Hard underwriting

An IPO does not always sell out. If demand from the public falls short, somebody has to buy the shares nobody else wanted — otherwise the issue fails and the company does not get its money.

That backstop is what an underwriter provides. The workbook's definition (section 2.4.1, Market Intermediaries): "Underwriters are intermediaries in the primary market who undertake to subscribe [to] any portion of a public offer of securities which may not be bought by investors."

The workbook then splits this commitment by timing. Hard underwriting is when "the underwriters make their commitments at the initial stages of the IPO" — before the price is set. Its counterpart, soft underwriting, is "the commitment given once the pricing is determined."

The distinction the workbook draws is entirely about when the underwriter is on the hook, and that timing changes how much risk they are carrying.

The workbook adds a further feature of the softer, later commitment: "the shares that devolve are usually placed with other financial institutions, thereby limiting the risk to the underwriter," and soft underwriting "also comes with a clause that provides the option to exit from the commitment in the event of certain events occurring." Hard underwriting carries neither of those cushions — it is a firm commitment taken on at the point of greatest uncertainty, which is precisely why it is called "hard."

Underwriters do not act alone: the workbook places them alongside merchant bankers, who are the "single point contact for issuers" and coordinate registrars, brokers, bankers, underwriters and credit rating agencies through the issue process. The merchant banker structures and prices the issue; the underwriter takes on the risk of it not selling.

Illustrative figures, following the workbook's hard/soft underwriting distinction.

Deccan Precision Components Ltd plans a Rs 500 crore IPO. At the draft filing stage — weeks before the price band is announced — a syndicate of three underwriters gives a hard underwriting commitment to subscribe to any part of the Rs 500 crore that the public does not take up, in return for an underwriting commission.

Six weeks later, once book-building fixes the price band and the issue is close to opening, one of the three underwriters revises its position to a soft underwriting commitment for its own Rs 150 crore share — now that the price is known and early demand from anchor investors looks strong, the underwriter is willing to commit, but with an exit clause if certain conditions occur, and any devolved shares would be placed with other financial institutions rather than held outright.

On listing, demand falls short by Rs 40 crore. Because the unmet portion falls within the underwriters' committed amounts, they step in and subscribe to the shortfall themselves, exactly as their underwriting agreement obliged them to — the difference between hard and soft in this case is only how early and how firmly that obligation was locked in, not whether it was ultimately called upon.

Chapter 2 (Introduction to Securities Market), in the section on primary market participants, defines underwriters and draws the hard/soft distinction in back-to-back sentences. Expect a direct question asking which type of underwriting commitment is given "at the initial stages of the IPO" before pricing (hard) versus "once the pricing is determined" (soft), and a question on which of the two carries more risk for the underwriter.

• Hard underwriting is earlier and firmer; soft underwriting is later and comes with an exit clause. The names describe firmness of commitment, not deal size.
• Soft underwriting typically follows pricing, and devolved shares under it are usually placed with other financial institutions — a cushion hard underwriting does not have.
• An underwriter is not the same as a merchant banker. The merchant banker manages and prices the entire issue; the underwriter specifically commits to buy unsold shares.
• The workbook gives no rupee underwriting-commission rate or percentage cap for hard underwriting — any specific commission figure in an answer must come from elsewhere in the curriculum, not from this chapter.
• Do not read "hard" as meaning "difficult to obtain" — it describes the firmness and timing of the commitment, not how hard it is to find an underwriter.