IPO book-building and the myth of price discovery

When in 1999, SEBI had given a green signal to price band mechanism for initial public offerings, many thought it was path breaking initiative. The expectation was that the book building exercise would help investors, especially retail, identify the right price for the stock through competitive bidding.

But current IPO pricing trends make a mockery of the price discovery mechanism as most of them offer a price band in a narrow range of just ₹1-2. This scarcely allows any room for “competitive” bidding. Of the 15 IPOs that hit the capital market this year, except for Nureca, the maximum gap between the floor and ceiling price was just ₹2. Even in the case of Nureca, the gap is just one per cent or ₹4 (₹396-₹400). This is has become the norm in the last few years.

Prior to the introduction of book-building, IPOs hit the capital market at a fixed price. As greedy promoters set the price at unsustainable levels in collusion with investment bankers, SEBI thought it was time to introduce a bidding mechanism, where investors themselves could discover the right price.

What is Book-Building?

The SEBI board in October 1999 had initially approved new guidelines under which an issuer was given an option to book build either 90 per cent or 75 per cent of the net offer to the public and the balance at a fixed price, determined through the book-building exercise. In a book building offer, the issuer discloses a price band or floor price before opening of the issue of the securities offered. On the basis of the demands received at various price levels within the price band, the book running lead manager in consultation with the issuer arrives at a price for the offer.

If retail investors were unable to arrive at the right price, they were allowed bid in the IPO at the ‘cut-off’ price, the final price - arrived after analysing the full bid details by investment bankers - at which the IPO will be allotted. Price bands in the initial set of book built offers used to be quite high.

Hughes Software & others

Hughes Sofware was the first company in 1999 to hit the capital market under the book building mechanism. Amidst the Y2K boom, the software major had come out with IPO at a price band of ₹480-630; HCL Technologies, the second, came out at a ₹500-580. Hughes Software, which later changed as Flextronics and was delisted from the exchanges in 2006, had fixed the price as ₹630 for the IPO and HCL Tech also set it at the upper end at ₹580. Tata Consultancy, which had hit the capital market with a price band of ₹775-900, had fixed the IPO price at ₹850.

According to SEBI guidelines, the spread between the floor and the cap of the price band should not be more than 20 per cent.

Compared with those issues, most IPOs currently come out with a very narrow price band defeating the very purpose of bidding for price discovery. This price band isn’t very different from a fixed price concept. Instead of a cut-off price, investors can bid at the upper band, which will not make much difference to their outgo.

It is time for market regulator SEBI to look into the price band once again. As they fixed the gap of the price band at a maximum 20 per cent, there should also be a minimum gap. A gap of 10-30 per cent could be ideal.