Back Stop

What is a back stop?

A back stop (or backstop) is a financial guarantee in a securities offering where an underwriter, investor syndicate, or major shareholder agrees to purchase any unsubscribed shares or bonds. It ensures the issuer raises a minimum amount of capital by committing to buy the portion of the offering that the open market does not absorb.

Key takeaways

• A backstop guarantees purchase of unsubscribed securities, acting as a safety net for the issuer.
• It transfers the risk of unsold securities from the issuer to the backstopping party.
• Backstops are commonly arranged during underwriting as firm-commitment agreements.
• If the market fully subscribes the offering, the backstop is not used.

How a back stop works

• The issuer and an underwriting organization (often an investment bank or syndicate) agree that the underwriter will buy any unsold securities at a predetermined price or under agreed terms.
• This arrangement is often structured as a firm-commitment underwriting: the underwriter is legally obligated to purchase a set number of unsold securities.
• Once the underwriter takes possession of the securities, it manages, holds, or sells them according to market regulations and its own strategy.
• Variants of support can include revolving credit facilities or letters of credit provided to the issuer as alternative guarantees.

Important considerations

• Ownership and disposition: If the underwriter acquires unsubscribed securities, it owns them outright and can trade them subject to applicable regulations.
• Pricing and fees: Third-party backstop purchasers (if used) may bid below the offering price or demand fees as compensation for taking on the risk.
• Risk transfer: The issuer secures capital certainty, while the backstop provider assumes market and liquidity risk.
• Contractual terms: Specific rights, timing, pricing, and termination conditions are set out in the backstop agreement.

Example

In a rights offering, Company A agrees to provide a 100% back stop of up to $100 million. If the issuer aims to raise $200 million but only attracts $100 million from public subscriptions, Company A purchases the remaining $100 million of unsubscribed securities to ensure the full $200 million is raised.

Back stops in bond issues

A bond backstop functions similarly: an underwriting bank or syndicate guarantees to buy any unsold bonds at an agreed price, thereby ensuring the issuer achieves its target funding.

Backstop purchasers

If an underwriting bank declines or cannot provide a backstop, third-party purchasers may step in. These buyers often:
* Require discounts or fees.
* Accept difficult-to-sell positions they later try to liquidate over time at a profit.

Regulatory constraints (Volcker Rule)

Regulations such as the Volcker Rule can restrict backstopping by banking entities when doing so would create a conflict of interest or expose the bank to material risk. The rule aims to prevent backstops that would lead to significant proprietary exposure to high-risk assets or threaten the bank’s safety and soundness.

Conclusion

Backstops provide issuers with greater certainty of raising targeted capital by shifting the risk of unsold securities to underwriters or other purchasers. They are useful tools in underwriting but carry costs and regulatory considerations for the parties that provide them.