What is 'Gross Spread'

Gross spread is the difference between the underwriting price received by the issuing company and the actual price offered to the investing public. The gross spread is the compensation that the underwriters of an initial public offering (IPO) make to cover expenses, management fees, commission (or takedown) and risk. The majority of profits that the underwriting firm earns through the deal are often achieved through the gross spread. In addition to the gross spread, an initial public offering typically involves "fixed costs," such as legal and accounting consultants and registration fees.

BREAKING DOWN 'Gross Spread'

To better understand the concept of gross spread, consider the following example. Company ABC, receives $36 per share for its initial public offering. If the underwriters turn around and sell the stock to the public at $38 per share, the gross spread – the difference between the underwriting price and the public offering price – would be $2 per share. The gross spread value can be influenced by variables such as the size of the issue, risk and volatility. Gross spread is also called "gross underwriting spread," "spread" or "production."

Gross Spread Ratio

In the above example, the difference between the per-share price the investment bank paid the issuer and the public offering price is $2. Expressed as a ratio, this $2 is about 5.3 percent. This figure is known as the gross spread ratio.

The higher the gross spread ratio, the bigger the slice of the IPO proceeds goes to the investment bank. A study of gross spreads by Oxford University revealed that in the U.S. IPO market, underwriters almost always charge a gross spread ratio of around 7 percent. In Europe, where more investment banks in multiple countries are competing for IPO business, gross spread ratios tend to be lower and distributed over a wider range.

Underwriting Costs Covered by the Gross Spread

Funds produced by the gross spread typically must cover the following underwriting costs: the manager's fee, the underwriting fee (earned by members of the underwriter syndicate), and the concession, which is earned by the broker-dealer selling the shares. The manager is entitled to the entire gross spread. Each member of the underwriting syndicate gets a (not necessarily equal) share of the underwriting fee and the concession. A broker-dealer, who is not a member of the underwriter syndicate, but sells shares, receives only a share of the concession. The member of the underwriter syndicate that provides the shares to that broker dealer would retain the underwriting fee.

Proportionately, the concession increases as total gross spread rises. Meanwhile, the management and underwriting fees decrease with gross spread. The effect of size on the division of fees is usually due to differential economies of scale. The extent of investment banker work, for example, in writing the prospectus and preparing the roadshow is somewhat fixed, while the amount of sales work is not. Larger deals will not involve exponentially more investment banker work, but it might involve much more sales effort, requiring an increase in the proportion of the selling concession. Alternatively, junior banks may join a syndicate, even if they receive a smaller share of the fees in the form of a lower selling concession.

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