Auctioned IPOs: Breaking Underwriter Dominance
Are IPO auctions a credible alternative to book building? François Derrien, François Degeorge, and Kent L. Womack have uncovered an answer to this question by studying 19 auctioned IPOs in the United States. They have found auction mechanisms to be effective in strengthening the investor’s position in the transaction.
In 2004, Google’s announcement of its forthcoming IPO (initial public offering) auction caused quite a commotion in the investment banking universe. The company’s strength enabled it to impose this mechanism, but when other firms tried to follow suit, investment banks flat out refused! Why are underwriters so reluctant to offer their clients IPO auctions? To answer this question, François Derrien and his co-researchers conducted the first empirical study on the performance of auctioned IPOs auctions. Their conclusions are enlightening. Investment bankers may be disappointed, but auctioned IPOs are indeed a highly credible alternative to book building!
THREE IPO MECHANISMS
Derrien explains that, theoretically, there are three IPO mechanisms for companies aiming to access capital by going public.
• Fixed pricing: Share price is defined and communicated in advance to all potential investors. Shares are distributed according to the amounts requested.
• Book building: The underwriter sets the share price with the agreement of the issuer. The underwriter under writer also chooses which investors will be allowed to purchase the shares.
• Auction: Investors submit price and quantity bids. With this IPO mechanism, share price and quantity are determined by offer and demand.
CRITICISM OF BOOKBUILDING
The book building approach was developed in the United States and is currently the most commonly used IPO mechanism on both sides of the Atlantic. However, the opacity of the system is drawing increasing criticism, especially because it is suspected of granting underwriters too much power. Not only do they determine share price, but they also select the investors to whom they are sold. Derrien explains that in comparison, “the auction system is far more transparent, because the market determines share price and quantity per investor.” Nonetheless, at the current time, this mechanism is practically inaccessible to companies. For example, at the time of this study, WR Hambrecht was the only investment bank in the United States to provide this option. Does that mean that book building is a better system? No, says Derrien. He believes that investment banks lobby companies to convince them that IPO auctions are risky. “By pushing book building, underwriters are really protecting their interests,” he comments.
IPO AUCTION PERFORMANCE
An IPO is successful for investors when the share purchase price is lower than the market price (they thus make a profit). For this to occur, investors must be able to gather pertinent information during the auction. Derrien explains that the most important thing is to limit the impact of free-riders (investors who have no relevant information to offer but who take advantage of information revealed by others). The researchers did, in fact, detect the presence of free-riders, but they also found that, contrary to popular belief, institutional investors still represent the majority of participants in IPO auction (84%of share demand in dollar value). They also show that demand for auctioned shares is highly elastic, which implies that institutional investors reveal large amounts of relevant information. “The presence of these well-informed investors makes up for that of free-riders,” Derrien explains, thus affirming the effectiveness of the IPO auction mechanism.
Based on an interview with François Derrien and on the article, “Auctioned IPOs: the US Evidence” by François Derrien, François Degeorge, and Kent L. Womack, the Journal of Financial Economics .
This article received the prize for the best finance article from the private bank Espirito Santo and the Swiss Finance Institute.
APPLICATIONS FOR REGULATORS
Derrien is well aware that financial regulators are currently preoccupied with other issues, but he feels it is nonetheless essential to inform the public about the shortcomings of bookbuilding. IPO auctions are more market-oriented and thus present an alternative that Derrien believes should be encouraged, despite resistance from investment banks. Financial institutions should, in fact, be pressured into allowing issuers to engage in IPO auctions.
The researchers studied 19 IPO auctions in the United States realized between 1999 and 2007. Data was supplied by WR Hambrecht, the only American investment bank to propose this type of IPO mechanism. To evaluate the effectiveness of the auction mechanism, the researchers studied the participation of institutional investors and the quality of the information they revealed.