Underwriter Profits

Recently we commented on a post by Tom Evslin regarding how underwriters profit from an IPO.  We felt that Tom's post was an unfair assessment of underwriter motivations and incentives.  Let us try to explain simply how and where underwriters make money on an IPO.

Gross Spread -- The Easy Part

First the easy part, underwriters earn a commission (known as a gross spread) calculated as a percentage of the capital raised for the issuing company.  As a rule this is 7%.  When all is said and done, on average about 70% of the gross spread is actually kept by the underwriters and split amongst themselves in a very disproportionate manner.  Where does the balance of roughly 30% go? To pay the salespersons' (employees of the underwriters) commissions who sold the shares and the underwriters' expenses of the deal (legal and travel mostly).  These fees are quite lucrative, for example a $75mm IPO will net roughly $3.7mm in fees to the underwriters as a group.  If your a lead, book running underwriter (managing the deal) you get a big chunk of these fees.  If your a co-manager, not quite so interesting, but crumbs are better than no crumbs.  If the deal is large enough, those crumbs tend to be large also.

Aftermarket Trading -- A Bit More Tricky

Okay, now lets get to the part that is a bit more complex, the aftermarket.  This is the area there there seems to be some misconception that underwriters stand to profit handsomely.  Let's look at exactly where and how underwriters make money in the aftermarket.  There are two ways that underwriters can profit in aftermarket trading of an IPO, (1) trading and (2) inventory profits.

Trading: First underwriters act as a market maker and essentially match buyers to sellers.  In doing so, the underwriter is buying shares from willing sellers at the "bid" price and reselling them to willing buyers at the "ask" price.  There is a small difference between these prices and the underwriter pockets that "spread" for every share which is purchased then resold.  So, how much do these profits represent in a typical IPO?  Well in the first 10 days following an IPO (a rough approximation of the stabilization period following an IPO) these profits average only about 9% of the gross spread that we described in the paragraph above.  This equates to about $473,000, again assuming a $75mm IPO.  This statistic is according to the research paper, When the Underwriter is the Market Maker: An Examination of Trading in the IPO Aftermarket published in June 1999 which studies 306 IPO's completed between September 1996 to July 1997. 

So trading can be a decent business but is hardly a gold mine.  This business has actually become far less attractive with the advent of decimalization in 2001 as spreads used to be at minimum increments of 1/16 ($.625/share) because that was the smallest fraction available.  Now average spreads are more on the order of $.01-$.02/share as decimal-based quotation has enabled competition to drive spreads down.

Inventory Profits: The second way for underwriters to profit in aftermarket trading is to actually make a bet on the direction of the stock by either owning the stock (holding inventory and being long) and speculating that the stock goes up or being short the stock (naked short) and speculating that the stock price will decline.  In my direct experience, holding material inventory positions, either long or naked short, in an IPO during its stabilization period (again lets assume the first 10 days) is NOT a position underwriters intend to be in.  Any inventory held is usually the result of the underwriters' attempt to stabilize the issue following pricing, not an attempt to make a bet on direction.  In fact, the same research paper as referred to above, also evaluated profits generated from inventory positions following the IPO.  Their findings were that on average underwriters generated NO net profits from inventory positions during this stabilization period.

Conclusion

So, IPO underwriting is a lucrative business but the vast majority of profits are generated via the gross spread that is paid by the issuer to the underwriters.  The aftermarket activities of the underwriters are certainly generally additive to profits but do not represent a mother lode.

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