A back stop is a financial mechanism providing last-resort support or security in a securities offering. Specifically, it refers to the commitment by a third-party entity to purchase any unsubscribed portion of shares during an offering.
Mechanisms of Operation
Definition and Purpose
In the context of a securities offering, a back stop arrangement ensures that the issuer can raise a predetermined amount of capital by having an underwriter or a committed investor purchase any shares that remain unsubscribed by the public. This mechanism serves to guarantee the success of the offering and instills confidence in prospective investors.
Key Players and Structures
Underwriters
Underwriters are often the ones providing back stop arrangements. They assess the risk of the offering and may charge a fee for their commitment to purchase unsold shares.
Investors or Sponsors
In some cases, a significant investor or sponsor might step in as the back stop, providing a safety net for the issuer.
Types of Back Stop Commitments
Hard Back Stops
A hard back stop refers to an unconditional commitment by the back stop entity to purchase all unsubscribed shares, regardless of the number.
Soft Back Stops
A soft back stop, on the other hand, might involve conditions or limits to the purchase commitments, often specifying a maximum number of shares or a specific funding threshold.
Practical Examples
Real-World Application
Consider a company aiming to raise $100 million through a public offering. If the public subscribes to only $80 million worth of shares, a back stop agreement would ensure that the remaining $20 million worth of shares are purchased by the back stop entity, thus securing the required capital for the company.
Historical Cases
One of the notable uses of back stops was during the financial crisis of 2008, where many financial institutions relied on back stop agreements to ensure the success of their capital offerings under volatile market conditions.
Applicability and Considerations
Risk Management
Back stops are crucial in risk management for both issuers and investors. They provide a safety net that can reduce the perceived risk of the offering, making it more attractive to potential investors.
Regulatory Aspects
Regulatory bodies might have specific requirements or disclosures related to the use of back stop arrangements, ensuring transparency and fairness in the market.
Comparisons with Related Terms
Underwriting vs. Back Stop
Though often related, underwriting typically involves the underwriter’s commitment to buy the shares before selling them to the public, whereas a back stop specifically refers to the purchase of any remaining shares not taken up by the public.
Standby Underwriting
Standby underwriting is similar to a back stop, where the underwriter commits to purchase any unsold shares. However, it tends to be used interchangeably with back stops in various contexts.
FAQs
What is the main advantage of a back stop?
Are there any disadvantages to using a back stop?
Can any company use a back stop?
References
- Ross, S. A., Westerfield, R., & Jaffe, J. (2016). Corporate Finance. McGraw-Hill Education.
- Damodaran, A. (2012). Investment Valuation: Tools and Techniques for Determining the Value of Any Asset. Wiley.
Summary
A back stop in securities offerings provides critical support ensuring the completion of funding rounds despite incomplete public subscription. By understanding the definition, operational mechanisms, and practical implications, stakeholders can better navigate the complexities of financial offerings and investment strategies.
