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What is underpricing?

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Underpricing occurs when the offer price to participant lenders in the primary syndication of a loan is lower than the loan’s break price in the secondary market.  Underpricing rewards participant lenders and captures their profit on the loan when selling into the secondary market.

Arrangers often adjust the offer price and/or the underwriting spread of the facilities they syndicate relative to the loan’s anticipated break price.  A loan’s break price is the first available secondary market price after syndication closing and the deal is completed, reported in percentage points of par:

Underpricing = Break Price – (Par – Original Issue Discount)

The total cost of the syndication to borrowers is the sum of the underpricing and the underwriting spread.  The greater the underpricing, the lower the amount of funding borrowers receive from the sale of their facilities, where any increase in underpricing increases the cost of financing facilities.

Underpricing may also depend on whether arrangers are commercial banks or nonbank lenders (e.g., investment banks, finance companies) and the syndicate structure.  The participation of commercial banks in syndicates is significantly higher if the loan is a line of credit and the borrower is rated.  They also have a competitive edge over nonbank lenders in providing liquidity insurance.

 [Observations] demonstrate that syndicated loan pricing differs depending on whether a commercial bank or an investment bank is the lead arranger.

– Hallak & Schure, 2011

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