What is Competitive Bid Underwriting?

Competitive bid underwriting allows companies to sell new stocks or bonds. The company picks the underwriter who offers the best deal. Underwriters are usually big banks. They buy all the new securities from the company. Then, they sell the securities to investors.

How Competitive Bid Underwriting Works

Companies can sell new stocks or bonds when they want to raise money. This is called an offering or an issue. The company hires an investment bank to be the underwriter for the offering. The underwriter’s job is to:

Help decide the price and terms for the new securities
Buy all the new securities from the company
Sell the securities to investors

With competitive bid underwriting, the company asks many underwriters to make offers. Each underwriter says what price and terms they would buy the securities for. They also say how they would sell the securities to investors.

Underwriters Compete to Win the Deal

The underwriters are in a contest. They each want the company to pick them. To win, they have to make the most attractive offer.

The company looks at a few key things when comparing the offers:

The yield or interest rate on the securities
The fees the underwriter charges
How well the underwriter can sell the securities to many investors
If the underwriter will support trading of the securities after the offering

The underwriter who offers the lowest yield, charges the most negligible fees, has the most expansive investor network, and promises the most after-offer support usually wins.

Why Companies Use Competitive Bid Underwriting

Companies like competitive bids because they create competition. Competition pushes the underwriters to give their best terms. The company gets to raise money most cheaply.

An Alternative to Negotiated Underwriting

The other main type of underwriting is called negotiated underwriting. With this method, the company picks one underwriter without a bidding process. Then the company and underwriter negotiate the terms.

Negotiated underwriting can be faster and more flexible. The company works closely with the underwriter they know and trust.

But competitive bids often lead to better terms for the company. The competition keeps the underwriters honest. They can’t overcharge or give themselves a cushy deal.

When are Competitive Bids Used?

Not all security offerings use competitive bids. It’s most common for:

Simple, plain-vanilla securities like investment-grade bonds
Well-known, established companies
Very large offerings

Complex securities, lesser-known companies, and smaller deals more often use negotiated underwriting. The company wants an underwriter who will put in extra effort explaining and marketing the offering.

The Competitive Bid Process

The competitive bid process usually goes like this:

The company announces it wants to do an offering
Interested underwriters do their research
The company sends out a request for bids
The underwriters submit sealed bids by the deadline
The company reviews the bids and picks a winner
The winning underwriter signs a purchase agreement with the company
The underwriter does the offering – buying the securities and reselling to investors

Setting the Terms

In their bids, the underwriters propose key terms like:

The price or yield on the securities
The underwriting spread (difference between their buy and sell price)
Amount of securities they will firmly commit to buy
Their plan for selling and allocating the securities to investors

The company may set some terms in advance, like the size of the offering. The underwriters then bid within those parameters.

The company wants the underwriter to set a fair market price on the securities. If the price is too high, investors won’t buy. If it’s too low, the company leaves money on the table.

Underwriter Compensation

The underwriters make money on the spread. This is the difference between the price they buy the securities from the company and the price they sell to investors.

They may also charge the company other fees, like an advisory or management fee. But with competitive bids, the fees are usually lower than in negotiated deals. The underwriters cut their fees to win the contest.

After the Bid is Won

After the company picks a winning bid, that underwriter gets to work. They sign an underwriting agreement that legally commits them to buy the securities.

Then the underwriter reaches out to prospective investors. They gauge demand and build a book of orders. This helps them see if they set the price right.

If investors are eager, the underwriter may raise the price or size of the offering. If demand is weak, they may need to lower the price or even call off the deal.

Assuming the offering goes ahead, the underwriter buys the full batch of new securities from the company. Then they quickly resell them to the investors who placed orders.

The underwriter’s job isn’t over yet. Most competitive bids include a promise to support secondary trading of the securities. The underwriter continues acting as a market maker – offering to buy or sell the securities to keep the market flowing smoothly.