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Lay out how an investment bank can raise funds through a Dutch auction, a firm commitment, best efforts, a public offering or a private placement.

FRM® Part I · Financial Markets and Products · Banks · FRM1.FM.1.e

The idea

An investment bank can raise funds for an issuer in several ways. In a firm commitment the underwriter buys the whole issue at a fixed price and resells it. It therefore bears the risk of unsold securities and earns the spread between its purchase price and the offer price. In best efforts the bank only acts as agent and sells what it can for a commission. The issuer bears the risk of an undersubscribed issue. In a Dutch auction investors bid price and quantity, and bids are ranked from the highest price downward. The clearing price is the lowest price at which the whole issue sells, paid by every successful bidder. A public offering is registered and open to all investors. A private placement goes to a limited group of institutions, avoids full registration, is faster and cheaper, but gives investors less liquidity. Exam point: ask who carries the unsold-securities risk, and remember the single price in a Dutch auction.

A practice question

From the question bank, with the reason each wrong option is wrong.

In a firm commitment underwriting, who bears the risk that the securities cannot be sold to investors at the offer price?

  1. The investment bank, which has bought the whole issue from the issuer at a fixed price. - correct
  2. The issuer, which receives proceeds only for the securities that are in fact sold to investors.Why not: This describes best efforts, not firm commitment.
  3. The issuer and the bank equally, since the spread is split between them as compensation.Why not: The spread is the bank's compensation, not a risk-sharing rule.
  4. The investors who subscribe, since the offer price may be revised after allocation to them.Why not: The offer price is fixed, and investors do not guarantee the sale.

In a firm commitment the underwriter purchases the issue and resells it, so it carries the unsold inventory risk and earns the spread. Under best efforts the issuer keeps that risk.

A harder one

An investment bank underwrites 10 million shares on a firm commitment basis at USD 24 per share, with a public offer price of USD 25. It sells 8 million shares at USD 25 and clears the remaining 2 million at USD 22. The bank's profit on the issue is closest to:

  1. USD 8 million.Why not: Counts the spread on the shares sold and ignores the loss on the unsold shares.
  2. USD 10 million.Why not: Assumes the full USD 1 spread on all 10 million shares.
  3. USD 4 million. - correct
  4. USD 2 million.Why not: Measures the loss on the unsold shares against the offer price of 25 (a loss of 3) instead of the purchase price of 24.

Revenue = 8 x 25 + 2 x 22 = 244 million. Cost = 10 x 24 = 240 million. Profit = 4 million. The spread earned on 8 million shares (8) is reduced by a 2 per share loss on 2 million shares (4).

The hardest tier

A company issues 5 million shares at USD 40 on a best efforts basis, with the bank earning a 3% commission on proceeds raised. The market weakens and only 3.5 million shares are sold. The issuer's net proceeds are closest to:

  1. USD 135.8 million. - correct
  2. USD 190 million.Why not: Takes the full-issue proceeds net of a 5% spread, which would apply under a guaranteed firm commitment but not here.
  3. USD 140.0 million.Why not: Counts only the shares sold at the offer price and forgets the commission.
  4. USD 133.0 million.Why not: Applies a 5% spread instead of the stated 3% commission.

Under best efforts the issuer bears the risk of undersubscription. Gross proceeds = 3.5 x 40 = 140 million, commission = 3% x 140 = 4.2 million, net = 135.8 million.

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