Underwriting

There are two main underwriting arrangements. In a firm commitment (standard for IPOs and most large offerings), the underwriter buys the entire issue from the company at a negotiated price and resells it to investors — the bank guarantees the company its proceeds and absorbs the loss if shares go unsold, so it bears full placement risk. In a best efforts arrangement, the underwriter agrees only to try to sell the securities and acts as an agent; unsold securities are returned to the issuer and the bank bears no inventory risk. Firm commitment is more common and more lucrative because of the risk taken; best efforts is used for riskier or smaller issuers. A related 'bought deal' is an aggressive firm commitment where the bank commits to the entire issue very quickly, taking on even more risk.

The underwriter's compensation is the gross spread (underwriting discount) — the difference between the price the bank pays the issuer and the price at which it sells to the public. For a typical U.S. IPO this is around 7%; for large investment-grade debt it's far smaller (often well under 1%). The spread is split three ways: the management fee (to the lead bookrunner for structuring), the underwriting fee (compensation for bearing risk, split among the syndicate), and the selling concession (the largest piece, paid to whoever actually places the shares with investors). Large deals use a syndicate of multiple banks to spread distribution and risk, with a lead bookrunner coordinating and co-managers supporting.

Beyond bearing risk, underwriters perform due diligence, help structure the security, draft the prospectus/offering documents, price the deal (via book-building for equity), market it to investors, allocate shares, and provide aftermarket support (including the greenshoe stabilization for IPOs). The core risk is placement/inventory risk: in a firm commitment, if the market sours after the bank has committed to a price, it can be stuck selling securities below what it paid, taking a loss. This is why pricing is done carefully and often at a slight discount, and why syndication spreads the exposure. Underwriting is distinct from 'advisory' work (M&A) — it's a capital-raising, risk-bearing function rather than pure advice.