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Monday, Feb 16, 2004

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Book-building: Information better than floor price

B. Venkatesh

THE PRIMARY market is likely to see several public offers in the next few months. Investor enthusiasm for such offers is very high and not without reason. Primary offers have given handsome returns to investors. Indrasprastha Gas, for instance, closed at Rs 119 on the first day of listing. Its offer price was Rs 48. Similarly, Maruti closed at Rs 163 on the first day of listing and has since risen above Rs 500. Its offer price was Rs 125.

The high premium that stocks command on their first day of listing suggests that public offers continue to be under priced. This suggests that the book-building system has not been able to improve price discovery process through competitive bids from prospective investors.

Under-pricing public offers rewards short-term investors — those who invest in the public offer and exit on listing. The problem is that there is a wealth transfer from existing long-term and prospective shareholders to these short-term investors. Take Maruti Udyog. Had the company priced its offer more aggressively, it may have offered fewer shares to the public. That means lower free-float and higher price-earnings multiple, other factors remaining the same. It is, therefore, necessary to change the book building system so as to enable companies get competitive offer prices.

Problem areas: At present, companies making offers through the book-building system have to state the floor price. Indraprastha Gas, for instance, had a floor price of Rs 40 to Rs 48. Providing such a price range skews the price-demand relationship for the stock. Here is why. Investors like bargain hunting. This means that majority of the investors will bid only at the floor price although such a price only serves as an anchor point for bidders. Eighteen out of 20 offers made through the book-building route have been allotted at the floor price. The remaining two offers, Maruti Udyog and Divi's Labs, were priced Rs 10 above the floor price.

The problem is that investors take the floor price to be the maximum price for the stock. Such risk-averse behaviour may be due to information asymmetry. Most of these companies make initial public offers (IPOs). This means that investors have limited information on the company. Bidding aggressively may lead to losses if the stock is valued at a lower price in the secondary market.

The second factor is the auction transparency. Any prospective bidder can see the total quantity bid at each price level on the National Stock Exchange Web site. This information may prompt an investor to change his decision and bid at the price that carries maximum bids. Such behaviour is termed information cascades in economics. It essentially means that an investor will be prompted by the collective decision of other bidders rather than base the decision on the information that he has.

Maruti Udyog is a case in point. Most of the bids by institutional investors were concentrated on the Rs 120 and Rs 125 price points. The same class of investors is now initiating "buys" on the stock. Surely, Maruti's business has not changed dramatically as to prompt these investors to initiate buy at higher levels even though they bid for Rs 125 in June last.

Suggestions: Companies should not give a floor price. Instead, they should provide all information necessary for the investors to arrive at a fair value. Of course, only the institutional investors may have the ability to use the information to price a stock. It, therefore, follows that only institutional investors can make competitive bids. These are bids where the investors mention the quantity and the price at which they are willing to buy the shares. The retail investors can simply bid for the maximum quantity that they are willing to buy. The shares will be allotted at the final offer price.

Not providing a floor price will force institutional investors to value the stock independently without an anchor price. This could lead to more aggressive bidding because each institution will have to carefully value the stock as well as second-guess others' bid prices. Indeed, this is typical case study for game theorists.

Finally, bids should be sealed. Such a system would prevent information cascade effect.

Of course, non-transparent auction could still lead to non-aggressive pricing. For instance, an institutional investor may place multiple bids at, say, Rs 400, Rs 390 and Rs 380 if it considers Rs 400 to be the fair price for the stock. The reason is that the lower price points would provide a downward bias, forcing the company to fix a lower offer price. But that is more an issue of auction pricing rather than the book-building system per se.

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