The Securities and Exchange Board of India, or Sebi, has decided to experiment with the auction system for public offerings, by allowing this for follow-on share sales, to start with. This seems to suggest that at some point, the option will be extended to initial public offerings (IPOs) as well.
The world over, the auction system has failed to take off. Most IPOs are done using the book-building method, where issuers and their merchant bankers indicate a price range they are comfortable with. Bankers market the offer through a series of roadshows and, finally, the book is built, with investors bidding for the number of shares they are interested in at close to the indicated price. Many experts have complained about the non-transparency of the book-building method, since bankers and issuers have the final say on allotments and pricing.
The auctioning system is superior in that sense, since it addresses the issue of transparency and enables the issuing firm to get the best possible price from the IPO. Still, an auction is very rarely used for public offerings in most markets. Google Inc. made it famous in 2004, but even that event didn’t revive interest in IPO auctions. Of course, opposition by merchant bankers may have a lot to do with that.
Researchers Ravi Jagannathan and Ann Sherman, from the Kellogg School of Management and DePaul University, respectively, pointed out in a 2006 paper titled “Why do IPO auctions fail” that the main reasons for the failure are “the winner’s curse” and “the free rider problem”. The winner’s curse is the tendency for the winner of an auction to overbid. Free riders refer to uninformed investors who bid high in the hope that the auction clearing price will be set by those who do their homework. But this behaviour, in turn, keeps out informed investors, making the auction process unstable. That could be the reason why Sebi is starting the auction process with follow-on offers, which have the advantage of a market price that investors could use as a benchmark for bidding.
It must be noted here that the idea of having a unified auction process was mooted in the economic survey for 2005-06, as a response to the abuse of the “retail quota” by those engaging in multiple applications. The survey had envisaged a new system where quotas will be done away with, and price discovery will move to an auctioning system.
Sebi’s announcement this week is a modification of that, since it leaves the quotas untouched and gives retail investors preferential treatment by allowing them to buy shares at the floor price. This is based on the view that retail participation needs to be encouraged in the capital markets and the primary markets are a good entry point for new investors. But this also takes away the issuer’s ability to raise capital at the most optimal price, to the extent of the retail quota.
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