5 Principles of Forex Trading Systems
Forex trading is a complicated affair. The complication largely arises because of the innumerable factors that are at play in the Forex market. However, this is further exacerbated by human emotions of greed and fear. Let’s see how forex trading systems can help simplify Forex trading for the average Joe. What is a Forex Trading […]
Introduction to Turnover Ratios
Turnover ratios (also known as efficiency ratios) are a very important class of ratios. These ratios are not only used by financial personnel but also by the people in charge of operations. However, we are going to consider these ratios from the point of view of outside investors. This is because judgments have to be […]
Savings and Loan Crisis in the United States (1980’s)
The United States banking industry and the economy in general was rocked by the Savings and Loans crisis in the 1980’s. The savings and loans associations had been an important part of the United States banking system. Hence, when one out of every four savings and loans in the US went under water, the nation […]
Valuation Divergence – Meaning and its Importance
For any startup financing to be successful, the startup company and the investors need to be on the same page about a lot of issues. This is because, in the absence of this understanding, valuation divergence can be a quagmire of ever-escalating tensions between the two parties. One major source of conflict between these two […]
What is Venture Leasing? – Advantages and Disadvantages
In the previous few articles, we have already learned about how venture capital and venture debt work. We now also know the pros and cons of venture debt. However, there is another form of debt called venture leasing which is commonly used by investors in the marketplace. In this article, we will have a closer […]
Book building has been one of the most widely used methods in the underwriting process. However, over the years, companies have realized that the book-building process is largely controlled by the intermediaries, i.e., the investment banks! The investment banks are the ones building the books. Hence, they can easily control who gets in and at what price.
Over the years, many companies raising capital have alleged that investment banks are corrupt, and many of them do not work in the best interests of their clients. Many companies learned this the hard way. For instance, the technology company Netscape was priced at $28 per share during the IPO process. However, as soon as the share was listed, it zoomed to $75 per share! Similarly, twitter was priced at $26 per share, whereas it went up to $46 per share after listing. In essence, Twitter, Netscape, and many other companies like them were simply leaving money on the table! Instead of companies raising this money during the IPO, secondary market speculators were making humungous profits by flipping the shares.
Over the years, this has led investors to doubt the entire system. In the above case, either investment banks were completely ill-informed that they could not gauge the price for which the stocks could actually be sold. Or, they were hand-in-glove with the speculators and were not acting in the best interest of their clients. The loss of trust in the book building system has led companies to search for alternative modes of price discovery, and the Dutch Auction is one of those modes. In this article, we will have a closer look at what the dutch auction process is and how it helps to overcome the shortcomings of the book building process.
Over the years, many firms have alleged that investment banks collude with investment funds while selling shares during an IPO process. This is because these funds hire the services of these investment banks in other forms and often pay them millions of dollars throughout the year. Hence, even though the bank is charging money from the client, they are often just doing the bidding of the investment fund! These investment funds, in turn, buy at low prices offered by the banks and then flip the shares on the day of the IPO for a higher price. This is why there is so much trading seen on the day of the IPO. Almost all the shares change hands the day these companies get listed.
The end result is that the investment banker and the investor make a killing. On the other hand, the company loses money since it raises much less than it would otherwise have. Also, genuine retail investors lose money since they get to buy stocks only at inflated prices. The root of this problem is that the investment banker has a lot of control over the IPO price.
The Dutch auction process of underwriting helps in solving this problem. This is because it takes away some of the control that investment bankers have in the price-fixing process. As a part of the dutch auction, companies solicit bids from prospective investors. The final issue price is decided based on the actual bids received. Hence, the chances of mispricing happening are quite low.
Also, the dutch auction process has been designed in such a way that it encourages investors to bid higher prices and raises the proceeds of the IPO. Let us understand the Dutch auction process with the help of an example:
Example: Company A wants to sell 300 shares. It has asked investors to bid for the shares and has received four bids.
Notice that the company wants to sell 300 shares. Hence, if it were to sell only to investor B, its supply would not be exhausted. If it sells to C as well, then too, it sells 200 shares only. However, when the company sells to investor D, it ends up selling more than 300 shares. There are two points to be noted here.
The bottom line is that even though book building is still the most popular underwriting method today, it is facing competition from the Dutch auction method, which many believe is more popular.
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