Firm Commitment

Firm Commitment: Detailed Explanation

A firm commitment in the context of securities underwriting is an arrangement in which investment bankers agree to purchase all securities directly from the issuer and then resell them to the public. This type of underwriting ensures that the issuer receives a specific amount of money, as the investment bankers assume the risk of selling the securities.

Examples

1. Underwriting an IPO (Initial Public Offering):

   • When a company decides to go public, investment bankers may agree to a firm commitment underwriting where they purchase the entire offering from the company and resell the shares to investors. The issuing company benefits from a guaranteed capital infusion while the investment bankers bear the risk of unsold shares.

2. Debt Security Issuance:

   • In the issuance of debt securities, investment banks might enter into a firm commitment to buy an entire debt offering from a corporation. The bank then aims to sell these securities to institutional and individual investors.

Frequently Asked Questions

Q: What is the primary advantage of firm commitment underwriting for the issuer?

• A: The primary advantage is the guarantee of funding. The issuer receives a specified amount of money up front, irrespective of how the securities perform in the market.

Q: How do investment bankers benefit from firm commitment underwriting?

• A: Investment bankers can earn substantial underwriting fees and also potentially profit from selling the securities at a price higher than their purchase price. However, they take on the risk of not being able to sell the entire allotment.

Q: What risks do investment bankers face with a firm commitment?

• A: Investment bankers face the potential risk of not being able to resell all the securities at the anticipated price, which could result in financial loss.

Q: How does firm commitment underwriting compare with a “best effort” underwriting?

• A: In a best effort underwriting, investment bankers do not purchase securities outright. Instead, they sell as many securities as possible on behalf of the issuer, without guaranteeing that all securities will be sold.

Q: Are firm commitments more common in equity or debt issuances?

• A: Firm commitments are often more prevalent in equity issuances, such as IPOs, where certainty and immediate funding are more critical.

Related Terms with Definitions

• Best Effort Underwriting: An underwriting arrangement where investment bankers commit to selling as many securities as possible but do not guarantee the sale of the entire issue.
• Public Offering: The sale of securities to the general public, typically through the issuance of shares or bonds.
• Investment Bankers: Financial professionals and institutions responsible for underwriting and facilitating securities issuance, mergers, acquisitions, and other large financial transactions.
• Underwriting Spread: The difference between the price at which securities are bought from the issuer by the underwriters and the price at which they are sold to the public.

Online References

• Investopedia - Firm Commitment
• SEC (U.S. Securities and Exchange Commission)

Suggested Books for Further Studies

1. “Investment Banking: Valuation, LBOs, M&A, and IPOs” by Joshua Rosenbaum and Joshua Pearl
2. “Underwriting Services and the New Issues Market” by Nicholas R. Molodovsky
3. “The Business of Investment Banking: A Comprehensive Overview” by K. Thomas Liaw

Fundamentals of Firm Commitment: Investment Banking Basics Quiz

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