If an entity decides to raise funds through an equity or debt offering, one or more investment banks will also underwrite the securities. This means the institution buys a certain number of shares (or bonds) at a predetermined price and re-sells them through an exchange.
Suppose Acme Water Filter Company hopes to obtain $1 million in an initial public offering. Based on a variety of factors, including the firm’s expected earnings over the next few years, FedericiInvestment Bankers determines that investors will be willing to pay $11 each for 100,000 shares of the company’s stock.
As the sole underwriter of the issue, Federici buys all the shares at $10 apiece from Acme. If it manages to sell all 100,000 at $11, the bank makes a nice $100,000 profit (100,000 shares x $1 spread).
However, depending on its arrangement with the issuer, Federici may be on the hook if the public’s appetite is weaker than expected.
If it has to lower the price to an average of $9 a share to liquidate its holdings, it’s lost $100,000. Therefore, pricing securities can be tricky. Investment banks generally have to outbid other institutions who also want to handle the transaction on behalf of the issuer. But if their spread isn’t big enough, they won’t be able to squeeze a healthy return out of the sale.
In reality, the task of underwriting securities often falls on more than one bank. If it’s a larger offering, the managing underwriter will often form a syndicate of other banks that sell a portion of the shares. This way, the firms can market the stocks and bonds to a more significant segment of the public and lower their risk. The manager makes part of the profit, even if another syndicate member sells the security.