ASX aims to trump old boys club, but Bookbuild will be a hard sell

Plans by the ASX to develop an on-market Bookbuild for public floats may have unintended consequences.

By the end of the year, the ASX aims to introduce the ASX Bookbuild platform, which will provide an alternative mechanism for companies to raise equity capital in Australia.

Some commentators already view this development as a necessary initiative to open up the exclusive and murky world of investment banking. Others see it as simply a diversification strategy by the ASX in response to increasing competition from other exchanges. Regardless of its true intention, the ASX will face an uphill battle in penetrating the investment banking market.

In Australia, the traditional method of pricing an equity issue such as in an initial public offering (IPO) is to set a fixed offer price before marketing the shares. Recently, investment banks have increasingly used bookbuilds to handle large IPOs and secondary equity offers. This involves the underwriter of an issue collecting demand indications from its institutional clients before determining the final price that sells all offered shares. The third method is to put up shares for sale in a public auction.

The most distinguishing feature of a bookbuild is that the underwriter has a lot of discretion over pricing and allocation of shares across investors, whereas in an auction, pricing and allocation follow some predetermined rules. Investment bankers argue that such flexibilities are necessary to create an incentive to bid, for example, by giving allocation priority to early and frequent bidders. But the book-building process is also often shrouded in secrecy and to outsiders, the mixture of underwriters’ autonomy and lack of transparency has fuelled suspicions of potential abuses in the process.

How will the ASX sell its new service?

ASX Bookbuild, despite its name, is actually more like an auction service than a bookbuild platform. It opens bidding opportunities to all investors (through their brokers) rather than just some exclusive clients of an underwriter. Bidding and allocation rules are also predetermined and disclosed to investors. The book-building process is for the most part automated and investors can observe the evolution of the likely auction clearing price in real time.

The emphasis on transparency will be high on the ASX’s sales pitch to issuing firms wary of being short-changed by all the quid pro quo dealings inside investment banking. But the ASX is also conscious to retain, to some extent, the key feature of bookbuilds, namely the discretion of underwriters over allocation. This hybrid design may boost pricing efficiency, but it also helps avoid an open war with the investment banking establishment.

Against the trend?

ASX Bookbuild is undoubtedly an important innovation that would encourage competition and transparency in the industry. But in terms of turning it into a commercial success, unfortunately, history may not be on the ASX’s side.

Despite its claim of being the world first, similar variants to ASX Bookbuild have existed before elsewhere. In studies conducted by Professor Ann Sherman from DePaul University and Northwestern University Professor Ravi Jagannathan, among 25 countries that have used some forms of IPO auctions, most have abandoned them in favour of bookbuilds.

In Japan, companies immediately switched to bookbuilds when this form was allowed in addition to auctions. In the US, despite the high profile adoption by Google and Morningstar, auctions were confined to a small number of 22 IPOs during the 1999-2009 period. In Australia, the market has not seen auction IPOs again since their brief appearance in the Dotcom bubble period.

More choices but no easy pick for issuers

The unpopularity of auctions is not surprising according to some theories. Auction mechanisms, especially in their transparent forms, often do not give much incentive for investors to make their first bids and the risk for overpayment (or “Winner’s Curse”) is high, as anybody who has been to a house auction would know. In IPOs, where investors face significant valuation hurdles, public auctions also do not provide a medium to credibly disseminate information about a firm’s true value.

ASX Bookbuild does address some of these issues in its design. The platform allows underwriters to give allocation priority to certain clients and investors who submit high bids. It even uses a random timer to close an auction to prevent some gaming behaviour by both underwriters and bidders, such as “sniping” (bidding at the very last moment) or withdrawing bids immediately at the auction close.

However, there is unlikely to be any safeguard against the risk associated with displaying running auction clearing prices. If investors are not particularly sophisticated and well informed, prices can either run very high or very low in an auction. Some research evidence has shown that surprisingly, auction IPOs are more mispriced than bookbuild IPOs. IPO firms thus face a very stark choice: do they trust their not very accountable investment banks or a transparent but potentially inefficient public market.

Their choice would be even more limited if some major investment banks decide to boycott the platform. These banks give share offers a significant certification effect that often boosts their success.

The ASX is currently open to comments on how to finetune ASX Bookbuild. Some of its features remain quite controversial, such as the random timer and the somewhat rigid price setting rules.

It is difficult to predict the impact of such features until the platform is tested on actual share issues. One can speculate though that like bidders in an auction, companies will carefully watch one another’s moves rather than being the first to put up their hands.