What Is a Back Stop?
When a company is trying to raise capital through an issuance—and wants to guarantee the amount received through the issue—it may get a back stop from an underwriter or a major shareholder, such as an investment bank, to buy any of its unsubscribed shares.
- A back stop is the act of providing last-resort support or security in a securities offering for the unsubscribed portion of shares.
- When a company is trying to raise capital through an issuance, it may get a back stop from an underwriter or a major shareholder, such as an investment bank, to buy any of its unsubscribed shares.
- Back stops function as a type of "insurance" and support for the overall offering, ensuring that the offering does not fail if all shares are not subscribed.
How a Back Stop Works
A back stop functions as a form of insurance. While not an actual insurance plan, a company can guarantee that a certain amount of its offering will be purchased by particular organizations, usually investment banking firms, if the open market does not produce enough investors and a portion of the offering goes unsold.
If the organization providing the back stop is an investment banking firm, sub-underwriters representing the investment firm will enter into an agreement with the company. This agreement is referred to as a firm-commitment underwriting deal or contract, and it provides overall support for the offering by committing to purchase a specific number of unsold shares.
By entering into a firm-commitment underwriting agreement, the associated organization has claimed full responsibility for the quantity of shares specified if they initially go unsold, and promises to provide the associated capital in exchange for the available shares.
This gives assurance to the issuer that the minimum capital can be raised regardless of the open market activity. Additionally, all risk associated with the specified shares is effectively transferred to the underwritten organization.
If all of the offering is purchased through regular investment vehicles, the contract obligating the organization to purchase any unsold shares is rendered void, as the conditions surrounding the promise to purchase no longer exist.
The contracts between an issuer and the underwriting organization can take various forms. For example, the underwriting organization can provide the issuer with a revolving credit loan to boost credit ratings for the issuer. They may also issue letters of credit as guarantees to the entity raising capital through offerings.
If the underwriting organization takes possession of any shares, as specified in the agreement, the shares belong to the organization to manage as it sees fit. The shares are treated the same way as any other investment purchased through normal market activity. The issuing company can impose no restrictions on how the shares are traded.
The underwriting organization may subsequently hold or sell the associated securities per the regulations that govern the activity overall.
Example of a Back Stop
In a rights offering, you may see a statement to this effect: "ABC Company will provide a 100 percent back stop of up to $100 million for any unsubscribed portion of the XYZ Company rights offering." If XYZ is trying to raise $200 million, but only raises $100 million through investors, then ABC Company purchases the remainder.
What Is a Back Stop in a Bond Issue?
Similar to the back stop in an equity placement, a back stop for a bond issue is a type of guarantee whereby the underwriting bank or syndicate will fix a price at which to purchase any unsold or unsubscribed bonds.
Who Are Backstop Purchasers?
If the underwriting bank or investment banking syndicate cannot or do not want to back stop a new issue, third-party backstop purchasers may be called upon to step in and buy any unsubscribed portion of a securities issue. These purchasers may provide a bid substantially below the issue price and/or may demand fees as compensation. They would then often try to sell off the holdings over time at a profit.
What Are Volcker Rule Backstop Provisions?
The Volcker Rule is a set of financial regulations that separates the commercial and investment banking activities of a firm. Its purpose is to prevent conflicts of interest and unfair practices to the detriment of a bank's customers. One provision of the Rule is to prevent the backstopping of a securities issue by an underwriting bank if it will create a conflict of interest. Moreover, a back stop would be prohibited if it would "result, directly or indirectly, in a material exposure by the banking entity to a high-risk asset or a high-risk trading strategy; or pose a threat to the safety and soundness of the banking entity or to the financial stability of the United States."