Wednesday, February 10, 2010

Do Auctions in Public Offerings Work?

The SEBI (Issue of Capital and Disclosure) Regulations, 2009 were recently amended to provide for “French” auction as one of the methods of price discovery in follow-on public offerings. This was supposedly brought about with a view to encourage the use of such auction mechanism in Government disinvestments.

However, the results emanating from the first offering where the auction mechanism was deployed are not all that encouraging. It has been reported that due to the lack of adequate response in the NTPC offering, the Government may reconsider the use of auctions and revert to the tried-and-tested bookbuilding method. As a column in the Financial Express notes:

And the government may want to give the French auction method a miss. Perhaps the method does facilitate better price discovery when the market sentiment is good because institutions do tend to put in a higher bid if they believe they will get a bigger allotment. But this time it didn’t work. The price of Rs 209 can hardly be called a discovered price and the signalling by the government may have kept other institutional investors away. In the normal book building process an investor can put in an application even on the last day and hope to get shares, and many investors may have done so had it not been for the large bids at Rs 209. Also, even if the government got itself a few rupees more, a fairly big chunk of the shares is now concentrated in the hands of two big investors, which cannot be good for the stock. That need not have been the case.
Intriguingly, the auction mechanism is used more as an exception in pricing public offerings as compared to the bookbuilding route which is more popular. One recent honourable exception has been the IPO of Google in 2004, which used the Dutch auction route, and not the French auction route that has been adopted in India. For a general discussion of the two methods, see the following:

… French auctions where the bidders who have bid at less than or equal to the cut-off yield get allotments at their bids – the bids at cut-off get pro-rata. Unlike this, in a Dutch auction, …, all the bidders who have bid at less than or equal to the cut-off get pro-rata allotment at the cut-off. The French auction imposes a bidding risk on the investors by imposing a penalty on successful bidders for being off the cutoff. Generally the standard deviation of bids in a French auction will be much lower than the Dutch auction. It has been seen that the Dutch auction brings down the cut-off in a bullish market.
Moreover, academic research has shown that auctions are less likely to succeed in a public offering of securities. The two reasons proffered in studies conducted by Ravi Jagannathan and Ann Sherman are ‘winner’s curse’ and the ‘free rider’ problem:

The winner’s curse, as its name suggests, is the tendency for the winner of an auction to overbid. Theory predicts that this will occur when the extent to which a bidder values the auction item depends on other bidders’ valuation. The winner’s curse applies to the case of tradable shares, since one’s valuation of the share depends on everybody else’s valuation.

In principle, the winner’s curse can be easily overcome: a bidder could simply revise her bid downwards to make allowance for her optimism. In reality, however, bidders often find it difficult to adequately adjust for the winner’s curse, especially when the number of bidders is uncertain and difficult to anticipate. Jagannathan and Sherman provide a simple, stylized example to illustrate what happens when the actual number of bidders turns out to be far bigger than what each bidder had assumed when they computed their bids. The winner’s curse will be severe, and opting out of the auction may make more sense.

The free rider problem, on the other hand, arises because some investors have the incentive to rely on others to collect information on the IPO stock. These uninformed investors will bid high, hoping that the auction clearing price will be set by those who have done their homework. However, high bidding by uninformed bidders reduces the incentives of sophisticated investors to devote time and resources to correctly value the shares—since they are less likely to win due to the aggressiveness of the uninformed investors. Hence the standard, uniform-price auction mechanism becomes unstable.
These may explain (at least partly) the lukewarm response received in the NTPC auction. For further detailed analysis, please see the two papers by Jagannathan and Sherman (here and here).

No comments: