How Securities are Priced in the Primary Market
We already know that primary financial markets are used by firms to raise funds from investors. This is done by issuing shares via an initial public offer, rights issue, or even using private placements. In each of these cases, the firm selling shares has to arrive at a market price at which they are willing to sell their shares. These prices have to be high enough that the firm selling its stake sees value in the sale.
Alternatively, the prices should not be so high that they drive away potential investors. As a result, price discovery is a very important process that requires that due attention be paid to it.
Over the years, different methods of price discovery have been used by different intermediaries in the primary markets. All these methods can be broadly classified into two types viz. fixed price and book building method. In this article, we will try to understand both the methods as well as the difference between them.
Fixed Price Method
An issue is said to be following the fixed price method when the price at which the shares will be sold is known to the investors in advance. If a company follows the book building method, it generally means that the management is very sure about the price that its shares will fetch in the open market. As a result, they decide to go ahead with the issue without actually testing the price which the market is willing to pay.
The problem with this type of issue is that the number of securities sold cannot be known until the issue is complete. This is because the company offering its shares sets a price and whether or not investors are willing to pay that price can only be known after the issue. This is the reason that fixed price issues sometimes go unsubscribed and, therefore, are considered to be a flawed method by many experts.
Fixed price issues are not very common when it comes to an initial public offering. However, in case of rights issues, etc. using the fixed price method is quite common.
Book Building Method
Since the fixed price method was considered to be flawed by many critics, an alternate process called the book building method was created.
In this method, the seller of shares does not give a fixed price to the buyers. Instead, the seller of shares gives a broad range of prices at which they are willing to sell their shares.
For instance, a seller may set their share price between $35 and $50 and then invite bids for a fixed period of time, like two weeks. Along with the price, the issuer also needs to clearly mention the number of securities that they want to sell.
Once the price range is set, and the number of shares to be sold is revealed, the buyers can start bidding for the shares.
Buyers are allowed to revise their bids several times during the bidding process if they wish to do so. After the specified period gets over, the seller is supposed to reveal all the bids which have been received. This is done to ensure that transparency is maintained during the process. The allotment is then done based on the prices.
The highest bids get the maximum shares. Only after the highest bids are exhausted, are shares issued at a lower price. Using this method, the sellers of shares are able to evaluate the demand levels at various price ranges. The people who bid the highest prices are issued the shares. Refund orders are given to the rest of the bidders.
This method is considered to be better than the fixed price method since it is more inclusive and takes into account the opinion of various investors.
Also, the probability of shares remaining unsold in a book building issue is reduced drastically. The demand for the shares is known beforehand. The sellers do not have to wait until the end of the issue to find out the actual demand.
Accelerated Book Building Method
One of the problems with the book building method is that it takes a lot of time. In order to solve this problem, a modified version of the book building methods called the accelerated book-building method had been created.
Accelerated book building is nothing but a faster version of book building. The entire process is completed within 48 hours. In order to do this, the selling companies and their investment banks only contact other institutional investors. The bids are received in an auction-style, and shares are awarded to the highest bidder.
This process works best when funds have to be raised quickly, like during mergers and acquisitions transactions. The accelerated book-building method helps companies raise funds even faster than selling debt. It has all the advantages and transparency of the book-building process and works at lightning speed as well.
To sum it up, there are different mechanisms that can be used for raising funds via the primary market. The book-building process has an obvious advantage over the fixed price method.
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