“Different types of IPO mechanism: book building vs. auction vs. fixed price”
The article that this research paper will used as a base article will be Why Don’t Issuers Choose IPO Auctions? The Complexity of Indirect Mechanisms. By Ravi Jagannathana, Andrei Jirnyiaa and Ann Shermanc.
Initial Public Offerings
This is the first time a company decides to sells its shares to the public. Initial public offerings are mostly done my small sizes firms who wants to raise capital for their expansion. Large companies also go for initial public companies when they want to switch from being the private limited companies to public limited companies.
Auction is an exchange process in which good or services are sell by the seller to the buyer with the highest bid.
The act of acquiring prospective traders for the objective of buying new shares that are first time issued. The level of the sign of attention can have an effect on the cost of the new shares because it allows getting a concept of how much requirement there is for these new shares.
It is a macroeconomic theory that explains that how organizations can obtain their social and economic goals provided that the customers might have incomplete information and have their own self interests.
This paper would compare the three methods used in the IPO mechanism over the last fifty years. The three methods used are auctions, fixed service public offers and book building. Among the three the least widely used among people is an auction. Because the complete auction process is quite complicated and difficult for the users. There is very less research on Initial public offering in the literature even though initial public offering is very important because as leads to price discovery which further helps in reducing the conflicts between the buyers and the sellers. But there are no single factors that influence the choice of which mechanism to be used. The paper will review all the factors that can possibility influence the choice of the issuers and investors internationally.
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Morever,this paper will suggests that one of the main reason that auctions is one of the less preferable methods by the investors is because they don’t like the whole procedure of participating in the auctions. Furthermore, it will suggest that the issuers should move to hybrid mechanism, similar to one followed by the U.S treasury department.
Whenever a firm issues its shares in the market for the first time which is that the firm is going for the initial public offering, and then the firm has to go through a whole process of deciding the right price for its shares, the potential buyers and the number of shares to be issued. Moving on to the options that a firms has for initial public offering are, fixed price offerings, book building, different types of hybrid and auctions.
If we talk about U.S, then in U.S book building is widely used for initial public offering. Book building is the act of acquiring prospective traders for the objective of buying new shares that are first time issued. The level of the sign of attention can have an effect on the cost of the new shares because it allows getting a concept of how much requirement there is for these new shares. However, with this option there are always the chances of abuse and prove that internet is always full of scandal of abuse during the book building.
But in sealed bid auction there are less chances of abuse because there is a less role of the administrator which leads to fewer chances to manipulation. And this method is being used for years for now for the U.S government securities and other debts and has been successful so far. And because of fewer chances of abuse and manipulation, auction has always been a famous possibility for initial public offering but these days book building is more preferred by the issuers and the investors and has become the most widely used method internationally.
There are numerous explanations in the literature that supports book building that why book building is the most preferred and widely used method. Sherman and Titman (2002) claim that the higher management and versatility of the book building technique and the attention that comes with it, under certain circumstances, offer significant advantages for the issuers who are enthusiastic about selecting a particular stage of under pricing to generate the preferred quantity of information gathering and cost finding by prospective investors.
It was when the Prime Minister of UK, Margaret Thatcher went for the privatization of the British companies which led to many changes internationally and that include the changes in the method of initial public offering internationally. Before the privatization, fixed price offering was the most popular method used but after the privatization trend followed many large companies were forced to go for new methods.The companies first went for auction and then book building became the most popular method used for the initial public offerings.
In fixed price offerings, the cost and allowance guidelines are set before details on requirement is obtained, and shares are assigned according to the guidelines declared previously. This technique may provide some versatility in allocating shares across categories (for example, favoring little purchases over huge purchases, as is done in many countries), but we do not categorize promotions as being set cost community provides unless the underwriters and providers have little or no discretion in conditions of discuss proportion.
In book building there is a proper road show arranged for the investors so that they can gather all important information and can enter it in their order book. The order book is the source of great guidance and information for the under writer as it helps him know about the demands of the investors and also the number of shared t be issued can be adjusted accordingly. The key difference between the fixed public offers and book building is that in book building the investors can influence the pricings and allocations.
There are different of auctions use in initial public offerings mechanism. For example there are uniformed auction also known as multi unit sealed auctions where all the winning investors have the same bids. The price that the bidders pay is known as market clearing price which is the highest price but sometimes the shares are sold for the price below the market clearing price. When the shares are sold below the market clearing price, such auction are known as dirty auction instead of the uniformed auctions because people believe that information of other bidders regarding their bids during the process is secretly leaked to other bidders. Then there is another form of auction which is known as pay-what-you –bid. In this form of auction the winning bidders pay what they have bid. Also, auctions are open for everyone who wants to bid but there are few auctions which have the restriction on participation of the investors. Unlike Book Building, auction rules are set and announced beforehand and no changes are made in them.Also, there are few countries that do not follow a single method but the combination of the one of the three methods for initial public offering. This is known as hybrid mechanism. The most popular combination used is of book building and of the public offers. Other combinations include, public offers and auction or book building and auctions. Countries that follow that combination of book building and public offers sues book building to set prices for foreign investors and use public offers to set price for local investors.
Furthermore, there are two types of hybrids: sequential and simultaneous. In sequential hybrid prices are set before and are not adjusted according to the investors demand and in simultaneous hybrids prices are open and are decided as late as possible like in book building.
The comparison between different countries’ initial public offering process
According to the data available on the international initial public offerings, there is one single method that the countries use. Most of the countries are using the combination of methods which is known as the hybrid mechanism. The trend that can be seen in many countries is that the investors are not forced to go for one particular method. Countries still are practicing auctions as well as the same time they are also going for book building. The two notable trends that can be seen are that book building has become more common and auctions that were more popular before have become rare today.
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U.S. is still using fixed price offers in some kind, either alone or as hybrid mechanism. That historical evidence shows that auctions were quite popular in Europe, Asia and American countries but this trend has been fallen within few years.
Experimentation with book building building exploded in the mid-1990s, and the technique seems to have ’stuck’ in most nations, again as a multiple with set price public provide. Auctions usually were discontinued before book building was presented, so that there have only been a few nations in which both techniques were in use at the same time.
They are the only technique permitted in Vietnam, and a limited kind of community auction is used in Native Indian, which prohibits book building. They have been regularly used in previous times in Israel, where sales were the only permitted method for a several years. Book building has been permitted in Israel since mid-2007, but the industry has not been effective since that regulatory modify, so it is too beginning to tell how the option of problem techniques will develop there.
Book building was first permitted in India in the 90’s but was not well-known for many decades. Gradually, after regulatory changes, book building became more well-known there.
In Italy, auctions were well-known in the first 50 percent of the 90’s. On the controlled transactions, they progressively lost market discuss to successive multiple book building developing over several decades, then run out quickly in 1999 when simultaneous
hybrid book building was permitted. Auctions continued to be used on the not regulated over-the-counter industry (theMarche Libre or Free Market) for several more decades, although they eventually seem to have run out there, also.
Auctions were the only technique permitted in Israel for a several decades. The law demanding their use terminated in Dec,2003, after which providers were permitted to successfully select a set cost community provide by setting a highest possible price for the community auction.
Many of the IPOs between 2004 and mid-2007 select to set a relatively low highest possible cost for their offerings, thus successfully choosing set cost over auction16. In 2007, a long-debated change went into effect, allowing guide book building for initial public offerings. It is too soon at this point to tell how auction will contest with book building in the Israeli industry.
Auctions were the only technique permitted in Asia from 1989 through 1997. Discriminatory (pay-what-you-bid) hybrids were needed; with the set cost community provide tranche paying the calculated regular successful bid cost from the community auction. Due to recognized problems with community auction overpricing, the rules were changed in 1992 to require more of the stocks to be sold (at least 50%) and to allow the set cost community provide tranche to be priced totally below the calculated regular successful bid cost from the community auction.
Maximum order size in the community provide tranche was limited, inducing institutional traders to join primarily through the community auction, and in some cases minimum bid sizes were used in the sales to try to prevent small visitors from taking part. When providers were permitted to choose between sales and guide developing beginning in 1997, and as a result auction disappeared.
Since 1995, Taiwan has permitted both sales and guide developing, in addition to the traditional set cost public offers. Taiwan’s sales are similar to those that were initially needed in Asia – discriminatory compounds. Auctions were initially well-known but missing business eventually, with more and more providers coming back to pure set cost public offers. Book building was initially permitted only in certain limited circumstances but has became popular in the last few decades.
In Latina America, sales have been used in Argentina, South America and Peru in the past. Latina American markets were quiet for many decades, with outnumbering listings in South america, Argentina and Chile18. Thus it was hard to estimate if auctions were gone completely. However, Brazil, Chilean and later Argentinean IPO marketplaces began picking up in 2004-2005, with even more powerful activity in 2006, and guide developing has been the prominent technique, with no auction over the last several decades.
In the US, the investment bank WR Hambrecht has been motivating providers to use sales since mid-1999.The technique got much advertising when Google, a well-known online search engine company, select to use the community auction method.
Explanation for the failures of initial public offerings.
One of the explanations advanced in the literature for the popularity of the book building method is the flexibility it offers the issuing firm relative to auctions when it comes to the tradeoff between minimizing underpricing and promoting information gathering by investors. Indeed, there are several reasons to believe that issuers care about other aspects of the process beyond just the magnitude of underpricing as evidenced by initial returns. For example, one reason to go public is to give current stockholders such as the founders, venture capitalists and angel investors a chance to diversify by liquidating at least part of their holdings. Such investors usually cannot sell until the end of the lock up period and thus care about the eventual stock price as well as the offer price and first day’s trading price. If a deep, liquid market is not established, those investors may be unable to sell their shares at a reasonable price, even after the time and expense of an IPO. Companies that go public but do not attract an institutional investor following may end up as ”Orphans”, not covered by analysts or otherwise monitored closely enough to be accurately priced.
This means that they will be unable to do follow-on equity offerings and will tend to trade at a substantial discount, due to their illiquidity and added risk. In order to minimize this possibility, firms may be willing to pay, through underpricing, to attract the attention of serious investors in the IPO19. This may explain the importance of analyst coverage found in Loughran and Ritter (2004), Cliff and Denis (2004) and Mola et al. (Forthcoming). In the words of Martin Manley, Chairman and CEO of Alibris20, “Taking a company public is like getting a heart transplant: you only do it once and you need it to be done very, very well. It is not a decision driven by price.”
This brings up the question of what objective function issuers are maximizing when choosing an IPO method.
Loughran and Ritter (2004); Sherman and Titman (2002); Sherman (2005), Chemmanur and Liu (2003) and Liu and Ritter (2011) offer alternative objective functions that consider more than just maximizing proceeds. The appropriate objective function for IPO issuers is a subject in itself, and one worthy of future research. In this paper, we simply note that the evidence indicates that issuers care about more than just maximizing the expected proceeds from the IPO.
Sherman (2005) compares open uniform-price and discriminatory auctions to the results of a mechanism-design approach in which the underwriter invites investors to participate and has discretion over both pricing and allocations.
This optimal mechanism is termed “book building”, because book building, from a regulatory standpoint, allows the issuer to chose price and allocations.
She considers the possibility that an issuer’s utility may depend on both expected proceeds and pricing accuracy21, and shows that the ability to control allocations offers additional flexibility, allowing the underwriter to decide on the tradeoff between the two objectives. However, as Sherman (2005) demonstrates, auction outcomes can sometimes be close to those of the optimal mechanism, as we can see from her example in which issuers who place a high value on pricing accuracy can do well with a discriminatory auction22. The key disadvantage of the sealed bid auctions that Sherman models is largely due to the “open public” (i.e. every investor has the option to participate) setting, rather than of the auction method itself. A private (“by invitation only”) auction would not have this disadvantage.
Moreover, the comparison in Sherman (2005) does not account for the lack of transparency and resulting potential for abuse that occurs with book building, because of the agency problem between the issuer and underwriter. One of the few papers that has modeled this agency problem is Biais et al. (2002), for the French regulatory regime. Thus, at least under certain conditions, auctions may have an advantage over book building because of their transparency.
Hence, it would be difficult to explain the extent to which book building has come to be the dominant IPO mechanism in practice based only on the reasons that have been advanced in the theoretical finance literature.
3.2. Unwillingness to try a new method?
Another possible explanation for the low numbers of IPO auctions in the US is that the auction method is simply too new and experimental, and that issuers are afraid to try an unproven method. This is plausible, since an IPO is a very expensive, very public step for a company, so issuers may not be anxious to experiment. However, this ‘lack of familiarity’ argument cannot explain the overall low market share of the auction method around the world. First, the mere fact that IPO auctions have been used in at least half the countries for which we have information implies that quite a few issuers have been willing to experiment. More importantly, if we look at relative usage patterns over time, issuers have been most enthusiastic about IPO auctions when the method was new, and they generally became less willing to use it after they had become more familiar with the method.
Figure 1 shows the relative auction usage patterns over time in four countries. For Singapore, Taiwan and Turkey, the main alternative method was fixed price public offers, which had been the traditional method in those countries.
Auctions were first allowed in 1993 in Singapore23 and Turkey, and in 1995 in Taiwan. In France, both auctions and fixed price public offers had been used for decades, but sequential hybrid book building was first introduced in the 1990s, while standard book building was only allowed beginning in 1999.
As can be seen from Figure 1 for the three countries in which the open IPO auction method was newly introduced, auctions captured their greatest market share early on, with two-thirds or more of issuers choosing to use auctions when they were relatively new. As issuers became more familiar with the method over time, a lower proportion of them chose to use the auction method. Hence, it is hard to argue that, in these countries, the disappearance of IPO auctions was due to lack of familiarity or to an unwillingness of issuers to try a new method.