Devolvement - Explained
What is Devolvement?
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What is Devolvement?
Devolvement refers to an act of passing ones duty to another or delegating to another. An individual can devolve the authority or responsibility to another person. In investment, devolvement is a situation in which an underwriter or underwriting firm is required to purchase the unsold shares in an undersubscribed issue. That is, if a company makes an investment or debt issue and encounters under-subscription, devolvement happens when an underwriting investment bank is forced to purchase unsold shares in the offering.
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How Does Devolvement Work?
Devolvement is often used when an underwriting firm has made a commitment to help a company sell an entire issue of securities but unable to sell the securities in an IPO. While devolvement offers substantial benefits to an issuing company, it poses risk to the underwriting firm or investment bank. An underwriting firm is mandated to purchase all unsold securities or unsubscribed portion of an issue at a price slightly higher than the market price. The purpose of mandating the underwriter to purchase an unsold issue is to allow the company to meet its capital goals which the underwriter has also pledged commitment to in the underwriting contract. Part of the risks devolvement poses to an underwriting firm or investment bank is financial loss given that the unsubscribed issue purchased by the bank are sold in the secondary market, often at a price lower than the purchase price. In most situations, devolvement is considered as an indicator that there is market resistance towards an issue. This is because under-subscription for a company's issue is not a good trait, it can also cause a decline in the subsequent demand for the company's debt offerings or existing shares.
Varying Levels of Devolvement Risks
Devolvement poses different risks to the issuing company and the underwriter. The underwriting contract between a company and in investment also determines the different levels of devolvement risk that the investment bank would face. Generally, investment underwriters do not absolutely guarantee that an issuing company will sell its total issue, but in some underwriting agreement, investment banks give such a guarantee. The different types of underwriting contracts and their varying devolvement risks are as follows;
- The best effort agreement: In this type of contract, the underwriter only guarantees an issuing company that it would use its best efforts to sell an entire issue. Hence, the best efforts can turn out to be under-subscription or oversubscription. In this case, the underwriter is not forced to purchase the unsold securities in an issue.
- A firm commitment: In this agreement, the underwriter purchases an entire issue of a company and resells it. It is also known as a bought deal in which the underwriter takes on all the inventory risk of the issue.
- A market out of clause agreement: This is a clause that permits an underwriter to opt-out of an agreement if it encounters a problem in selling the company's issue. The underwriter can cancel or exit the agreement without facing any consequence.
- Standby Agreement: In this underwriting agreement, the underwriter agrees to buy all the unsold shares of a company in an IPO.