Mendoza School of Business

Entry Level: Want part of an IPO? You could go Dutch

Published: November 10, 2006 / Author: Holly Preston

When initial public offerings of shares come to market, individual investors often find themselves playing second fiddle to big institutions. So the opportunity to participate in an equity or debt offering handled via Dutch auction is a tempting prospect.

A Dutch auction structure allows the bidder, not the investment banker, to decide the value of a company’s share price. Here’s how it works: A company decides how many shares it wants to
offer to the public and at what price range. Investors submit bids at a price they think the shares are worth. When all the bids are in, the company will allocate shares to all parties with bids at or above the minimum threshold or clearing price initially set by the company.

By making shares available to all investors at the same price level, the process effectively negates the inequities often found in more traditional IPOs, where investment banks are known for doling out underpriced shares to top clients who will, in turn, “flip” the shares back into the market as soon as the stock goes public.

Christine Hurt, an associate professor who specializes in business ethics at the University of Illinois College of Law, said that IPO auctions, though hardly perfect, “still hold the most promise” in terms of democratizing the investment process.

For individual investors, tired of coming to the IPO table after huge blocks of shares have already been doled out to favored insiders and institutions that translates into real empowerment.

Critics of the auction system argue that the average investor, either because of a lack of skill or lack of effort, cannot be counted on to produce accurately valued bids.

As a result, companies and their major shareholders could be put at risk with a share price that is less than stable. They also say that the auction system is biased toward individual investors, and actually drives institutions away.

“The problem for issuers is that there’s no way to predict who will bid, much less who will place a serious bid,” said Ann Sherman, an assistant professor at the business school of the University of Notre Dame who specializes in IPO finance issues.

Sherman teamed up with Ravi Jagannathan, a professor at the business school of Northwestern
University, to study of IPO auctions around the globe. Out of more than 20 countries that had used the IPO auction method, Sherman said, “virtually all of them had given it up.” It was a trend not driven by any sort of regulatory backlash but by the issuers themselves, who soured on the process, Sherman said.

“Auctions were too risky for issuers because demand varied so widely,” Sherman said. “It’s all left up to chance, and each issuer gets only one shot.”

At least with the book-building IPO method common on Wall Street, Sherman said, “there’s time for the underwriter to see how things are going.” He added: “If demand is lower than expected, they call more investors and make more of a push. With auctions, on the other hand, all that the issuer and underwriter can do is to keep their fingers crossed.”

Fans of the auction system acknowledge that although the method is not perfect, and certainly not impervious to market volatility, auctions tend to be less vulnerable to manipulation by a handful of interested parties.

“Underwriting banks who set the price in syndicated IPOs take samples of institutional sentiment in order to set the price,” said Ari Socolow, chairman and editor in chief of an investor Web site, “Even in the absence of outright manipulation, this process often does not involve the type of detailed supply-and-demand analysis that would set the price appropriately.”

In a Dutch auction, where a wide pool of investors is involved in setting the IPO price, “the price set is more likely to represent a more accurate estimation of the company’s value at that moment,” Socolow said.

Martha Dustin Boudos, chief financial officer for Morningstar, the market research company based in Chicago, said that Morningstar decided on the auction system for its 2005 IPO “in keeping with the ethos of the company” and its objective “to make the world of investing accessible to the individual investor.”

A process that was “completely transparent,” she said, allowed Morningstar to see “every single name behind every single bid submitted.” In that bidder pool, she added, were individuals and institutions alike.

Victor Fleischer, an associate professor of law at the University of Colorado who has studied the
auction system, said an auction IPO made sense for Morningstar, which bases its marketing on an image of impartiality in its research and ratings.

“Morningstar’s brand image is pure as the driven snow,” Fleischer said. “An auction IPO eliminates the concerns about insider favoritism in the allocation process.”

An auction also made sense for Google, which went public in 2005, because “it enhanced Google’s image as an innovative, egalitarian, trustworthy company,” Fleischer said.

“It wasn’t just about reaching out to the retail investor, but about doing the deal in a way that would ring true with Google’s users,” he said. “Google is in the business of aggregating information and organizing it in a user-friendly manner. How could it not do an Internet auction?”



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