THE SOFT SELL
Thinking of an IPO? Take a hard look at the practice of soft underwriting.
By Jasper Moiseiwitsch

Underwriting is central to the ipo process. Think of it - a bank tells its CFO clients that it believes in a deal so much that it will buy it from them. As with any transaction, money talks - and swift, full underwriting shouts commitment. But that description ignores underwriting's many shades of gray.

Specifically, it doesn't describe the more wobbly types of soft underwriting, in which a bank will commit to an equity underwriting only to the extent it offers a convenient and profitable exit. In other words, from a CFO's perspective, the banks have simply transferred market risk straight back to the company.

While planning IPOs may not be at the top of finance managers' agendas these days, global economies appear to be at the start of a rare synchronized upturn and equity is sure to soon return to favor. The upshot: CFOs may shortly need to review investment banks' IPO practices.

First, a clarification of terms. Soft underwriting is done on a 'best effort' basis. In other words, the bank underwrites a deal at its latest stages, typically after pricing. It then immediately places the investment with fund managers and syndicate members. The bank might only have the deal on its books for a matter of hours or days, and even then might invoke force majeure clauses that offer get-outs if sales go poorly post book-building.

Hard underwriting describes an increasingly rare practice by which a bank will 'buy' a deal at its earliest stage. In IPOs, to avoid complications with the offer process, banks will guarantee a set payment to the company for its shares following the listing, thus bearing all risk that the transaction might go south. Although still available through some of the smaller investment houses, the practice was phased out in Asia about six years ago with the implementation of American banks' preference for soft underwriting via a book building process.

The Game of Risk

Soft underwriting speaks to the sticky issue of corporate finance fees. Banks typically charge a percentage of the listing proceeds. They justify the practice of charging a percentage - as compared to charging on a per-hour or project completion basis, as most professional services are levied - by noting that their fees generally reflect their underwriting risk. The bigger the issue, the greater the risk, the higher their fees.

But banks so effectively manage their risk with soft underwriting, CFOs might wonder what they are paying for. Why, after all, should a bank earn so much more on a large listing if it entails the same amount of work (documentation, sales, etc) and risk of a smaller issue? CFO Sam Wong of Hong Kong technology firm DVN Holdings says banks are getting increasingly wary of hard underwritten deals. "The investment banks usually don't [hard underwrite deals] because they are very risk averse," says Wong. "We would clearly all prefer that they make that commitment," he says.

One Hong Kong-based investment banker with a large US house counters that banks offer real risk management services with soft underwriting. "If, in the time between the pricing and the settlement of the transaction, the market does fall apart, we are on the hook to some degree for what we agreed to do," he says.

He refers to a narrow window of risk - the time when the banks sign an underwriting agreement to the point when fund managers pay for the securities. With soft underwriting, the banks carry no financial risk in the crucial marketing period leading to a share sale. For example, in May, Goldman Sachs bailed out of a mandate to help place US$1.87 billion in Accenture shares in a secondary offering. Goldman Sachs was co-lead, along with Morgan Stanley, but it opted out of the deal as it found its portion of the offer undersubscribed. Morgan Stanley went on to do the deal successfully by itself, but the bailout by Goldman Sachs points to the weak commitments implied by soft underwriting.

Even after the underwriting agreement is signed, the many material changes/force majeure (acts of God) clauses included in standard IPO agreements nullify a bank's underwriting commitments. A copy of a legal document - described as boilerplate for Hong Kong IPOs - details 22 such clauses. These stipulate that a bank can get out of an underwriting agreement in the event of strikes, lock-outs, fire, explosion, flooding, riot, war or even transport delays.

More tellingly, the document says a bank can terminate its underwriting agreement if there are changes in "local, national, international financial, political, economic, military, industrial, fiscal, regulatory, stock market, commodities, or commodities futures markets, or currency markets or market conditions."

John Maguire, managing director of corporate finance at accountancy Ernst & Young in Hong Kong, says the typical underwriting agreements that are signed in Hong Kong state that banks can invoke these clauses up to three days after the IPO closes. "In Hong Kong, the underwriter knows whether the IPO has been undersubscribed and whether it has to take up the shares when deciding whether to claim that an event of force majeure or a material change in circumstances has occurred," he says.

A Quetion of Value

Best-effort underwriting also gives banks room to renegotiate on a company's valuation. They may promise one number when pitching for the mandate. But, as the listing date nears, the banks might ask for a lower share price or a smaller issue size - Maguire says this happens "all the time". If CFOs don't accept the renegotiated issue price, and its underwriting bank drops the mandate, they will have to go through a long refiling process.

Banks operating on a best-effort basis might also stretch out the listing date as they wait for the best moment to launch the issue. One investment banker in Asia describes the practice as 'bait and switch' in which banks lure companies into a deal promising a high valuation and speedy execution. Then reality hits. "If the market environment is not right due diligence could be delayed; documentation could be delayed. Of course if the market environment is right, the banks will launch a deal, because they know it is definitely saleable," he says.

Buying the Sell Side

Another Hong Kong investment banker with a large US house shifts gears by noting that banks also offer distribution services, which are best compensated with a percentage-based fee.

True. But distribution and underwriting are different functions and each carries a service charge. Marcus Brown, head of equity syndication at UBS Warburg in Hong Kong, says the typical commission structure for an equity offering would put 20 percent of the fee towards management, with 60 percent regarded as selling commission. The remaining 20 percent would be termed an underwriting fee. He adds that deal expenses, which can include flying company management on a global road show, documentation, legal fees and printing, are at least partly put against underwriting commissions.

But banks do not always pick up these expenses - they turn them back to the CFO whenever they can. Joanna Yeo, the Singapore-based CFO of Asiatravel.com, says her company took on all the extra costs during its April 2001 IPO, including legal and restructuring expenses, which came on top of the standard 2.5 percent underwriting fee she paid listing sponsor DBS. In all, Asiatravel paid out a numbing S$2 million (US$1.1 million) in IPO fees - almost half of the S$4.7 million gross proceeds. The deal was soft underwritten and, as a kicker, Asiatravel.com was asked to build its own book. "We needed the IPO to break through the market, at whatever cost. So we started building the book ourselves, through our own contacts. We did get help [from the bankers] but only at the latest stage," she says. When Yeo is asked what service her company got for its underwriting fee, she answers: "Not a lot."

Even when banks provide a full sales service there are problems with this combined underwriter/distributor role. Notwithstanding the previous banker's talk about percentage-based fees creating a convergence of interests for the banker and CFO, there might also be an advantage for banks in smaller, cheaper issues. For one, modest placements find easier passage into markets, which makes their sales job easier.

Equity Options

It all leaves CFOs with a difficult choice. While bankers generally offer both soft and hard underwritten services on any given transaction, they openly shun hard IPOs, arguing that the risk to themselves and the company is too high. This greatly tilts the field towards soft underwriting. The message: until the environment changes, and bankers no longer hold the upper hand, hard bargaining will be essential to make bankers deliver all they promise in a soft deal.

Jasper Moiseiwitsch is a contributing editor at CFO Asia based in Hong Kong.