What is an underwriter?
When a company chooses to make an initial public offering (IPO), they might employ an IPO underwriter, or usually an investment bank.
Underwriter definition: The role of the IPO underwriter is to make sure the company meets all regulatory requirements, contact potential buyers in the market, and help the company set its share price.
What is underwriting?
Underwriting is the procedure where an individual or institution takes on financial risk for a fee, it is basic insuring. Typically, the risk will involve promises to cover loans or investments if something does not go according to plan. The meaning of the term underwriter originates from the historical practice of having the risk-bearers name signed under the total amount of risk they were willing to take on for a specified premium.
The practice of underwriting primarily involves researching and assessing the degree of risk of each entity before deciding whether to take on that risk. This research is necessary in order to decide what borrowing rates for loans should be and to establish suitable premiums in order to cover the true cost of insurance policyholders. An underwriter can refuse to cover an entity if they deem that the risk is too high.
Where have you heard about underwriters?
Large IPOs often get a lot of news coverage, especially if it's an exciting company like Facebook or Alibaba going on to the market for the first time. Often, the amount of money that investment banks make from IPOs is just as interesting to media outlets.
What you need to know about underwriters.
IPO underwriters usually guarantee that they can sell a certain amount of stock during the IPO. If it fails to hit its target, the investment bank has to buy the stock itself.
The IPO underwriter fee is usually a percentage of the amount raised from the IPO, normally ranging from 3-5.5%
Investment banks can make huge amounts of money from underwriting IPOs. In 2014, Goldman Sachs topped the IPO underwriter rankings when it made around £3bn.
However, huge companies can sometimes offer a much lower fee as banks fight for their business.
As of 2016, Alibaba was the largest IPO in history, raising $25bn for the Chinese firm – that's roughly equal to the 2016 GDP of Estonia. However, it's reported that Alibaba paid underwriters just 1% of the total raised.
How does an underwriter set the market price?
An underwriter establishes a fair and stable market for financial transactions in the market. Whether it be underwriting a loan, insurance policy, or IPO, they all carry the risk that the customer will either default, which is a potential loss to the lender or insurer. The underwriter is required to assess the known risk factors and investigate an application in order to establish the minimum price for providing cover.
They help establish the true market price of risk by deciding which transactions they are willing and able to cover on a case-by-case basis, and for what premiums. Underwriters also play a function in exposing candidates who pose too high a risk, who they will not provide cover to.