Underwriting

By Prof. Samie

Underwriting - Definition
In the Indian Context underwriting is defined by SEBI as as an agreement with or without conditions to subscribe to the securities of a corporate body when the existing shareholders of such corporate body or the public do not subscribe to the securities offered to them. Underwriting is always in connection with a proposed issue of securities by a corporate body. Underwriting is a service that consists of a contingent obligation to subscribe to an agreed number of securities in an issue if such securities are not subscribed to by the intended investors. Underwriting is primarily a fee-based service.

Sub-Underwriting
Sub-underwriting is used by an underwriter to spread the risk assumed in underwriting an issue of shares. Sub-underwriting is a process under which an underwriter appoints another person to underwrite his or her underwriting obligation. In the third largest rights issue ever by HSBC, Goldman Sachs and JPMorgan underwrote 2.6 billion pounds of the 12.9 billion pound issue. Co-bookrunners BNP Paribas, Credit Suisse and RBS Hoare Govett underwrote1.6 billion pounds each. Over 5 billion pounds had been pledged in subunderwriting.

Underwriting Commission
The underwriters compensation for the services rendered is the fee that is paid by the issuer company. This fee which is known as underwriting commission, is paid as a percentage of the value of underwriting. Underwriting commission is payable irrespective of whether the underwriter ultimately has any requirement to purchase the underwritten securities or not. Underwriting commission should not confused with brokerage that is paid to a stock broker for dealing in shares or for procuring subscriptions.

The Underwriting Process

Devolvement
A devolvement occurs when the under subscription of a security issue forces the underwriting investment bank to purchase unsold securities during an offering. In India, a pubic offer or issue devolves when it fails to attract 90% of the offer size. Devolvement is often an indication that the market currently has negative sentiments toward the issue. This negative sentiment can have a significant impact on subsequent demand.

The Devolvement Notice

The issuer company shall within 30 days after the date of closure of the subscription communicate in writing to the underwriter, the total number of securities remaining unsubscribed, and the number of securities being taken up by the underwriter. The company shall make available to the underwriter the manner of computation of devolvement and also furnish a certificate in support of such computation from the companys auditors. The underwriter shall within 30 days after the receipt of the devolvement notice, make or procure the applications to subscribe to the securities and submit them along with the require payment. In the event of failure of the underwriter fulfill his obligations the company can look into legal action against the underwriter and claim damages.

The Underwriting Agreement

The underwriting agreement is a document that establishes the contract between the underwriter and the issuer company. It forms a part of material contracts for the issue and requires to be approved by the concerned stock exchange apart from being filed with ROC as part of prospectus registration. The SEBI evolved a model underwriting agreement which is recommendatory and should be followed to the extent possible by all the underwriters.

Model Agreement
The model agreement lists out the following main clauses: Amount being underwritten Provision for sub-underwriting Computation of devolvement Procedure for effecting or discharge of underwriting obligations Right to receive commission within statutory stipulation Statutory declaration

Hindalco Rights Issue

Hindalco Industries Ltd. informed NSE vide its letter dated October 15, 2008, that: "The Issue period of the proposed rights issue of 525.8mn equity shares of Hindalco pursuant to the filing of the letter of offer dated September 13, 2008 with the stock exchanges closed on October 10, 2008. As per the provisional data provided by the Registrar, Hindalco had received a subscription of 55.967% of the Issue size, being 294.2mn equity shares in the Issue. As per regulations in India, this rights had devolved and the underwriters were bought into play.

Hindalco Devolvement
Pursuant to the underwriting agreement entered into by the Hindalco with ABN AMRO Asia Equities (India) Limited, ABN AMRO Securities (India) Private Limited, Citigroup Global Markets India Private Limited, Deutsche Equities India Private Limited, DSP Merrill Lynch Limited, State Bank of India (together referred to as the "Underwriters"), dated September 12, 2008, the Committee of the Board of the Company in its meeting approved the issuance of a devolvement notice dated October 15, 2008 to the Underwriters. The notice required the Underwriters to subscribe or procure subscription for equity shares aggregating to 178.9mn at the price of Rs. 96 per equity share, for an amount of Rs. 1717.88 crores

IFCI Sub-Underwriting
IFCI had sub-underwritten Hindalco rights issue and the sub-underwriting contract was struck when the scrip of the company was 30 per cent above their current market prices. The Rs 5,000-crore Hindalco rights issue was priced at Rs 96 per share and the scrip traded at around Rs 65 at the time of the conclusion of the rights issue. IFCI had an agreement with Citibank to sub-underwrite Rs 150 crore of Hindalcos rights issue. Citibank charged underwriting fees of 3 per cent and paid IFCI 1.35 per cent, investment banking sources said.

The case of Wockhardt Hospitals

After a jittery start in late January, Wockhardt Hospitals Ltds IPO eventually succumbed to the volatility in the stock markets. The hospitals major officially withdrew its IPO due to feeble response from investors. Wockhardt Hospitals IPO was subscribed 0.20 times, receiving 4.9mn bids, on the day of the IPOs closing. A company statement, however, said that Wockhardt Hospitals had indeed decided not to proceed with its proposed IPO of 25.08mn equity shares constituting 24.06 per cent of the proposed post-issue paid-up equity share capital of the company. The decision not to proceed with the IPO was made in light of continued global and domestic market volatility and poor market sentiments and the resultant effect on the subscription levels in the IPO.

The case of Wockhardt Hospitals

Wockhardt had slashed its price band from Rs280-310 to Rs225-360 for its Rs800 crore issue that opened on 31 January. It was slated to close on 5 February but was extended by two days to 7 February. It finally had to be shelved as it could sell only 20% of the 25 million shares that it floated. Citibank and Kotak were the book running lead managers for the issue.

The case of Wockhardt Hospitals

In India, there is no hard underwriters to public issues who buy the unsubscribed portion of an issue. However, the merchant bankers do soft underwriting. They are responsible for putting in money if investors, after bidding for shares, do not pay up on allotment. The clause as per disclosure and investment protection (DIP) guidelines where if the book was not built 75%, price remained undiscovered and hence underwriters did not oblige and the underwriters did not shell out a single rupee.

Assessment of an issue for UW

The critical risk factors in underwriting business are :
Devolvement probability Devolvement quantum Capital loss from devolved securities

In order to mitigate this risk, the critical success factors for an underwriter are capital adequacy and the capacity to procure subscriptions. The capacity to procure depends upon the distribution network and investor base of an underwriter and the marketability of an issue. While underwriters build an expansive network of brokers, sub-brokers and marketing agents over a period of time, the have to carefully assess the marketability of every issue that they underwrite.

Assessment for UW
Assessment of an issue for underwriting should always be made from an investors perspective since the issue is successful only when it finds favor with investors. Institutional investors generally look at medium term growth while retail investors tend to look at short-term profit booking within the first three to six months. Institutional investors are driven more by fundamentals of the issue and are therefore keen to wait for appreciation in the market price over a longer time frame. The success of the issue depends on a lot of factors including industry, pricing of an issue, fundamentals of the issue, past track record, soundness of the business plan, financial performance, level of brand visibility.

Assessment for UW
Retail investors are driven more by profit motive and arbitrage opportunities than by fundamentals. Therefore what matters more to retail investors is affordability and possibility of price appreciation. Keeping the mind-set of investors in perspective, the underwriter should look at the potential of the issue to meet these expectations and their own distribution strengths to reach these investors. Many underwriters develop a strong and loyal investor base that can support significant number of issues.

Types of UW
There are broadly two types of underwriting Firm underwriting Best effort underwriting In firm underwriting, the underwriter enters into a purchase agreement with the issuer and the purchase price is fixed a day before or usually on the morning of the date on which the registration statement becomes effective. By this time, the underwriters would have completed the road shows and marketing and would have practically pre-sold the issue to investors although technically, investor bids cannot be accepted until registration statement becomes effective.

Types of UW
In best effort underwriting, which is very uncommon in the US as well as Indian market, the underwriting is more on the lines of an agency function as is the case with brokerage houses in India. The investment banks would make best efforts to sell the stock and whatever is not sold is not issued by the company. Therefore, in this model there is not contract for purchase and sale by the underwrite and there is only an agreement to market the securities.

Safety Net
Safety Net is a mechanism whereby an issuer company enter into an understanding with its merchant bankers or underwriters or any other financial intermediary to provide a limited period facility to investors subscribing to the issue. The arrangement would be to provide the investors with a buyback facility for the securities subscribed by them in the public issue at the issue price. For example, if an investor has been allotted 100 securities in a pubic issue at a price of Rs. 60 per share, if a safety net has been offered by the company the investor may choose to sell all or any of those securities to the Safety Net provider for a price of Rs. 60 per security

Safety Net
SEBI has imposed certain regulations on the operation of a safety net keeping view the need for such facility to be provided only for small investors. The following regulations apply to safety net arrangements:
Any safety net scheme or buyback arrangement of the shares shall be finalized by issuer company with the lead merchant banker in advance and disclosed in the prospectus. Such buyback or safety net arrangement shall be made available only to all original residents individual allotte. Such buyback or safety net facility shall be limited up to a maximum of 1000 securities per allotte and the offer shall be valid at least for a period of six months. The financial capacity of the person making available buyback or safety net facility shall be disclosed in the draft prospectus

Safety Net
Safety Net is an additional protection that may be made available by an issuer company to small investors entirely at its option. Issuer company usually do this as a marketing factor for the issue. Providing a safety net in a high price issue may also send a signal to prospective investors about the confidence of the company in its pricing and post issue performance of the scrip. Safety Net was used in some public issues in earlier years such as Infotech Enterprises Limited and IDBI.

Bought Out Deals

Bought Out deals were a common occurance in the IPO in the early 90s in India during which several companies went public through a BOD and a subsequent offer for sale to the public. BOD is an alternative to a straight IPO where by a company places certain amount of stock with an investment bank with the understanding that it would take the company public by making a secondary offer within an agreed time frame. The bought out deal refers to the fact that the investment bank buys the entire stock meant to be issued to the public from the issuer company. Usually, within 9 to 12 months the investment bank makes an offer for sale to the public thereby listing the company.

Bought Out Deals

The risk in a BOD is similar but not exactly the same as that in firm underwriting. In a firm underwriting, the risk is in terms of being saddled with stock that would be listed but not having demand with investors. In a BOD, the risk is in terms of being saddled with unlisted stock in case the issue cannot be made due to adverse market trends setting after a bought deal is done. Divis lab is good example of a bought out deal in India. The first bought out deal ever was done US by CSFB for GMAC.