IPO VIEW-Banks ramp up underwriting risk with 'bought deals'
* Underwriters buying large blocks of stock before lining up investors
* Private equity firms often push "bought deals"
* With IPO volume low, banks feel pressure to do these deals
By Olivia Oran
Nov 27 (Reuters) - Investment banks, desperate to win business as stock issuance volumes dwindle, are taking on more underwriting risk by buying large blocks of stock from U.S. companies before lining up investors to take the shares.
These stock purchases, known as "bought deals," account for 23 percent of secondary share issues from publicly traded companies so far this year, up from 15 percent last year. It is the highest level since the financial crisis flared up in 2007, according to market data firm Ipreo.
Typically, investments banks conduct a marketing road show to line up investors for a share offering before signing an underwriting agreement with a corporate issuer. Banks get a percentage of the proceeds as their underwriting fee, averaging about 5 percent.
In bought deals, banks sign an underwriting agreement before looking for investors and buy the shares from the company outright - which means banks can be stuck with the stock if prices fall. There is no fee as banks get the shares at a discount to the market price, usually 2 percent to 5 percent.
Bought deals offer banks lower profits - a concern for some analysts, who say underwriting is one of the few profitable investment banking businesses as merger volumes slump and regulations crimp trading profits.
"If they shift the equity capital markets business it's going to push down the returns of one of the few good markets left on Wall Street," said Brad Hintz, an analyst at Sanford Bernstein.
Bought deals have historically offered banks a profit of roughly 2.3 percent of the issuance amount, which is about half of that of a fully marketed secondary share offering, said Jay Ritter, a finance professor at the University of Florida.
Companies like bought deals because they can sell shares faster at a guaranteed price. Typically, a company asks underwriters to bid on a block of shares - say, a million - by the end of the day. The bank that bids the highest price, which means accepting the smallest market discount, usually wins.
The bank then tries to sell the shares quickly and for a profit, usually by targeting existing investors who are already comfortable with the company. But if market prices plunge after the underwriter buys the stock, the bank loses money.
Many of the companies taking advantage of bought deals are owned by private equity firms, which have large portfolios of stocks to sell and can use their weight as big Wall Street clients to pressure banks to bid on the deals.
Banks are susceptible to pressure now. Fees for U.S. listed IPOs, traditionally the most lucrative source of profit from stock underwriting businesses, have fallen 20 percent so far this year to $1.7 billion and are on track to drop to their lowest level since 2009.
Doughnut seller Dunkin Brands Group Inc and natural gas pipeline operator Kinder Morgan Inc are among the private equity backed-companies that have been involved in big bought deals this year.
"Are these deals a necessary evil? I don't know," said one equity capital markets professional who declined to be identified because he is not authorized to speak to the press. "But no one likes taking on unnecessary risk."
One factor that has helped underwriters in the United States this year: the market has generally risen, with the Standard & Poor's 500 index up more than 10 percent for the year and the volatility index trading below its historical average.
In Europe, where markets have struggled this year, some banks have been left holding stock after the deals failed to enthuse investors.
In February, Morgan Stanley was stuck with almost half of $1 billion worth of shares of Danish phone company TDC A/S after failing to attract sufficient investor interest. Morgan Stanley has since sold the shares, according to a source close to the situation. The bank declined to comment.