Can you remember the last time an issuing company not named “Google” tried an IPO auction? Neither can we.
As IPOs continue to rebound this year, largely driven by activity in Asia, a new paper explains why companies don’t try auctions more often despite the imperfections of the book-building approach. (Hat tip Marginal Revolution.)
And the answers diverge, mostly, from popular ideas of what companies worry about when they go public.
If you’re depressed that the weekend is over and just don’t feel like reading hundreds of words about obsolete IPO models on a Monday afternoon, here’s the abstract (emphasis FT Alphaville’s):
At least 25 countries have used IPO auctions, but most have since abandoned them. We argue that this is because auctions, being indirect mechanisms, require a level of sophistication above that of many investors. Through suitably calibrated examples, we show that even sophisticated investors can make mistakes while bidding in auctions, especially when facing uncertainty about the number and type of bidders, and such mistakes impose costs on other participants. We provide empirical support for our arguments. IPO auctions have been plagued by unexpectedly large fluctuations in the number of participants, return chasing investors, and high-bidding free riders. Our analysis suggests that a direct mechanism that resembles a transparent version of book building would be preferable to auctions.
The paper looks at the conventional understanding for why there aren’t more auctions, including:
1) Issuers won’t try new things, so they’re unaware that auctions would be advantageous, 2) Investment banks apply pressure on issuing companies to use the book-building method, 3) Issuers focus on maximising the price they get for the shares they sell.
The first is dismissed with a references to historical examples in countries that have experience with both kinds of IPOs, specifically France, Taiwan, Singapore, and Turkey. In each, issuers “became less likely to choose auctions as they gained familiarity with the method.” (There’s more detail on pages 9-12 of the paper)
As for the idea that abusive investment bankers are bullying their clients to do it their way:
This argument is somewhat inconsistent – it assumes that underwriters have sufficient market power to keep book building fees artificially high, and sufficient power to force issuers to use the book building method in spite of the high fees, but that they do not have sufficient power to demand artificially high fees for auctions.
Regardless, this argument cannot explain the disappearance of auctions in most countries, because auctions have usually been replaced by fixed price public offers, and public offer fees are typically as low as, or even lower than, the fees for auctions. Ljungqvist et al. (2003) show that average fees tend to be quite low for fixed price public offers across most countries, substantially below those for book building.
A third explanation to consider is that underwriters might be pressuring issuers to use methods that lead to higher initial returns, so that the underwriters can allocate the underpriced shares to their favored clients. This cannot explain the choice between auctions and fixed price public offers, since neither method allows the underwriter to control allocations.
This time, it seems, we can’t blame the bankers. Finally, it’s not the wish to obtain a better price that keeps companies away from the auction block, according to the authors of the paper.
This is surprising, both for obvious reasons and because investment banks are often judged based on the movement in their client’s stock price on the first trading day. But the researchers say that other considerations are equally important:
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 a following may end up being ignored and stuck in the socalled Orphanage. If they do not attract an institutional investor following, they will generally not be covered by analysts and will not be 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 IPO.
What, then, is the real reason for the apparent aversion to auction-based IPOs? We find out towards the end:
Unlike book building which is a direct mechanism where truth telling may be optimal, auctions are indirect mechanisms, and participants in auctions require both knowledge of the environment and sophistication on the part of all the participants. Because of that there are diculties in making auctions work in practice. As Vohra (2001) notes, “A direct mechanism places a huge computational burden upon the auctioneer”, and the rules are hard to specify explicitly – especially when all possible uncertainty about the environment is taken into account. On the other hand, in an indirect mechanism the computational burden is shifted to every participant, and every one of the participants has to be as sophisticated as the auctioneer of the equivalent direct mechanism, which is dicult to achieve in practice.
The paper is not an unambiguous endorsement of the way IPOs are normally underwritten by investment banks, which have a large amount of discretion over a process that could (and should) be a lot more transparent. But for now, it appears to be the best option.
Related links:
The Art of AgBank IPO – FT Alphaville
The return of the IPO – Fortune.com
Why don’t issuers choose more IPO auctions – Marginal Revolution
What cornerstones say about IPOs – WSJ