What is a backstop?
– A backstop (or back stop) is a contractual promise that ensures an issuer will receive a minimum amount of capital from a securities offering. If the open market does not buy the full issue, the backstop counterparty agrees to purchase the remaining unsold securities.
Key definition
– Firm-commitment underwriting: an underwriting structure in which the underwriting party guarantees to buy any portion of the offering that investors do not subscribe to. The underwriter thereby takes on the capital and market risk for that unsold slice.
How a backstop works — step by step
1. Issuer sets an offering target (e.g., $200 million) and arranges distribution with underwriters or a lead investor.
2. The issuer negotiates a backstop agreement specifying how much the backstop will cover, the purchase price or pricing formula, fees or compensation, and the time window for the commitment.
3. If public demand meets or exceeds the full offering, the backstop commitment is not used and typically lapses.
4. If demand is insufficient, the backstop counterparty buys the unsubscribed portion under the agreed terms.
5. Once the backstop purchaser acquires the securities, it owns them outright and may hold or sell them subject to market rules and any regulatory restrictions.
Who typically provides backstops
– Investment banks or underwriting syndicates (often using sub-underwriters) are the most common backstop providers.
– Major shareholders or strategic investors can also backstop an offering.
– In some cases independent third-party purchasers agree to backstop but may demand lower purchase prices or extra compensation.
Main economic effects and risks
– For the issuer: provides certainty that the minimum raise will be achieved, which can help with planning, investor perception, and credit standing.
– For the backstopper: it accepts price risk and liquidity risk for the unsold securities; it may face mark-to-market losses if price falls or profit opportunities if it resells at higher prices.
– For the market: use of a backstop may affect perceived demand and post-issue trading; aggressive discounts by third-party backstoppers can pressure secondary prices.
Special mechanisms and alternatives
– Letters of credit or committed revolving credit lines can be arranged by the underwriter to support an issuer’s credit profile instead of direct share purchases.
– For bond issues, underwriters may commit to buy unsold bonds at a set price; third-party backstoppers may bid substantially below the intended issue price or charge fees to compensate for the risk.
Regulatory constraint: the Volcker Rule
– U.S. regulations that separate some proprietary trading from client-oriented banking can limit or forbid a banking entity from backstopping a securities issue if doing so would create a conflict of interest, lead to significant exposure to high-risk assets, or threaten the firm’s safety and soundness. Issuers and banks must consider these rules before finalizing backstop arrangements.
Checklist for issuers (quick practical guide)
– Decide whether you need a backstop to meet minimum proceeds.
– Quantify the shortfall you want guaranteed (amount or percentage).
– Screen potential backstop counterparties for creditworthiness and regulatory constraints.
– Negotiate price mechanics (fixed price, discount, or formula), fees/commissions, and duration of the commitment.
– Clarify whether support is firm-commitment underwriting or a softer standby arrangement.
– Document resale restrictions (if any) and settlement mechanics.
– Confirm compliance with applicable regulations (e.g., Volcker Rule) and disclose backstop arrangements in offering materials as required.
– Plan communication to investors and rating agencies about the backstop’s role.
Worked examples
1) Rights offering (equity) — simple numbers
– Issuer target: $200 million.
– Rights offering attracts $100 million in subscriptions from shareholders.
– Backstop agreement: Investor A agrees to provide a 100% backstop up to $100 million.
– Outcome: Investor A purchases the remaining $100 million of rights, enabling the issuer to raise the full $200 million.
2) Bond issue — impact on an underwriter
– Issuer offers 1
,000 bonds at par ($1,000 face) for total proceeds of $1 billion; coupon 4%, maturity 10 years. Syndicate sells $900 million of the issue to investors at par. Underwriter B has agreed to a 100% firm-commitment backstop for the unsold $100 million.
Step-by-step outcome and economics
1) Gross spread (underwriting fee). Assume the syndicate’s gross spread is 1.0% (100 basis points) of par. Total fee = 1.0% × $1,000,000,000 = $10,000,000. If fees are split pro rata, Underwriter B receives its portion based on commitment size. For simplicity, assume the lead underwriter keeps the whole backstop fee associated with the $100m: fee on $100m = 1.0% × $100,000,000 = $1,000,000.
2) Immediate fill of inventory. Underwriter B now holds $100m face of bonds. If market yields stay unchanged and bonds trade at par, B