- To identify the underwriter that will deliver the best results within your objectives, it is important to understand the services that underwriters provide.
- Underwriters’ experiences can be considered based on a list of each firm’s bond issues in the last 12 to 24 months.
- To determine underwriters’ willingness to underwrite, consider a review of their pricing expertise and interview comparable clients.
At first glance, large investment banking firms may look very much alike, and many not-for-profit hospitals and other healthcare providers simply hire firms with the lowest fees to sell their bonds in the public market.
However, to identify the underwriter that will deliver the best results, it is important to understand the services that underwriters provide. Developing a list of questions to ask candidates can help hospitals, health systems and other providers find the best-suited firm.
For example, hospitals should identify whether their offerings present specific challenges and ask candidate firms about their expertise in those areas. Factors such as complicated credit, highly regulated environments, competitive service areas or other unique situations should be considered during the selection process.
Each question should be assigned a weighting, so answers from the firms interviewed can be scored. Weights will vary depending on the situation. For example, issuers in the AA category can place less weight on the strength of the underwriter’s credit professionals because credit will be a lesser concern for investors.
Four groups involved in underwriting
Before developing a scorecard, it is helpful to understand that underwriting a bond issue requires input from four groups within the investment banking firm: bankers, credit staff, underwriting and trading professionals, and sales.
Bankers. These professionals explain the issuer’s credit characteristics and financing needs to other areas of the firm, and they structure the terms of the offering. They can also assist hospital or health system financial advisers in preparing rating presentations and “road shows” for prospective investors.
Credit staff. The credit staff ensures that the offering meets the firm’s minimum requirements and assists bankers in preparing credit analyses as part of presentations.
Underwriting and trading professionals. These professionals determine the most appropriate mix of securities to be offered to investors based on market conditions. Underwriting and trading professionals also coordinate pricing and structuring ideas with co-managers, and they determine the need for a selling group to round out the underwriter’s sales force.
Sales force. The sales force contacts potential investors prior to the formal sale to determine their interest level and respond to any credit concerns. The sales force also informs the underwriting staff of expected yield levels, as well as market preferences regarding the issue structure. This feedback allows the underwriting staff to adjust the structure seeking to maximize investor demand. Finally, the sales force actively markets the bonds to customers and secures orders.
Underwriter interview questions
It is prudent to ask the following questions when conducting a request for proposals or when interviewing underwriters:
1. How well do bankers understand the hospital’s unique structural or credit needs?
2. Do they have a track record of providing creative financing solutions?
3. Do they have the skills necessary to assist in preparing credit presentations?
4. How well do they understand the market for the hospital’s bonds?
5. Does the firm have clients who compete in the hospital’s current or future marketplace?
6. How well does the credit staff understand the credit and proposed structure?
7. How experienced are they with the same type of credit?
8. How well would they communicate key credit considerations to their internal sales force?
Underwriting and trading professionals
9. How experienced are they in underwriting the same or a similar type of bonds?
10. Do they have a track record of aggressively pricing similar credits?
11. Have they demonstrated willingness to purchase unsold bonds for their own account?
12. Do they have a history of maintaining a visible secondary market presence and a special commitment to making markets in senior-managed underwritings?
13. Does the sales force have relationships with major institutional investors and/or a substantial retail customer base?
14. Have they demonstrated the capacity to market the same or a similar type of bonds?
In addition to asking the 14 questions, the following factors should be considered and evaluated:
Potential conflicts of interest. The underwriter typically should not represent directly an existing or potential competitor.
Overall experience. Underwriters’ experience can be evaluated based on a list of each firm’s bond issues in the last 12 to 24 months. Most bond issues are reported on Electronic Municipal Market Access (EMMA). Once relevant bond issues are presented, the hospital can contact some of the entities on the list and request feedback on each underwriter’s performance.
Underwriters should have experience in the following areas and be able to share their past performance:
Fixed-rate issues. An underwriter’s performance in pricing fixed-rate bonds can be evaluated based on a comparison of yields on bonds the firm sold to benchmarks in the last year. For taxable issues, the typical convention is a comparison to U.S. Treasury yields on the day the bonds were sold. For tax-exempt issues, the comparable benchmark is the Municipal Market Data (MMD) AAA scale, which is published daily and reflects yields offered on high-grade, tax-exempt bonds that day.
In both cases, the spread (difference in yield between bonds sold and the associated benchmark) for each maturity is compared. Typically, the lower the spread, the better the firm’s pricing and structuring expertise.
Variable-rate issues. Pricing performance for variable-rate issues can be evaluated by asking the underwriter to provide rate histories for several of their clients. For tax-exempt variable rate bonds, the spread can then be calculated based on the Securities Industry and Financial Markets Association Municipal Swap Index (SIFMA) published weekly and compared with spreads for other similarly rated issues.
Willingness to underwrite. To determine the underwriter’s willingness to underwrite, consider a review of their pricing expertise and interview comparable clients. In general, narrow spreads to benchmarks signal that the underwriter is willing to risk using its own capital to achieve lower yields. Alternatively, wider spreads show that the firm may price issues less aggressively at higher yields to avoid the risk of being left with unsold bonds it will have to purchase for its own account.
Starting with the initial meeting, the bankers’ creativity and presentation skills can be assessed by observing and interacting with them. In addition, bankers’ responses to interview questions will help reveal their level of professionalism, presentation skills and readiness.
To gain a stronger sense of each candidate’s suitability, each firm can be asked to outline its process for evaluating the hospital’s credit, its proposed credit and marketing strategy, and its recommended plan of finance.
An underwriter’s fee or “spread” is generally composed of three elements:
1. Management fee
2. “Takedown” or sales commission
3. Reimbursement for expenses incurred
Expenses include fees paid to the underwriter’s counsel, fees for travel and — to a lesser extent — charges imposed by regulatory authorities. It is important to note that a seemingly low “all-in” fee quote assumes that the hospital will pay fees charged by the underwriter’s counsel. Therefore, expense quotes should be adjusted to make them comparable.
In considering evaluation criteria, borrowers commonly place the greatest weight on fees. After all, prioritizing fees makes the ranking process easier. Since 2013, the average underwriting spread for hospital bonds went from $7.22 to $5.50 per bond.
While fees paid to underwriters are important, they have a lesser impact on the cost of capital than the total interest cost on the bonds. The reasons for this are twofold:
The largest component of an underwriting fee is the commission paid to the firm’s sales force. Logically, salespeople working for a minimal fee may have less incentive to develop a robust market for an issuer’s bonds than a firm expecting a higher fee.
A low fee can work against the issuer by increasing the underwriter’s risk aversion. In other words, a firm charging a low fee would likely be unwilling to expose itself to the risk that rising rates will lead to a fall in the market value of unsold bonds. In such cases, issuers can expect a higher interest cost on bonds than if the firm were working for a market-based fee.
On average, underwriter fees do not vary significantly based on issue size, although due to minimum underwriting costs, fees for smaller issues below $25 million tend to be higher as a percentage of par.
Typically, it may be best to negotiate fees after settling structural components, receiving credit ratings and evaluating market conditions. Only then do hospitals and health systems have all the information necessary to determine what may constitute fair fees.
Careful consideration of underwriters
Prior to selecting an underwriter, it is crucial to consider the proposed firm’s demonstrated marketing and structuring expertise, its understanding of the hospital’s unique situation and challenges, the suggested plan of finance and sales commission and management fees. Healthcare organizations will likely benefit from assigning less importance to fee quotes and emphasizing investment banking firms’ proven abilities to deliver financing that meets hospital and health system needs at the lowest available cost of capital.
Important Disclosure Information
PFM is the marketing name for a group of affiliated companies providing a range of services. All services are provided through separate agreements with each company. This material is for general information purposes only and is not intended to provide specific advice or a specific recommendation. Financial advisory services are provided by PFM Financial Advisors LLC and Public Financial Management, Inc. Both are registered municipal advisors with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) under the Dodd-Frank Act of 2010.