Devolvement: What It Is, How It Works, Types

What Is Devolvement?

Devolvement refers to a situation when a security or debt issue is undersubscribed, forcing an underwriting investment bank to purchase unsold shares during the offering. In the underwriting process, an investment bank will help to raise capital for the issuing companies. The bank may include making a commitment to the company to sell all shares of the issue.

However, if investors do not purchase those securities, the responsibility for the unsold shares may devolve to the underwriters. Devolvement may happen in the issue or selling of company debt and also through selling an initial public offering (IPO).

Understanding Devolvement

Devolvement poses a substantial risk to an underwriting investment bank. In those instances where the investment bank is contractually obligated to purchase unsubscribed shares of an issue, it often will need to do so at a price that is higher than the market-value price. Typically, the investment bank will not hold onto the floundering issue for long but will sell the shares on the secondary market.

Many times, the bank will experience a financial loss if they are unable to sell all the securities available and devolvement occurs. For this reason, investment banks may attempt to mitigate their exposure by including clauses in their contracts with issuing companies that eliminate or limit their devolvement risk.

Special Considerations

Devolvement may be seen as an indication that the market has negative sentiments toward the issue. This negative sentiment may have a significant impact on subsequent demand for the company's existing shares or debt offerings. Underwriting banks may suffer the results of negative views as they try to move any shares they hold.

Enhanced capital and media attention associated with a company with an undersubscribed offering has risks for companies and underwriting banks. Typically, the goal of a public offering is to sell at the exact price at which all the issued shares can be sold to investors, and there is neither a shortage nor a surplus of securities.

Most of the time in the United States, the company that hopes to go public and the investment bank underwriting the IPO have done the necessary homework to ensure the initial shares are all purchased and devolvement isn't necessary.

Types of Devolvement Risk

Investment underwriters do not necessarily guarantee that a total issue will sell. It will depend on the underwriting agreement the bank and the issuing company agree upon. Different types of contracts will involve varying levels of devolvement risk.

Firm Commitment

In a firm commitment deal, an underwriter agrees to assume all inventory risk and purchase all shares of a debt or stock offering directly from the issuer for sale to the public. This is also known as a bought deal. The underwriter purchases a company's entire IPO issue and resells it to the investing public. The bank will receive the shares for a reduced price. Compensation comes from the difference between what they can sell the shares for and what they paid. 

Best Effort

In a best-efforts deal, the underwriter does not necessarily purchase any of the IPO issues. Instead, it only makes a guarantee to the business issuing the stock that it will use its "best efforts" to sell the issue to the investing public at the best price possible.

Standby Underwriting

Standby underwriting is a type of agreement to sell shares in an IPO in which the underwriting investment bank agrees to purchase whatever shares remain after it has sold all of the shares it can to the public. Risk will transfer from the company to the underwriting investment bank. Because of this additional risk, the underwriter's fee may be higher.

Market Out Clause

A market out clause reduces risk exposure by allowing the underwriter to cancel the agreement without incurring a penalty and without having to purchase any unsold shares. The reasons for withdrawing from the agreement must be clearly stipulated in the contract. For example, the underwriter may cancel if they are having difficulty selling the company's stock due to a lack of investor interest or if market conditions have deteriorated over the course of time.