A Firm Commitment is an arrangement in securities underwriting where investment bankers make outright purchases of securities from the issuer before offering them to the public. This method ensures that the issuer receives a guaranteed amount of money and shifts the risk of selling the securities onto the underwriting investment banks. Firm Commitment is also known as firm commitment underwriting.
Types of Firm Commitment Underwriting
Full Firm Commitment
In a Full Firm Commitment, the underwriter buys the entire issue of securities and takes on the risk of selling these securities to the public. The underwriter guarantees the issuer a fixed price and bears any risk of losses if the securities can’t be sold at the anticipated offering price.
Partial Firm Commitment
A Partial Firm Commitment involves the underwriter agreeing to buy a portion of the securities from the issuer. This reduces the total risk taken on by the underwriter while still providing some level of financial guarantee to the issuer.
Key Considerations in Firm Commitment Underwriting
Underwriter’s Risk
In a firm commitment underwriting, the underwriter assumes the risk that the securities can’t be sold at the expected price. If demand is weak, the underwriter must still honor the guaranteed price to the issuer, potentially incurring a loss.
Issuer’s Benefit
The primary advantage for issuers is the certainty of funds. Since the underwriter guarantees the purchase, the issuer is assured of receiving the proceeds from the sale, regardless of market conditions.
Examples of Firm Commitment
Example 1
Company ABC plans to issue 1 million shares at $50 per share. An investment bank agrees to a firm commitment underwriting, purchasing all 1 million shares for a set price of $50 million, regardless of the ultimate sale price to the public.
Example 2
XYZ Corporation seeks to raise $100 million through a bond issuance. The underwriter offers a firm commitment, purchasing all securities at a predetermined amount, thereby ensuring XYZ receives the full $100 million needed.
Historical Context
Firm commitment underwriting has been a mainstay in financial markets for decades. Its roots trace back to early 20th century practices, providing companies with the capital assurance needed for growth while transferring risks to more adept financial intermediaries.
Applicability
Firm commitment underwriting is commonly used in equity markets but can also apply to various securities like bonds. It’s preferred in markets with stable and predictable demand patterns.
Comparison to Best Effort Underwriting
Firm Commitment
- Risk: Borne by the underwriter
- Proceeds Guarantee: Guaranteed to the issuer
- Market Stability Requirement: Less dependent on
Best Effort
- Risk: Borne by the issuer
- Proceeds Guarantee: No guarantee; based on sales success
- Market Stability Requirement: More dependent on
Related Terms
- Best Effort Underwriting: The underwriter commits to selling as much of the issue as possible but does not guarantee the total amount of securities will be sold.
- Securities: Financial instruments that hold some type of monetary value, including stocks, bonds, and options.
- Underwriting: The process by which underwriters raise investment capital from investors on behalf of corporations and governments that are issuing securities.
FAQs
What is the main advantage of a firm commitment underwriting for issuers?
How does a firm commitment impact the underwriter?
When is a firm commitment underwriting preferred?
References
- “Investment Banking: Valuation, Leveraged Buyouts, and Mergers & Acquisitions,” by Joshua Rosenbaum and Joshua Pearl.
- “Securities Regulation,” by Barbara Banoff and Marvin Chirelstein.
- SEC’s Firm Commitment Underwriting Guidelines
Summary
A Firm Commitment underwriting arrangement substantially benefits issuers by providing financial certainty through guaranteed proceeds from securities issuance. This guarantee comes at the expense of the underwriter, who assumes the risk associated with the sale of these securities. Understanding the nuances of firm commitment versus other underwriting types, such as best effort underwriting, highlights its strategic importance in financial markets.
