The flaws of the book- building mechanism, which gives the underwriter substantial discretion over allocations in an initial public offer (IPO), are well known. That is why the suggestion often is that issuers are best served by using an auction method instead.
Auctions are relatively more transparent, giving little discretion to the auction administrator, and are consequently less subject to manipulation and abuse. Yet, many countries have tried the auction method and abandoned it. The usual reason given is that lobbying by investment bankers has scuttled the adoption of the auction method, because they benefit by charging higher benefits or by granting favoured allocations to their cronies.
The researchers examine the arguments for and against the book-building method and why the auction method has not been universally adopted.
Incidentally, while in India we continue to talk about our IPO method being one of book building, the authors say that, “Although India still labels its method book building, the method is now a uniform price auction, with no allocation discretion.”
That’s because underwriters no longer have power over allocation, which are required to be proportionate to bids. In true book building, the authors argue, “the offering price is set only after the order book is full, giving the underwriter some idea of demand. The underwriter has substantial discretion over allocations, with those customers who helped in pricing the issue and those with long term relationships with the underwriter getting more favourable treatment.”
After conducting a study of IPO practices in 50 countries the researchers find that while the book-building method that was once rare outside the US is now common, auction methods have been tried in 25 countries, but are rare today. Moreover, the auction method has been tried for issues of all sizes and the auction methods too have varied.
Yet, says the paper, “the outcomes have been surprisingly consistent: When issuers have been given a choice, they have generally chosen not to use auctions once they became familiar with the method. In this sense, IPO auctions have consistently failed the market test.” Book building is gaining in popularity or is already the dominant method in more than 40 of the countries, while fixed-price public offers are still used in smaller countries and for smaller offerings. In fixed-price public offers, the price and allocation rules are set before information on demand is received, and shares are allocated according to the rules announced earlier.
Why did the auction method not succeed?
The researchers say they did not find support for the common explanations offered for the unpopularity of IPO auctions in the US—that issuers were reluctant to use a new, experimental method, or that underwriters pressured issuers to use a method for which they charged higher fees or were able to allocate underpriced shares.
They also said there is little support for the popular view that auctions lead to highly accurate pricing and, hence, to a low mean and variance of initial returns.
In India, for example, they point to a paper by A. Bubna and N.R. Prabhala which found that “when underwriters control allocations, bookbuilding is associated with lesser underpricing, but this effect quickly dissipates when regulations withdraw allocation powers.”
Why, then, is the auction method not used? The authors say that auctions are a very complex mechanism and even sophisticated investors have difficulty in getting prices right in an auction. In sum, “optimal auction bidding strategies are complicated, requiring sophistication and discipline, and mistakes by some impose costs on all bidders. Without some way to screen out ‘free riders’ and ensure the participation of sophisticated, long term investors, IPO auctions are highly risky for both issuers and bidders.” The conclusion: the optimal placement method is likely to be different from both traditional book builds, with their lack of transparency and resulting opportunities for potential abuse, and standard sealed bid auctions, with their high risk for both investors and issuers.
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