Managing Money Laundering Risks in Commercial Banks
Up until now, we have seen various ways in which commercial banks are able to serve their corporate clients. Almost all the products and services created by commercial banks are created with the intention to serve their customers. However, corporate customers are not the only stakeholders that the banks have. Commercial banks are also answerable […]
Bankruptcy as a Strategy – Part 2
In the previous article, we have already studied that all bankruptcies are not involuntary. In many cases, the shareholders and/or the management of the company make a conscious decision to file for bankruptcy. This happens because the benefits that may accrue as a result of filing bankruptcy are greater than the loss of reputation and […]
Why Do Mutual Funds Lend To Promoters?
After the banking crisis, the Indian capital markets are facing another dire situation. It has recently come to light that many mutual funds have been lending money to promoters of companies. It needs to be understood that these loans are not being made to companies but rather to promoters of companies. The problem is that […]
History of Accounting
One can never really understand a subject, unless they know where it came from. Therefore, a short history of the subject of accounting may be of interest to students of accounting. Here is a very brief history of how accounting evolved: Single Entry Accounting System Accounting is as old as financial transactions themselves. As soon […]
Advantages of Behavioral Finance
The problem with traditional financial theories is that they tend to operate in an ideal world! The underlying assumptions are that the information available is perfect, the investors are capable of interpreting the information. Another assumption is that there is a single right answer which can be mathematically worked out. However, when investors use this […]
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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