Finance & Accounting Entrepreneurship May 1, 2007

Why Do IPO Auc­tions Fail?

Free rid­ers’ and the winner’s curse’ can lead to less-than-desir­able out­comes. But some auc­tion fea­tures can lend trans­paren­cy to the tra­di­tion­al IPO approach.

Based on the research of

Ravi Jagannathan

Ann E. Sherman

When Google suc­cess­ful­ly launched its ini­tial pub­lic offer­ing (IPO) by auc­tion in 2004, there was much media and indus­try fan­fare. In real­i­ty, using an IPO auc­tion to deter­mine who gets to buy how many shares at what price is an old approach that either nev­er took off in some coun­tries, or has gone out of fash­ion in oth­ers. IPO auc­tions were attempt­ed in more than twen­ty coun­tries in the 1980s and ear­ly 1990s, but are rare today.

Google’s high-pro­file IPO did not alter the trend: only three of more than 250 U.S. IPOs in the twelve months that fol­lowed were con­duct­ed using auc­tions. Why is this so?

In a recent paper, Pro­fes­sors Ravi Jagan­nathan (Finance Depart­ment, Kel­logg School of Man­age­ment) and Ann E. Sher­man (Finance Depart­ment, Uni­ver­si­ty of Notre Dame) set out to find the answer. They scru­ti­nized var­i­ous expla­na­tions as to why auc­tions are los­ing out to the seem­ing­ly infe­ri­or book­build­ing method and fixed-price pub­lic offers as the pre­ferred ways to con­duct IPOs. They con­clude that unpre­dictable vari­a­tions in the num­ber of bid­ders and the pres­ence of unso­phis­ti­cat­ed investors often make stan­dard, uni­form-price auc­tion out­comes unsta­ble and less than desirable.

Eco­nom­ic the­o­ries show that when cer­tain con­di­tions are met auc­tions can be very effi­cient in allo­cat­ing a scarce good. They allow price dis­cov­ery and may even max­i­mize a seller’s prof­it. Hence, it is some­what sur­pris­ing that vir­tu­al­ly all of the many coun­tries that once used IPO auc­tions have aban­doned them.

Two com­mon expla­na­tions giv­en for the unpop­u­lar­i­ty of auc­tions are reluc­tance on the part of issuers to try a new exper­i­men­tal method, and pres­sure from invest­ment banks to use bookbuilding.

The first claim does not stand up to scruti­ny, say Jagan­nathan and Sher­man. IPO auc­tions were used as an alter­na­tive to tra­di­tion­al, fixed-price pub­lic offers in Italy, Por­tu­gal, Swe­den, Switzer­land, and the Unit­ed King­dom in the 1980s, and in Argenti­na, Malaysia, Sin­ga­pore, and Turkey in the 1990s. How­ev­er, they were aban­doned in all of these coun­tries long before book­build­ing was intro­duced from the Unit­ed States. Hence, the rar­i­ty of IPO auc­tions can­not be due to unfamiliarity.

No more con­vinc­ing is the sug­ges­tion that invest­ment banks have pres­sured issuers to use book­build­ing because they gar­ner high­er fees. Jagan­nathan and Sher­man point out that in most coun­tries where IPO auc­tions were test­ed and lat­er aban­doned, they were usu­al­ly replaced by fixed-price pub­lic offers, and pub­lic offer fees were typ­i­cal­ly as low as, or even low­er than, auc­tion fees.

So why do we still see the replace­ment of auc­tions by book­build­ing, which is poten­tial­ly prone to abuse, and by fixed-price offers, which can lead to sub­stan­tial underpricing?

Jagan­nathan and Sher­man argue that there are two seri­ous short­com­ings with stan­dard, uni­form-price auc­tions under the IPO set­ting: the winner’s curse and the free rid­er problem.

The winner’s curse, as its name sug­gests, is the ten­den­cy for the win­ner of an auc­tion to over­bid. The­o­ry pre­dicts that this will occur when the extent to which a bid­der val­ues the auc­tion item depends on oth­er bid­ders’ val­u­a­tion. The winner’s curse applies to the case of trad­able shares, since one’s val­u­a­tion of the share depends on every­body else’s valuation.

In prin­ci­ple, the winner’s curse can be eas­i­ly over­come: a bid­der could sim­ply revise her bid down­wards to make allowance for her opti­mism. In real­i­ty, how­ev­er, bid­ders often find it dif­fi­cult to ade­quate­ly adjust for the winner’s curse, espe­cial­ly when the num­ber of bid­ders is uncer­tain and dif­fi­cult to antic­i­pate. Jagan­nathan and Sher­man pro­vide a sim­ple, styl­ized exam­ple to illus­trate what hap­pens when the actu­al num­ber of bid­ders turns out to be far big­ger than what each bid­der had assumed when they com­put­ed their bids. The winner’s curse will be severe, and opt­ing out of the auc­tion may make more sense.

The free rid­er prob­lem, on the oth­er hand, aris­es because some investors have the incen­tive to rely on oth­ers to col­lect infor­ma­tion on the IPO stock. These unin­formed investors will bid high, hop­ing that the auc­tion clear­ing price will be set by those who have done their home­work. How­ev­er, high bid­ding by unin­formed bid­ders reduces the incen­tives of sophis­ti­cat­ed investors to devote time and resources to cor­rect­ly val­ue the shares — since they are less like­ly to win due to the aggres­sive­ness of the unin­formed investors. Hence the stan­dard, uni­form-price auc­tion mech­a­nism becomes unstable.

The avail­able data on IPO auc­tions is sparse and not eas­i­ly amenable to pre­cise qual­i­ta­tive analy­sis. Nonethe­less, Jagan­nathan and Sher­man exam­ined a small sam­ple of IPO auc­tions in Sin­ga­pore to find empir­i­cal evi­dence on the winner’s curse and the free rid­er prob­lem. They found that IPO clear­ing prices were indeed an increas­ing func­tion of the num­ber of bid­ders, and at the same time, a high­er clear­ing price tend­ed to be asso­ci­at­ed with low­er IPO returns lat­er on.

Reform­ing the Build­ing Process for IPOs

Giv­en that stan­dard, uni­form-price auc­tions are often tout­ed as an alter­na­tive to the abuse-prone book­build­ing method, can IPO process­es still be improved if auc­tions have gen­er­al­ly proved disappointing?

In a relat­ed paper writ­ten in 2005, Jagan­nathan and Sher­man point out that much of the wide­spread con­cern over IPOs’ under­pric­ing may be mis­di­rect­ed, as under­pric­ing is nec­es­sary in order to com­pen­sate larg­er, more influ­en­tial investors for their cru­cial role in build­ing the demand curve for a mar­ket that did not pre­vi­ous­ly exist. The real issue after all may not be the pres­ence of under­pric­ing, but the extent of underpricing.

The solu­tion, argued Jagan­nathan and Sher­man, is to adopt a hybrid” mech­a­nism — one that pre­serves the main advan­tages of book­build­ing while address­ing con­cerns about its exclu­siv­i­ty and lack of transparency.

Specif­i­cal­ly, this involves improv­ing the well-estab­lished book­build­ing process by apply­ing trans­paren­cy fea­tures of stan­dard, uni­form-price auctions.

Stan­dard, uni­form-price auc­tions weigh bids on only one sin­gle fac­tor: price. Jagan­nathan and Sher­man pro­pose that bids be weight­ed on their qual­i­ty and tim­ing as well. For exam­ple, lim­it bids (orders to buy at no more than a spec­i­fied price) could be favored over mar­ket bids, since lim­it bids demon­strate the will­ing­ness of investors to pur­chase shares at the bid price. As such, lim­it bids con­vey more infor­ma­tion on investors’ val­u­a­tions than mar­ket bids (orders to buy at the cur­rent price), which sim­ply mean that the investors want shares at the offer­ing price.

Jagan­nathan and Sher­man dis­cussed sev­er­al vari­a­tions of the hybrid” solu­tion in their paper, but the basic prin­ci­ple behind these vari­a­tions is the same: add more trans­paren­cy into the book­build­ing approach.

The debate over the reform of the IPO process has focused main­ly on replac­ing book­build­ing with stan­dard auc­tions. But large, mul­ti-unit IPO auc­tions will work only if essen­tial­ly all par­tic­i­pants are high­ly knowl­edge­able, dis­ci­plined, and sophisticated.

Jagan­nathan and Sher­man metic­u­lous­ly demon­strate the impos­si­bil­i­ty of this task. The very nature of IPOs — occur­ring spo­rad­i­cal­ly, with each issuer dif­fer­ent from the pre­vi­ous one — makes it impos­si­ble for mil­lions of poten­tial investors to obtain such a high lev­el of skill and sophistication.

How­ev­er, the authors sug­gest that not all is lost. Their analy­sis of the strengths and weak­ness­es of IPO auc­tions pro­vides use­ful insights on how cer­tain fea­tures of stan­dard auc­tions can be incor­po­rat­ed into the well-estab­lished book­build­ing process (or vice ver­sa) to address con­cerns regard­ing exclu­siv­i­ty and lack of trans­paren­cy. Whether you call this method a non­stan­dard auc­tion or mod­i­fied book­build­ing, it may be the way forward.

Featured Faculty

Ravi Jagannathan

Chicago Mercantile Exchange/John F. Sandner Professor of Finance and Co-Director, Financial Institutions and Markets Research

About the Writer

Sng, Tuan Hwee, a doctoral student in the Economics Department at the Weinberg College of Arts and Sciences, Northwestern University.

About the Research

Jagannathan, Ravi and Ann E. Sherman (2006). “Why Do IPO Auctions Fail?” NBER Working Paper No. 12151

Jagannathan, Ravi and Ann E. Sherman (2005). “Reforming the Bookbuilding process for IPOs.” Journal of Applied Corporate Finance, 17(1): 67–72

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