On the face of it, Sebi?s latest move to allow auctions for the Qualified Institutional Buyers (QIBs) part of follow-up offerings, presumably a precursor to its use in IPOs as well, is a major change?a welcome and, some would even say, overdue one. It is hoped to lead to better price discovery, and perhaps more importantly, help issuers get a better price for their equity offerings.
To understand the implications of the Sebi order, one needs to tread into the somewhat complex world of share allocations in equity offerings. An issuer interested in going public appoints an investment banker to manage the issue process. The investment banker then checks the demand with potential investors to arrive at a preliminary filing range?the ?price band??consisting of a floor and ceiling not more than 20% above the floor. Next, investors are allowed to bid for the issue. The information in the bids is electronically transmitted to the book-runner, who sets a final price within the band after at least three days of bidding. About half of a share issue is reserved for institutional players?QIBs?who submit firm bids for the issue.
Prior to November 2005, issue managers had discretion in making allocations to QIBs. Since then, QIBs face proportionate allocations, just like their retail counterparts, so the orders have to be filled proportionately starting from the highest bidder down. QIBs cannot bid outside the price band, so this limits them from possibly paying more for the scrip and, since they anticipate getting only a part of their bid volume fulfilled, incentivises them to inflate the bid volume, leading to oversubscription. Essentially, the issuing company ends up losing some of the money that the QIBs were willing to pay. Sebi?s new rule would allow QIBs to bid without an upper limit, allowing them to buy at their true ?bids?.
Given the possibility of foul play and reciprocal arrangements and clubby relationships between underwriters and institutional investors, one would expect the 2005 change to have brought about significant improvements in price discovery. Interestingly, however, a recent research paper* finds the opposite effect. IPOs, almost always and everywhere, are underpriced. What the paper looks at is the difference in the extent of underpricing between the two regimes?pre-November 2005 when managers had control over allocations among institutional buyers, and later when that control was taken away. The extent of underpricing seems to be more marked in the latter period, pointing to actually poorer price discovery when allocative powers are taken away from the hands of the issue managers.
While, in principle, auctions appear to be the best way of selling financial assets like stocks to the public, the enthusiasm for using auctions in equity offerings worldwide has been lukewarm. While France, the Netherlands, the UK, Poland and Portugal allow it, on the whole it has been in decline in Europe, and, Google notwithstanding, is a rarity in the US.
Book-building has remained the key institutional mechanism worldwide. Taiwan uses an auction method, but because of the regulatory constraints that exist there on the auction mechanism, considerable underpricing stays. The US largely follows book-building with soft, ?indicative? bands and discretionary allotments. It seems that the book-building process provides access to certain ?soft? non-bid information that a straightaway auction setting fails to improve upon. Of course, this is not to say that abuse does not happen with allocative powers, but then an
auction system is not entirely free from the chances of being rigged either. So, in terms of price discovery, in spite of the theoretical advantage of the auction model, empirically it has not become the standard worldwide.
Sebi is rightly cautious in allowing the change in the Seasoned Equity Offerings first, rather than going to IPOs at once?the price discovery issues are less marked here. It will be interesting to see how frequently this mode is adopted in the issues to come. It is likely that the QIB bidding behaviour will change with the new rule, and companies are more than likely to be able to raise more funds, but the change may not be as much of a giant leap as it appears at first glance.
The other parts of the Sebi announcement, including the halving of the market capitalisation requirement for a firm to approach the market with an equity issue, are as important. Notwithstanding the market?s excitement about mega issues, it is the mid-corporates that need greater access to equity markets, and this move can go a long way in achieving that. Finally, asking firms to make more current disclosure can also go a long way in improving the information quality of stock prices in Indian bourses. So, overall, it is good news for markets.
The author teaches finance at the Indian School of Business
*Bubna, A and N Prabhala, ?When Bookbuilding Meets IPOs?, working paper, ISB and University of Maryland