FOUR WAYS TO USE UNDERWRITERS
Fischer Black
Sloan School of Management
Massachusetts Institute of Technology
March, 1982
Revised
April, 1982
FOUR WAYS TO USE UNDERWRITERS
SUMMARY • • • • • • • • • • • • • • • • • • • • • • • i
INTRODUCTION • • • • • • • • • • • • • • • • • • • • 1
THE FOUR WAYS • • • • • • • • • • • • • • • • • • • 2
Offering Strategy • • • • • • • • • • • • • • • • • • 3
Expansion of the Universe • • • • • • • • • • • • • 4
Service to Investors • • • • • • • • • • • • • • • • • 5
Certification • • • • • • • • • • • • • • • • • • 6
"BOUGHT" OFFERINGS • • • • • • • • • • • • • • • • • • • 8
SUMMARY. By allowing "shelf
registration," the SEC has opened up
new strategies for companies that want
to issue securities. While it is hard
to put dollar values on them, there are
four ways in which an offering through
a traditional underwriting syndicate
may help a company's stockholders. A
company that issues shares directly to
an institution that has decided to buy
on its own may miss out on the benefits
of a traditional underwriting. If the
company fails to issue shares to the
institution, the institution will bid
the price of the company's shares above
what the price would otherwise have
been. The traditional underwriting,
when it comes, may then allow the sale
of securities at a price higher than
the price offered to the company by the
institution.
INTRODUCTION
The Securities and Exchange
companies that want to issue
requirements in several ways.
Commission has been revising the rules for
securities. It has simplified registration
One change, allowing "shelf registration," is
designed to let a company register in advance the securities it expects to
sell over a two-year period.
A company that has registered its securities in advance will be able to bypass
the traditional underwriting syndicate in offering its securities. Brokers
may offer to sell the company's shares gradually, without an intensive sales
effort. Other brokers may approach the company as agents of institutions who
have already decided to buy the company's securities. Such a "bought"
offering at or near the current market price may seem attractive to a company
that is worried about depressing its stock price when it annOunces a formal
underwriting.
It's not
to the
easy to say
traditional
what a company should do when faced with an alternative
underwriting process like a "bought" offering. The
company's stockholders want the company to make the choice that will maximize
the company's stock price. When an institution offers to buy shares directly
from the company at the current market price, that's a sign that it feels it
would drive up the stock price if it bought the shares on the open market.
But the company's stockholders may be quite happy to let the institution drive
up the stock price. That may more than offset the cost of using an
underwriting syndicate to issue the company's securities. In other words,
there is a hidden cost in accepting a "bought deal" that may exceed the known
cost of a traditional underwriting.
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THE FOUR WAYS
What does an investment banker who works with a company on a traditional
underwriting do for the company? Does the underl<riting syndicate simply
contact buyers for the securities, or does it do things that increase the
company's stock price in the face of a new offering of securities?
It's hard to answer these questions by looking at stock prices before and
after an underwriting. Since the underwriting will be known in advance,
prices both before and after the underwriting will be affected. We would like
to know what the prices would have been if there had been no underwriting, or
if there had been an offering of some other kind. Unfortunately, we can't
observe what the prices would have been.
We can, sometimes, get information from the reaction of a company's stock
price to announcements of actions it plans to take. A rise in price means the
market thinks the announcement was more favorable than it expected, while a
fall in price means the market thinks the announcement was less favorable than
it expected. The trick here is figuring out what the market expected. This
kind of event is easiest to interpret "hen it is plausible that the market
expected no announcement at all.
It's also possible that the market's reaction to an announcement is based on
misinformation or misinterpretation. The market may not see the full
implications of an action the managers plan to take as well as the managers
do. Still, when the stock price falls significantly afte~ an announcement, it
makes sense for the managers to reassess their decision.
I am not aware of any systematic study of stock price reactions to
announcements about stock offerings. Thus we can't rely heavily on data in
making decisions about ways to offer stock. We must use theory.
A company's stock price is most heavily influenced, of course, by the
fundamentals of the company and its business. The better the prospects for
the industry the company is in, the higher its stock price will be. Within an
industry, the better a company is at making and selling its products and
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services, the higher its stock price will be.
The price is also influenced, though, by the approach the company takes to its
investors and
policy matters,
potential
public
investors. Accounting
relations policy matters,
policy matters, disclosure
and the· handling of new
issues of securities matters. While these factors are not as important as the
fundamentals, I believe they can easily make a difference of 10% or 20% in the
stock price. Sometimes they make an even bigger difference.
Let's look more closely at the handling of new issues of securities. It seems
to me that a company can use its investment banker in at least four different
ways. Each of these will have an impact on the stock price, including the
price at which the company can sell its securities.
Offering Strategv
At any given time, some kinds of securities will be easier to sell than
others. The choices are almost endless: stocks ,. bonds, convertibles,
preferreds, royalty participations, leasebacks, and many others. And what's
easy to sell now may not be easy to sell next week or next month.
The investment banker has special information about the market: how customers
feel about new issues; how current offerings are going; and what offerings are
coming up. The investment banker can give advice on what kind of security to
issue, and on when to issue it.
The right security issued at the right time will cost the company less than
the wrong security or the right security at the wrong time. Since it will be
relatively easy to sell, the net proceeds to the company will be high.
The market pays attention to a company's financing plans. Choosing to issue a
security gives information about a company's performance and prospects. The
investment banker can advise the company on what message issuing a security
will give the market. A company with a track record of appropriate ·messages
should have a higher stock price than a company with a poor record.
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Preregistration of securities can help the company prepare to issue the right
securi ty in the right market environment. That does not mean, however, that
the company should issue securities whenever an institution decides to take a
large position.
The arrival of a large institutional buyer may well allow the company to issue
securities without depressing its stock price. But if the company does not
issue securities, the institutional buyer may force the stock price up.
What's relevant is the difference between the price if the company sells
securities and the price if it does uot. The investment banker can help the
company estimate that difference. We will look af this question in more
detail in the last section of this paper.
Expansion of the Universe
For a very few companies, the universe of investors who are potential
stockholders is essentially all investors. Information on these companies is
widely available in the press, and there is a large number of actual
stockholders. People decide to hold stock or not based on their perceptions
of price and value. They hold a stock when they think its price is below its
value.
For most companies, the universe of actual and potential stockholders is not
so large. Each stockholder will hold only so much stock. If a company wants
to expand the amount of tts stock outstanding, it must offer a lower price to
its existing stockholders, or it must draw in new investors who are willing to
hold stock at the current price.
Normally, both devices are used. A new offering is priced at a market price
that is below what the stock would otherwise sell for, and the underwriting
syndicate uses a marketing program to draw in new investors. There is some
optimal mix of underpricing and selling. The degree of underpricing is hard
to detect, because the market price is affected before the actual offering by
the prospect of the offering.
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Under this view, the selling is not aimed at putting a rosy image on the
company. New investors who are drawn into the universe of potential
stockholders may underestimate or overestimate the company's value. Those who
correctly estimate the company's value will buy the stock if it is correctly
priced or underpriced. Those who overestimate the company's value will buy
the stock if it is correctly priced or even somewhat overpriced. Dra,dng new
investors into the universe of potential stockholders means selling more stock
without depressing the price.
It works a little differently in reverse. If an institution changes its mind
on a stock, and decides to take a large position, it can do so normally only
by inducing existing stockholders to sell.
not have the option of telling existing
company.
It must bid up the price. It does
stockholders to forget about the
But if the company supplies stock to the institution without a formal offering
through a syndicate, it relieves the pressure on the price. The price will
not go up as much as it would have gone up.
Moreover, the institution may later decide to sell its stock, and would not
normally use underwriters in that sale. That later sale may push down the
price more than a sale by underwriters will push it down, because the
organized marketing element will be missing.
Thus a company should think carefully before selling stock using a method
other than a traditional offering through an underwriting syndicate. The
organized marketing provided by the syndicate may be important in expanding
the universe of potential investors.
Service to Investors
While the underwriting team is formally working for the issuer, it has lots of
contact with investors too. The sales people provide various services to
these investors: they give information about the company and its industry,
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they give advice on portfolio strategy, and they discuss economic trends.
Investors value these services. That's one reason they buy what the
underwriting team is selling.
correctly priced.
overpriced.
Sometimes
They buy even if
they even buy
they think the securities
securities . they think
are
are
As a result, companies that use traditional underwriting methods induce extra
demand for their securities from investors who value these services. Other
things equal, the stock of a company that uses traditional methods will be
priced higher than the stock of a company that doesn't, and its securi tles
will be distributed more widely.
Of course the cost of the underwriting must be balanced against this and other
benefits from the underwriting process. There will be times when the cost of
the underwriting exceeds the benefits. Judging from the extent to which
companies use traditional methods, those times are rare.
When considering a particular strategy, such as offering preregistered stock
through a "bought deal," it's important to think carefully about the four
kinds of potential benefits of a traditional underwriting. The costs are
easier to estimate than the benefits, but the benefits may well exceed the
costs in most cases.
Certification
Sometimes investors buy securities from companies with serious problems
without knowing how serious the problems are. This happens with both
underwritten issues and issues that are not underwritten, but it is less
likely when an underwriter is involved, because an underwriter will try to
uncover such problems. The underwriter will refuse to issue the securities or
will make sure the problems are known to potential investors.
Underwriters have different strategies for rooting out problems, of course.
Some underwriters will only handle issues where the probability of an unknown
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major problem is very small. So there's a message in what kind of underwriter
is handling an issue, as well as a message in the fact that the issue is
underwritten at all.
Thus a company using preregistration will want t.o consider using a major
investment banker as managing underwriter, if that option is available. It
may also pay to go through the traditional underwriting process when the
securities are sold so that the fact of the certification becomes widely known
in the market.
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"BOUGHT" OFFERINGS
We have noted that an offer by a broker to buy your preregistered stock for an
institutional customer or for a group of customers or for its own account may
have hidden costs. If you don't sell through this broker, the buyers are
likely to force your stock price up trying to attract stock from existing
holders. If you de sell through this broker, and the broker takes some of the
stock or the customers intend to resell it, your stock price may be forced
down by the fact that the sale is not organized in the way a formal
underwriting is organized.
Let's illustrate this process with an example. Since I don't know how to
estimate the indirect costs and benefits, the figures I will use are purely
hypothetical. However, I believe that they are within the range of
possibilities.
Your stock is trading around $20. Based on a new and correct analysis of the
prospects for your business, a large institution decides that your stock is
worth $25. Since you have preregistered a large block of stock, it approaches
you with an offer to buy a block at a net price to you of $20. If you accept
the offer, you will receive $20 a share. As others make the same analysis and
arrive at the same conclusions, the market price will rise to about $25,
assuming that economic conditions remain about the same. You will regret
having sold your shares for $20.
If you decline the offer, the institution will buy in the open market. Its
buying will force the price up toward $25. Since it will be paying higher
prices than $20, it will buy fewer shares than it wanted to buy from you.
Your market price will approach $25 sooner, assuming that economic conditons
remain about the same, than it would have if you had accepted the offer.
With a traditional underwriting, your net price might be $24. The
underwriting syndicate's selling activities will motivate investors to look at
your company more closely. This may speed the spread of the new analysis of
your prospects.
1,
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Moreover, if you accept the original offer, there is always the danger that
the institution will change its mind and sell your stock, forcing the price
down again from $25 to $23. With a traditional .. .mdenlriting, this is less
likely, because the stock is more widely dispersed, and because there has been
an attempt to place the stock with investors who will hold on to it. Perhaps
a limited amount of reselling might force the price down from $25 to $24.
In this example, you receive $20 if you accept the "bought deal," and $24 if
you go for a traditional underwriting. After the offering, the price goes to
$23 with the "bought deal," and $24 with the traditional underwriting.
Eventually, the price will reflect the correct results of the new analysis of
your prospects and the costs of the kind of offering you have chosen.
This example is a case where the traditional underwriting is the correct
choice. In other cases, accepting the bought deal is the correct choice. I
believe, though,that the- tradltional -underwri1:1ng --will betne -corr-ect- choice- -
in most cases.