Investment Banking The primary market involves the distribution to investors of newly

Investment Banking The primary market involves the distribution to investors of newly

issued securities by corporations and other entities seeking to raise funds. The entity issuing a security is referred to as the issuer. The par- ticipants in the marketplace that work with issuers to distribute newly issued securities are called investment bankers. The activity of invest- ment banking is undertaken by basically two types of firms: securities houses and commercial banks.

Traditional Process for Underwriting New Issues The traditional process in the United States for issuing new securities

involves investment bankers performing one or more of the following three functions:

1. advising the issuer on the terms and the timing of the offering,

2. buying the securities from the issuer, and

3. distributing the issue to the public. 1

In the sale of new securities, investment bankers need not undertake the second function—buying the securities from the issuer. An invest- ment banker may merely act as an advisor and/or distributor of the new security. The function of buying the securities from the issuer is what we

1 When an investment banking firm commits its own funds on a long-term basis by either taking an equity interest or creditor position in companies, this activity is re-

ferred to as merchant banking.

FOUNDATIONS

referred to earlier as “underwriting.” When an investment banking firm buys the securities from the issuer and accepts the risk of selling the securities to investors at a lower price, it is referred to as an “under- writer.” When the investment banking firm agrees to buy the securities from the issuer at a set price, the underwriting arrangement is referred to as a firm commitment. In contrast, in a best efforts arrangement, the investment banking firm agrees only to use its expertise to sell the secu- rities—it does not buy the entire issue from the issuer.

The fee earned from underwriting a security is the difference between the price paid to the issuer and the price at which the invest- ment bank reoffers the security to the public. This difference is called the gross spread, or the underwriter discount. There are numerous fac- tors that affect the size of the gross spread.

The typical underwritten transaction involves so much risk of capi- tal loss that a single investment banking firm undertaking it alone would

be exposed to the danger of losing a significant portion of its capital. To share this risk, an investment banking firm forms a syndicate of firms to underwrite the issue. The gross spread is then divided among the lead underwriter(s) and the other firms in the underwriting syndicate. The lead underwriter manages the deal (or “runs the books” for the deal). In many cases, there may be more than one lead underwriter.

A successful underwriting of a security requires that the underwriter have a strong sales force. The sales force provides feedback on advance interest in the security, and the traders (also called market makers) pro- vide input in pricing the security as well. It would be a mistake to think that once the securities are all sold the investment banking firm’s ties with the deal are ended. In the case of bonds, those who bought the securities will look to the investment banking firm to make a market in the issue.