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So what exactly are we getting when we pay underwriting commissions?

The balance between risk and reward is still heavily skewed in favour of the underwriters, says Jeremy Wagener - even allowing for an occasional Black Monday or two.

I have good reason to remember the October convulsion. Two months earlier my company had been taken over and I had exercised my remaining share options. I sold the last of the new shares on 12 October, just one week before Black Monday.

Meanwhile, events on a more cosmic scale were taking place elsewhere in the City. The government had decided to sell its remaining 31.5% stake in BP which was to be the biggest share sale the Stock Exchange had ever seen. On 15 October Sir Peter Walters, then chairman of BP, and Norman Lamont, watched as Royal Marines abseiled down the face of Britannic House, unveiling the offer price of 330p per share. That night the great storm struck, delaying the City’s reaction to the falls on Wall Street until the following Monday.

It so happened that The Association of Corporate Treasurers (ACT) held its annual dinner that year on 28 October in the aftermath of the crash and the guest of honour was Sir Peter Middleton, then permanent secretary to the Treasury. As the guests sat down to dinner the Chancellor, Nigel Lawson, summoned Sir Peter to Downing Street to discuss the mounting crisis over the BP issue. The Association history relates: “It speaks very well for Sir Peter and the Association that he firmly rejected Nigel Lawson’s attempt to take him away”.

These events, 10 years ago, are interesting today in the light of the debate surrounding the costs and methods of issuing equity shares. When the sale of the Government’s shares flopped in 1987 there was talk of “pulling” the issue as BP’s shares fell well below the offer price. But Lawson stood firm arguing that the underwriters would have to earn their fees. His robust attitude would certainly find supporters today among those who feel underwriting commissions are excessive in relation to the risks being run.

John Bridgeman, director general of the Office of Fair Trading, said recently that he stands ready to ask the MMC to investigate whether a monopoly exists in the provision of underwriting services. Meanwhile, he is looking for evidence that market practices are changing. There are some indications (but not enough yet for Bridgeman) that things are improving.

In a few instances recently the standard 2% underwriting fee (0.75% to the lead underwriter and 1.25% to the sub-underwriters) has been varied with some of the sub-underwriting going out to tender. The fact that the fee has almost invariably been 2% regardless of company size, the reasons for the rights issue or market volatility should make a treasurer or finance director suspicious.

In a perfect world risks would be priced to take account of these factors; the result would be a raising of underwriting costs for some companies – such as smaller ones with no track record – and lower fees for larger firms with good stories to tell. Paul Marsh of the London Business School has done research on the costs and benefits of sub-underwriting. He likens it to a put option where the company can put a failed issue to the underwriters if the shares fall below the issue price. The option can be priced using standard Black-Scholes option valuation methods. His conclusion is that, on average, underwriting fees far exceed the fair value of the option taking into account the actual risks being run and this is still true taking into account a market jolt of the size experienced in 1987.

There is something of a paradox here. In the past 10 years, derivatives have increased in their variety, sophistication and use. Many of the more prosaic kind, for example OTC currency and interest rate swaps, have become like commodities and are keenly priced. Moreover, the City’s investment banks who act as advisers and lead underwriters can hardly be accused of living in an uncompetitive world. How then is it that underwriting fees have remained untouched by these pressures? I suggest that custom and practice has a lot to answer for.

It is not uncommon for an investment bank to justify the fees by pointing out that much – unpaid – work has been done over a period on abortive deals and the rights issue is the opportunity to catch up. On the company side, however outraged the treasurer may feel about the proposed fee, he will not be keen to change advisers when faced with the pressures of the issue and perhaps an acquisition. As I have remarked already, the costs and methods of issuing equity shares are under scrutiny and not just by the OFT. The ACT has held two discussion meetings this year with representatives from the investing institutions, The Hundred Group of Finance Directors and others. There was a general consensus that pre-emption rights, already enshrined in UK and EU law, should be preserved.

Moreover, the ACT believes only the shareholders should determine when a transfer of wealth to a third party is permissible, as for example happens when costs are incurred in a rights issue. The arithmetic of a discounted rights issue ought to be better understood: an issue of shares at a discount by way of rights is the same, economically, as an issue of shares at market value plus a bonus issue; therefore the size of the discount is in no sense a cost provided a subsequent adjustment is made to the earnings and dividend per share figures. In that connection, companies should be encouraged to look at deep discounted, non-underwritten rights issues.

Treasurers are ready to shed light on these issues, some of which are poorly understood particularly in the boardroom, and should develop the intelligent customer role in their dealings with investment banks and others. New methods of equity raising like the book-building system used in America may be worth using but only if they are cost-effective and increase share prices. The tax and legal systems should be overhauled so as not to favour one method of financing over another.

The effects of the crash of 1987, in market value terms, were short-lived.

But we still have some way to go before the accepted market practices are fully understood and, where appropriate, discarded in favour of new ones.

Jeremy Wagener is director general of The Association of Corporate Treasurers.

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