Underwriting Equity Vs. Debt

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A firm uses equity and debt to fund operating activities.
A firm uses equity and debt to fund operating activities. (Image: money image by shime from <a href='http://www.fotolia.com'>Fotolia.com</a>)

Underwriting activities help organizations, including governments, nonprofit institutions and business entities raise operating cash on securities exchanges or in private transactions. An investment bank typically underwrites, or authorizes, debt and equity securities on behalf of a firm. Debt products may include bonds, whereas equity securities may be common or preferred stocks.

Equity Defined

Equity represents an ownership stake (portion) that an investor has after purchasing a company's stock. A buyer of equity, also called a stockholder or shareholder, generally has voting rights and can appoint corporate directors. He also receives periodic dividend payments and can attend annual shareholders' meetings. Additionally, a shareholder makes profits when share prices rise on securities exchanges or in private transactions. Examples of equity products include common stocks and preferred shares.

Debt Defined

Debt represents liability that a corporation must reimburse. Short-term debt indicates amounts that a firm must pay in 12 months or less, whereas long-term debt refers to amounts payable after a year. A buyer of debt products, or bondholder, receives regular interest payments and principal amounts loaned at maturity. Examples of debt products include corporate bonds and U.S. Treasury notes and bills as well as convertible bonds.

Underwriting Function

An investment bank that engages in underwriting activities typically applies different methods for equity and debt products. In a stock underwriting process, an investment bank reviews the issuer's (client) financial information and evaluates general development in stock markets such as market returns and the state of the economy. Then, the bank recommends the client's shares to potential investors, or buy-side institutions. (In this case, the underwriter is the sell-side institution.) The underwriting process for a debt product is similar, with the exception that the underwriter analyzes market levels of interest rates and the issuer's creditworthiness before recommending bonds to potential buyers.

Underwriting Significance

Underwriting activities play a significant role in modern economies because they help firms raise operating cash on global financial markets or in private transactions. Even profitable firms often may have liquidity problems because customers typically do not pay for goods on delivery. Without underwriting, a firm may be unable to operate. It also may be unable to engage in transactions with business partners such as lenders, customers and suppliers.

Underwriting Equity versus Debt

Underwriting processes for debt and equity products are distinct. However, instances occur in which both methods interrelate. For example, the senior leadership of a large insurance company believes debt and equity market developments are currently unfavorable to the firm because stock returns are poor and interest rates are high. They may ask an investment banker to underwrite debt-equity, or hybrid, products such as convertible bonds and preferred shares.

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