An Introduction to Gross Spread
The gross spread is the compensation that the underwriters of an initial public offering (IPO) receive. An IPO is the process of taking a private corporation public by issuing shares of stock. Gross spread represents the difference between the underwriting price received by the issuing company and the actual price offered to the investing public. Essentially, the gross spread is the financial institution’s cut or profit from the IPO listing. Gross spread is also known by terms such as gross underwriting spread, spread, or production.
Key Takeaways
- The gross spread is the compensation that the underwriters of an initial public offering (IPO) receive.
- The majority of profits that the underwriting firm earns through the deal are often achieved through the gross spread.
- Funds produced by the gross spread cover management and underwriting fees as well as sales concessions to broker-dealers.
Understanding the Gross Spread
The gross spread covers the cost incurred by the underwriting firm for conducting an IPO. A company may choose more than one underwriter to leverage specific areas of expertise. The majority of the underwriting firm’s profits are typically derived through the gross spread.
When a company decides to raise funds from investors, it hires an investment bank to act as the underwriter for its IPO. The underwriters, in collaboration with the company, determine the amount of capital the IPO will raise and the compensation the bank will receive for their services. The company and the underwriters file a statement with the Securities and Exchange Commission (SEC) to register the IPO. After the SEC reviews the application and verifies the necessary information, a filing date is established.
The investment bank buys shares at a specific price to support the IPO and then sells these shares to its distribution network at a higher price. The difference between these prices constitutes the gross spread, which is effectively the underwriter’s profit.
Gross Spread and Underwriting Costs
Funds generated by the gross spread must cover various underwriting costs including the manager’s fee, underwriting fees (obtained by members of the underwriter syndicate), and concessions (the price spread earned by the broker-dealer selling the shares).
The syndicate manager is entitled to the whole gross spread, while each member of the syndicate receives a share of the underwriting fee and concession, which may not be equal. Broker-dealers who aren’t part of the underwriter syndicate yet sell shares receive only a concession share, while the firm providing them with the shares retains the underwriting fee. Legal and accounting expenses, as well as registration fees, also fall under the gross spread umbrella.
Interestingly, the proportion of the concession typically rises with the total gross spread, while management and underwriting fees shrink inversely. This effect is due to differential economies of scale; larger deals often entail more significant sales efforts without necessarily requiring proportionally more work in other areas like drafting the prospectus or preparing the roadshow.
Real-World Example: Breaking Down a Gross Spread
Consider Company XYZ, which receives $36 per share for its initial public offering. If underwriters then sell the stock to the public at $38 per share, the resulting gross spread—the difference between the underwriting price and the public offering price—would be $2 per share. Several factors, including issue size, risk, and market volatility, can influence the gross spread’s value.
Determining the Gross Spread Ratio
The gross spread can also be expressed as a ratio. For example, with a $2 per share difference between the investment bank’s purchase price from the issuer and the public offering price, the gross spread ratio is around 5.3% ($2/$38 per share).
A higher gross spread ratio indicates a more significant portion of the IPO proceeds goes to the investment bank. This ratio can variably range between 3-7%, depending on the deal’s size and the country of origin.
Related Terms: public offering price, underwriting fee, concession, prospectus, roadshow.
