Going, going ... sold to the highest bidding block; do Dutch auction IPOs help issuing companies capture more value?
A Dutch auction is designed to level the playing field by allowing potential investors the chance to help set the price of the IPO through bidding prior to the date of the offering. It's a way of democraticizing the IPO process, making it fair game for everyone, not just a small group of Wall Street insiders. By reducing the "hurdle rate" (the size of the minimum investment), Dutch auctions give many individual investors--who were largely excluded from IPOs of the late 1990s-a chance to jump into the game at the opening whistle.
Dutch auctions aren't new; Treasury bonds, for example, are sold this way. Salt Lake City-based Overstock.com, an Internet-based retailer of excess inventory and other low-priced items, used a Dutch auction to go public in 2002 to raise nearly $40 million, and has used it again to raise additional funds.
Traditional auctions, such as those found at Sotheby's and eBay, start at a low price that then rises to the highest bidding point before being sold. Dutch auctions used with IPOs, which are also called uniform price auctions, work somewhat in the opposite direction.
On August 20, Google raised $1.67 billion in its initial public offering of stock, among the largest ever in the technology sector. Shares jumped 18 percent in the first day of trading to close at $100.34. The much-anticipated public offering left Google's market value at more than $27 billion.
The Dutch Auction Way
Let's assume investors commit to buying an aggregated nine million shares at $135 each, seven million at $130, nine million at $120, 10 million at $110, etc. After bids from all investors are compiled in a huge list, with the highest bid first, the bankers go down the list and allot IPO shares until they run out. When all available shares have been spoken for, the bankers take the price of the last bid that made the cut and call it the clearing price.
In our example, at $120 a share, 25 million shares have been committed to. This becomes the clearing price because that's the highest price at which all the shares will be sold. All who bid $120 or more get shares at this price. Those who bid below $120 get no shares. If the number of shares bid at $120 exceeds the number of shares available, the shares will be allocated to the successful bidders on a pro rata basis.
The Traditional Way
The traditional way of going public is much more controlled, driven by investment bankers. It is sometimes called "book building" because bankers gather indications of interest from institutions and other major investors, or "build a book," in advance of an offering. Based on the strength of the market's interest in the offering, the bankers then set a price range based on this so-called "price talk." The company, in consultation with its underwriters, determines the number of shares to be sold.
If the offering is hot, the shares are highly desired because they will probably jump up during their first day of trading. This burst in price is called a "pop." Lest you think a pop is a mere burp, consider the first-day pops of these stocks back in the wild days of the late 1990s: Marketwatch.com went up 474 percent its first day of trading; TheStreet.com, up 216 percent; Priceline, 331 percent; theglobe.com, 606 percent; and VA Linux Systems, almost 700 percent. There were also many examples of stocks rising 25, 50 and 75 percent or more in their first day of trading.
There's evidence that the pop for Dutch auctions is considerably lower than for traditional IPOs. Kent L. Womack, associate professor of finance at Dartmouth University, researched IPOs during the 1990s in France--where both the Dutch auction and the system which is traditional to the U.S. are widely used--and found that auction IPOs yielded a first-day pop only half as big as IPOs done in the traditional method.
Problems with the Traditional Method
The primary problems with the traditional method of going public, in the eyes of its detractors, include:
* Only the favored institutions, large clients and other investment banker favorites--get the hot stocks. Everyone else buys in the aftermarket, generally after the pop.
* The issuing company loses out. If a company sells its stock at the IPO for $14 and it closes at the end of its first day of trading at $28, the increased value goes to the first-time investors (who took little or no risk), rather than the company. Jonathan Johnson, vice president of corporate affairs at Overstock.com, estimates that if his company had used the traditional IPO method, the investment bankers would have priced its stock at between $10 and $11; via the Dutch auction method, the company's clearing price was $13.
* "The biggest problem in the way we have done underwritings in the U.S. is it gives the underwriter too much discretion in pricing and that discretion can be abused," says Womack.
* The costs to the issuing company are high. The Wall Street Journal reports that the underwriters of Google's offering will earn slightly less than 3 percent of the deal's overall value (about $90 million), compared with average fees of 3.5 percent on large IPOs. Johnson says his company paid four-to-five percent of its proceeds in fees, compared to six-to-seven percent using the traditional underwriting method.
* Investors can get burned by chasing after hot issues (though one could argue they deserve what they get). In 2001, Forbes found that only one of the 20 hottest-popping stocks held their first-day gains over time; 12 ended the decade trading below their offering price. Overstock.com opened at $13 in 2002, has since traded between about $5 and $40, and at the time of this story's publication, was priced at approximately $30.
Downsides to Going Dutch
But Dutch auctions are no guaranteed panacea for the issuing company. Johnson claims that when Overstock.com talked to investment bankers about its offering, they threatened not to have their analysts follow the company if it used the auction method. "They have been true to their threats and have not covered us," reports Johnson.
Another downside, cited by Dick Clayton, a partner in Holland & Hart's Salt Lake City law offices, is that the company might end up with a mix of retail and institutional investors not to its liking. It's easier to control things with a traditional IPO.
The company also has to be vigilant that investors don't bid extremely high in order to virtually guarantee obtaining stock at a much lower price. Google threatened to disqualify unusually high bids that it considered speculative. Overstock.com, which gave $12 to $16 as pricing guidance, got bids ranging from $9 to $29.
And while the Dutch auction may be good for the company, that doesn't ensure that investors will do well. Issuing companies like Dutch auctions because they are a way to get maximum value for their shares. The company gets only the proceeds generated by the initial sale of shares; the amount of money it rakes in from the IPO is not affected by how the stock performs once it begins trading in the public markets.
Top investment gurus such as Warren Buffett wouldn't consider investing stocks which are not, according to their analyses, bargains. By broadening the pool of potential investors, Dutch auctions reduce the likelihood of a deal being an investor's bargain. With more demand for the stock, the auction may set the IPO price at a level higher than would be expected if it were open only to the large investors who typically buy IPO shares. This reasoning suggests that the low prices of IPOs using the traditional method may, at least in part, be due to lower demand and smarter buying, rather than just because the investment banker under-priced the stock.
Under-Pricing on Purpose
Of course, as already noted, with hot IPOs, few investors have access to the bargain stocks anyway. Interestingly, some companies using Dutch auctions under-price their clearing price on purpose to give investors a chance for a pop, albeit a more modest one. Overstock.com priced its stock at $13, even though, based on the bids received, it could have gotten upwards of $14. "We wanted people who had faith in us to have a little reward," comments Johnson.
Ann E. Sherman, assistant professor of finance at University of Notre Dame suggests another downside to the auction method: that having a larger number of investors doesn't necessarily translate to more careful scrutiny of the offering. In fact, she believes the traditional method results in larger investors more carefully scrutinizing an offering because these investors are rewarded for their analysis by getting in at the offering price with the potential of a pop. Individual investors often don't have the ability or inclination to do serious due diligence themselves.
Sherman writes: "My research indicates that ... more accurate pricing of IPOs may be better achieved through limiting access. If estimating the value of a new company takes time and effort, then allowing too many investors to participate may actually decrease the accuracy of the pricing process ..." Clayton, a supporter of Dutch auctions, notes, "An argument could be made that individuals get into offerings they shouldn't have entered because it's too easy [to get in]."
The financial advantages of Dutch auctions to companies, based on the more accurate pricing touted by many proponents of the method, may also be overstated. Proponents auctions frequently charge that in traditional IPOs, issuing companies are routinely shortchanged the money from the initial pop, assuming that all the offering shares would have been bought at this higher price using the Dutch auction method. That's unlikely--with a hot Dutch Auction IPO, the offering shares may have sold at a higher price than with a traditional IPO, but probably not at the top of the pop.
Whether auctions or book building will prevail in the coming years remains to be seen, but there's a good chance a battle royal is shaping up on Wall Street and in board rooms across the country.
Alan S. Horowitz is a Salt Lake-based freelance writer and a frequent contributor to Utah Business magazine.
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|Author:||Horowitz, Alan S.|
|Date:||Sep 1, 2004|
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