The initial public offering (IPO) is a process followed by joint stock companies in raising capital through issuing new shares of stock to the general public. It can be made through a fixed price method, a book building method or a combination of both. The fixed price method is being commonly used in IPO for many years. But, recently the book-building method has gained popularity in developed countries and has been making inroad into emerging markets as well.
Accordingly, Bangladesh introduced this method first in 2010. Following market crash in 2011, the method was suspended for that year due to massive allegation on misuse of its process. After about two years of suspension, the method was resumed in a modified form in 2014. Only six companies got listed in the Dhaka Stock Exchange (DSE) under this method up to November 2017. Looking at the numbers, it is evident that the method is yet to hold water at DSE. However, today's discussion will revolve round different issues of book building method.
Book building method is a systematic process of getting efficient price discovery for IPOs through using investors' demand for shares. In other words, book building method is the process by which an underwriter attempts to determine at what price to offer an IPO based on demand from institutional investors. Here, we focus on two downsides of book building method: one is the flaw in its process and another is its complexity and lengthiness in process.
Let's start discussion with the flaws. This method is being disputed and criticised since its introduction. Although the method has gone under several amendments, still it has some weaknesses. The first anomaly occurs at the time of setting indicative price of IPO under this method. The exchange amended some provisions in this regard, but still the issuers have room to manipulate the process in their favour. \
On the other hand, the eligible investors who participate in road shows do not have adequate knowledge on valuation of firms. The issuers with the help of auditors and issue managers and at times with the help of the regulator fix inflated indicative prices, which do not match with the fundamentals of their firms. Auditors basically help companies in window-dressing their balance- sheets and hiding negative information. Companies with support from issue managers mostly try to convince eligible institutional investors to propose higher prices for their new issues at the road shows.
After fixing indicative price, bidding for cut-off price takes place. Eligible institutional investors put their bid prices and desired shares into the book building system. There is 20 per cent upward and downward limit for putting prices in the bids. But investors always put prices at the upward ceiling in order to win their bids. Stiffer restrictions can be imposed in fixing indicative and cut-off prices to check anomalies, but that will be against the principles of book building method and accordingly the method will lose its objective. Earlier, each investor was allowed to quote up to 10 per cent of total security offered for sale. In that case, there was a scope for fabricating the cut-off price with just 10 bids.
But now, no institutional investor is allowed to quote for more than 5 per cent of the total security offered for sale. As a result, it has been difficult to influence the cut-off price through a few bids. But, still issuers can manipulate the cut-off price through forming a syndicate with a number of institutional investors.
If we review the recent IPOs under this method, we get evidence that indicative prices were fixed at exceptionally high level. In addition, the cut-off prices are always fixed higher than indicative prices (at the upward ceiling). Finally, by the time the offer prices are fixed, the P/E ratios increase by more than 15 times. The P/E ratios are further increased to around 25 times at the debut of their trading at the exchanges. Thus, the new issues start trading at the exchange with higher prices. However, the high prices usually continue until the institutional investors realise their benefits. After that the prices start falling and the general investors who are holders of these shares, become the ultimate sufferers. This method certainly contributes to the market volatility.
Therefore, revision of rules of the method can not be effective in checking the anomalies. In reality, the wrongdoers somehow find their ways to accomplish their jobs in spite of stiffening of the rules. In this way, the companies are being benefited with the method while the general investors are losing money. From this point of view, it may seem that the issuers ought to be encouraged to offload their shares using this method. But, looking at the numbers of IPOs under this method, it does not appear like that. The main reason could be the lengthy process that this method usually takes to offload shares.
The book building method includes a number of complex steps, which may take normally several months. Looking at the latest statistics, it is evident that all IPOs under this method have taken almost one year or more to complete the whole process. Many things may happen during this period. For instance, the country's economy may go down, political situation may deteriorate, the companies' business may fall and global economy may have depression etc. All these will obviously push down companies' profits. Hence, the firms' valuation at the road shows will have no meaning at all. Additionally, bureaucracy involved in the process discourages the companies to offload their shares under this method.
On the other hand, the fixed price method usually takes less time and the process is relatively simple. As a result, companies are more inclined to offload their shares under this method (fixed price) despite lower prices.
The book building method was introduced to attract good and renowned companies. But, it has failed to draw their attention and more importantly, the companies that showed interest, were not fundamentally good expected to be. However, only book building method is not enough to bring these big companies into the market. The regulators have to impose specific rules and regulations that will require them (big companies) to be in the market. Nevertheless, the book building method is a very sophisticated as well as complex method. To understand and use it properly the institutional investors have to be more efficient and literate. We believe that Bangladesh's stock market has not been prepared yet to adopt this method.
Therefore, it can not be said that the book building method is suitable for our stock market. As we said earlier, whatever correction you do in the rules of this method, they (wrongdoers) will find their ways out to accomplish their dishonest motives. Therefore, it is high time for both the exchanges and regulators to decide whether the book building method should continue or be withdrawn from the market. Now onwards, the authority should not permit companies anymore for raising capital under this method unless they can ensure a fair atmosphere where no further anomalies are likely to occur under the method. Otherwise, the method will continue to be blamed for creating turmoil in the stock market.
The writer is a capital market researcher and Assistant Professor, Department of Finance and Banking, Islamic University, Kushtia.
