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What Is a Back Stop?
In a securities offering, a back stop (or backstop) is a last-resort support or bid for the unsubscribed portion of shares.
When a company is trying to raise capital, it may get a back stop from an investment bank or a major shareholder. The company providing the back stop promises to buy any unsold shares at the end of the offering, thereby guaranteeing a minimum share price. A backstop is typically established during the underwriting process.
Key Takeaways
- A back stop acts as a safety net, guaranteeing the purchase of unsubscribed shares in a securities offering.
- Companies use back stops to ensure they raise a targeted amount of capital, even if market support is lacking.
- Back stops often involve investment banks entering firm-commitment agreements to purchase unsold shares.
- This mechanism transfers the financial risk of unsold shares from the issuing company to the underwriting organization.
- If all shares are subscribed in the open market, the back stop agreement becomes unnecessary.
Understanding the Mechanics of a Back Stop
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 is called a firm-commitment underwriting deal, which commits to buying a set number of unsold shares.
With this agreement, the organization promises to buy specific unsold shares, providing the needed capital.
This gives assurance to the issuer that the minimum capital can be raised regardless of the open market activity. Also, the organization takes on all the risks associated with these shares.
If all shares sell through regular means, the contract for buying unsold shares is void.
Fast Fact
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.
Important Considerations for Back Stops
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. These shares are managed like any other market investment. The issuer can’t restrict how these 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 Action
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.”
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