressed as a percentage of the total gross proceeds of the securities offering. This percentage is known as the underwriting spread or discount. The formula to calculate underwriting fees is:

Where:

• Underwriting Spread: The percentage charged by the underwriter, representing the difference between the price at which the underwriter buys the securities from the issuer and the public offering price.
• Gross Proceeds of Offering: The total value of the securities offered to the public before deducting any fees or expenses.

The underwriting spread can vary, often ranging from less than 1% for large, stable debt offerings to 7% or more for smaller, riskier initial public offerings (IPOs).¹³,¹² For very small deals, a "nonaccountable expense allowance" might be added, increasing the total compensation.¹¹

Interpreting Underwriting Fees

Underwriting fees provide a critical insight into the cost of capital raising and the perceived risk of an issuance. A higher underwriting fee often indicates a higher level of risk assumed by the underwriter or a smaller, less liquid offering. Conversely, lower fees are typically associated with larger, more established companies and highly sought-after offerings, reflecting lower risk and easier distribution for the underwriting syndicate.

The fees also reflect the extensive work performed by the underwriters, including market analysis, investor targeting, and compliance with regulatory requirements. The transparency of these fees is essential, as they are generally disclosed in the offering documents, such as the prospectus.¹⁰ Issuers with strong financials or high investor demand may be able to negotiate lower fees.⁹

Hypothetical Example

Imagine "TechInnovate Inc." decides to go public through an IPO. They aim to raise $100 million by issuing 10 million shares at a public offering price of $10 per share. After negotiations, they agree with their investment bank on an underwriting spread of 7%.

1. Calculate Gross Proceeds:
   Gross Proceeds = 10,000,000 shares * $10/share = $100,000,000

2. Calculate Underwriting Fees:
   Underwriting Fees = 7% of $100,000,000 = $7,000,000

In this scenario, TechInnovate Inc. pays $7 million in underwriting fees. This means that out of the $100 million raised from investors, the company will receive $93 million ($100 million - $7 million) before other offering expenses. These fees compensate the underwriters for their due diligence, marketing, and distribution efforts.

Practical Applications

Underwriting fees are prevalent in various financial transactions, most notably in the primary market for:

• Initial Public Offerings (IPOs): When private companies first offer shares to the public. Underwriters facilitate the sale of shares, determine the offering price, and provide market support.
• Secondary Offerings: When existing public companies issue new shares or bonds to raise additional capital.
• Debt Offerings: When corporations or governments issue new bonds to borrow money. The underwriting process ensures the debt instruments are priced appropriately and distributed to investors.
• Mergers and Acquisitions (M&A) Advisory: While not direct underwriting, investment banks charge fees for advisory services that can involve capital raising components for transactions.

These fees are critical revenue streams for financial institutions, compensating them for the expertise and risk assessment involved in evaluating and executing complex financial transactions. Academic research often scrutinizes these fees; for example, some studies investigate how underwriter influence might impact the distribution of IPO profits.⁸

Limitations and Criticisms

Underwriting fees, while essential for facilitating capital formation, face several criticisms:

• High Costs: Critics, including organizations like the OECD, have pointed to the substantial nature of underwriting fees, particularly for IPOs, suggesting they can be "akin to tacit collusion." In the U.S., the median underwriting fee has often been around 7% of total IPO proceeds, and can be higher for smaller offerings.⁷
• Information Asymmetry: Issuers often rely heavily on underwriters for pricing and market access, potentially leading to situations where the offering price is set too low. This "underpricing" effectively acts as a hidden fee, as the issuer receives less money than the market might have been willing to pay.⁶
• Conflicts of Interest: Underwriters serve multiple clients, including the issuer and institutional investors. This can create potential conflicts of interest, for instance, if an underwriter prices an IPO favorably for their long-term institutional clients rather than solely maximizing proceeds for the issuer. Research has explored the relationship between underwriter influence and abnormal underwriting fees, suggesting that greater underwriter influence can sometimes lead to a larger share of IPO interest distribution for the underwriter.⁵
• Market Maturity: In less developed financial markets, the amount of underwriting fees paid by IPO firms can be a more significant indicator of investment risk than the underwriter's reputation. As markets mature and regulations strengthen, reputation tends to become a more dominant factor.⁴

Underwriting Fees vs. Issuing Costs

While closely related, underwriting fees are a specific component of broader issuing costs.

Underwriting fees are the largest single component of issuing costs for most public offerings. Issuing costs encompass all the expenditures required to prepare, register, and distribute a new security, making them a more encompassing financial term.

FAQs

What are underwriting fees for an IPO?

For an Initial Public Offering (IPO), underwriting fees are the charges collected by the investment banks that manage the offering. These fees compensate the banks for their expertise in pricing the shares, marketing them to investors, and often for guaranteeing the sale of a certain number of shares. They are typically a percentage of the total amount of money raised in the IPO.

Are underwriting fees negotiable?

Yes, underwriting fees can be negotiable. The exact percentage depends on various factors, including the size and type of the offering, the reputation and financial strength of the issuer, the prevailing market conditions, and the complexity or perceived risk of the deal. Issuers with strong financials or high investor demand may be able to negotiate a lower underwriting spread.²

How do underwriting fees impact the issuer?

Underwriting fees directly impact the net proceeds an issuer receives from a securities offering. The higher the fees, the less capital the company ultimately raises. These fees are a significant cost of going public or issuing new equity or debt, influencing the overall financial strategy of the company.

Do insurance companies charge underwriting fees?

While the term "underwriting" originated in insurance, most insurance companies do not typically charge a separate "underwriting fee" in the same way investment banks do for securities. Instead, the costs of underwriting—which involve assessing risk and determining premiums—are usually integrated into the overall premium paid by the policyholder. Som¹e may charge nominal administrative fees.