28-08-2014, 03:52 PM
Auctions as an Alternative to Book Building
in the IPO Process: An Examination of
Underpricing for Large Firms in France
Auctions as an Alternative.pdf (Size: 549.39 KB / Downloads: 48)
Abstract
A relevant factor in determining the quality of an initial public offering (IPO) mechanism is the
level and variability of underpricing that occurs. The percentage difference between the IPO
price and the closing price after one day of trading is a common way to define the “underpricing”
of the stock. Although companies may value a small amount of positive underpricing, they
certainly want this to be controlled. Both extreme positive and extreme negative underpricing
are undesirable for a company. Building off of a paper that found a lower mean and variability
of underpricing for firms that use the auction IPO mechanism as opposed to the book building
IPO mechanism, this paper argues that auctions are not disadvantaged when only large firms are
considered. Although this paper finds that the book building mechanism controls underpricing
better than the auction mechanism, the advantage disappears when considering only large firms.
This analysis is relevant because, aside from two companies, only small companies have used the
auction IPO mechanism in the United States. Due to the lack of auction IPOs in the United
States, this paper uses French data in its analysis. By showing that large firms using the auction
mechanism are not disadvantaged when compared to large firms using the book building
mechanism, this paper attempts to encourage large firms in the United States to consider using
the auction method for their IPOs.
Introduction
Motivation:
When LinkedIn conducted its initial public offering (IPO) in May 2011, the offer price
was $45 per share.1
After one day of trading, the stock closed at $94.25 per share.2
The
LinkedIn IPO exhibited a substantial amount of “first day underpricing,” which is defined as the
percentage difference between the closing price on the first day of trading and the offer price.3
Specifically, LinkedIn experienced 109% underpricing. Had LinkedIn priced its offering at
$94.25, the company and selling stockholders would have received an additional $386 million.
Instead, the beneficiaries of the $386 million were the investors who were fortunate enough to
receive shares in the discretionary allocation of the initial shares. Investors that receive shares in
the initial allocation of shares often have a relationship with the firm. For example, a major
client of the underwriting bank is more likely to receive shares in an IPO than an unknown retail
investor.4
As highlighted earlier with regards to LinkedIn, a substantial amount of underpricing
can cost companies millions of dollars of equity. While the LinkedIn IPO is an extreme
example, underpricing exists in almost every IPO. Loughran and Ritter (2002) claimed that the
“average IPO leaves $9.1 million on the table.”5
Determining that the auction IPO mechanism
controls underpricing6
better than the book building mechanism adds support to the literature that
the auction mechanism is superior.
Furthermore, only two of the 22 auction IPOs that have been conducted in the United
States since 1999 have been by large companies.7
However, I hypothesize that the auction
mechanism does not lose its advantage at controlling underpricing when only large firms are
considered. In addition to testing the overall control of underpricing by each mechanism, I also
test to see how the mechanisms control underpricing when focusing on large firms in hopes that
this analysis will demonstrate that large firms in the United States should strongly consider the
auction mechanism for their IPOs.
Comparison of Auction and Book Built IPOs
Potential Advantages of Auctions as Compared to Book Building:
Scholars advocating for the viability of the auction mechanism as an alternative to the
book building method have advocated the superiority of the auction procedure across a number
of dimensions. Some of the ways in which the auction mechanism is allegedly better are listed
below.
Free-Riding and Overpricing:
Small investors have the incentive to “free-ride” in the auction mechanism. “Free-riders”
submit bids far above any reasonable valuation in order to essentially guarantee themselves
shares in the offering. In doing so, they assume that the price of the stock will not be
significantly affected by their small bid and will instead reflect the valuation of other investors
who have invested time and energy in an attempt to correctly value the stock. If too many
people free-ride, the market demand curve will suggest a higher value for the stock than the
actual market valuation. This will lead to overpricing and a fall in the stock price in the
secondary market, which is undesirable because overpricing affects the perception of the firm
and angers investors who received shares in the IPO (and therefore lost value on their
investment). Free-riding is not really an issue in the book building mechanism because investors
do not give commitments to buy the stock before the stock has been priced. The French auction
method attempts to combat the problem of free-riding by setting a maximum bid price at which
all bids above the maximum price are thrown out.22
Data
The data set consists of 237 companies listed between 1991 and 1998 on either the
Second Marchè or Nouveau Marchè. 243 companies in total were listed on these two exchanges,
but I eliminated 6 due to missing data. There were a very small number of IPOs that occurred on
a different French exchange, but, apart from those IPOs, the 243 companies represent all the
IPOs listed in France between 1991 and 1998. 34 of these companies used the fixed-price
method, which is the other IPO mechanism. Since I am not interested in testing the fixed-price
method, I remove these 34 observations from the data. Therefore, the total number of
observations is 203. The list of 243 companies and the type of IPO mechanism used were
graciously given to me by Professor Francois Derrien. This data set was collected for use in
Degeorge and Derrien (2001)
. Conclusion
This paper explored whether the auction mechanism is superior to the book building
mechanism at controlling underpricing, with a particular focus on how the IPO mechanisms
compared when focusing on large firms. The motivation for this topic came from the surprising
level of popularity of the book building mechanism in the United States despite a number of
perceived advantages of the auction mechanism. Some of these perceived advantages include
more accurate pricing, lower underwriter spreads, and lower risk of conflict of interest. Despite
these perceived advantages, there have only been 22 auctions in the United States since 1999,
compared to 1932 book built IPOs.40
Of these auctions, only 2 of them have been conducted by
large firms, which surprised me. In order to test my theory that the auction mechanism deserves
to be considered by large firms, I researched both whether the auction mechanism controlled
underpricing better than the book building mechanism and how the mechanisms performed when
considering large firms. The goal of this paper was to show that auctions are not disadvantaged
at controlling underpricing when considering large firms, and I wanted to use these findings to
argue that large US firms should strongly consider using the auction mechanism for their IPO.
The evidence was inconclusive. I found that the book building mechanism results in a
lower level of underpricing, although this advantage was not significant when looking at only
firms with market capitalizations greater than the median overall market capitalization. In
addition, the book building mechanism results in a lower variability of underpricing. However,
the auction mechanism results in a lower variability of underpricing when only considering firms
with market capitalizations greater than the median overall market capitalization. Neither of
these results dealing with the variability of underpricing is statistically significant.
Even though the results of this paper do not add much support to the argument that the
auction mechanism is a viable alternative to the book building mechanism for large firms, I
believe that the topic merits further consideration for a couple of reasons. First of all, the
findings in this paper contradict many empirical studies that find that the auction mechanism
controls underpricing better than the book building mechanism. I hope that future papers
continue to examine the ability of each mechanism to control underpricing by using different
data sets and different explanatory variables. Secondly, I believe that the auction mechanism
should be more attractive to firms for reasons beyond the control of underpricing. Some of the
criticisms of auctions (lack of marketing and lower analyst coverage) should be less critical for
larger and more widely known firms. A large, well-known firm does not need the underwriter to
market the firm as much and is unlikely to suffer from a lack of analyst coverage. In addition,
some of the alleged advantages of auctions (lower underpricing and lower underwriter spreads)
should be accentuated with large firms. After all, since underwriter spreads and underpricing are
measured as percentages, the absolute impact is greater with larger offerings. Testing these
theories would shed more light on the viability of the auction mechanism for large firms.