In simple terms, the book building process of IPO is a mechanism used for price discovery by merchant banks and lead issuers. In the IPO process, the underwriter invites qualified institutional investors, foreign portfolio managers, and other heavy-hitters to submit bids for shares, which is then used to set the stage to price the IPO for the general public.
The underwriter 'builds' the book by analyzing aggregate demand arising from institutional investors. The weighted average is considered to arrive at the final price for the security, called the 'Cut-off' price.
The bids submitted by institutional investors, their selection, and allotment are showcased to the public to promote transparency and justify the price that is arrived at for retail investors. This process remains a mainstay for pricing securities and is often mandated by leading stock exchanges worldwide.
Book Building Vs Fixed Price Issue
Price discovery can follow two popular mechanisms in an initial public offering: the most commonly used book building IPO or a fixed price issue. Both have their merits and demerits. However, a transparent book building process is most sought after in markets worldwide.
In a fixed price issue, the price of securities is already notified in the prospectus. There is no bidding or aggregating of demand to arrive at the right price. The full amount, including the price of the shares, should be paid while applying for them. The public demand for shares is only disclosed after the conclusion of the offering.
In the book building mechanism, as discussed earlier, the prices are determined by a transparent bidding process, with only the price band disclosed to investors in the prospectus. In this method, only the application money is to be paid at the time of bidding. The full amount is collected after the issue price has been fixed.
The fixed price model is restricted to follow-on issues, rights issues, and ESOPs, whereas the initial public offering almost always uses a transparent book building process. Under fixed pricing, the company also faces significant IPO pricing risks if it fails to realize sufficient demand for the offering based on an arbitrary price, which can be eliminated for the most part with the book building method.
Partial & Accelerated Book Building
Other variances come with book building, such as partial and accelerated book building. Under partial book building, bids are invited mainly from qualified institutional investors and not the general public before the price is offered to retail investors, with a very small range and little intake coming from them.
Companies in urgent need of funding adopt an accelerated book built issue IPO, usually within 24 to 48 hours. The company contacts various investment banks to act as underwriters, with the contract falling to the bank that offers the highest backstop price. The bank then solicits bids from other institutional investors to offload its position in the company.
The IPO Pricing Risk
This exercise effectively prices an offering and ensures that it neither undervalue nor overvalue a company. Either way, this is far from a perfect system, and prices from the book building process may not reflect the company's fundamentals.
The company is not bound to respect the prices arrived at from the process and can offer securities at an arbitrary price that the promoters think best reflects the fundamentals and prospects of the company.
Despite decades worth of data and a system fine-tuned after numerous trials and errors, there are numerous instances of it falling short, with stocks taking a plunge on listing after being priced too high, going under, or oversubscribed, due to the price not reflecting reality.
Other IPO Pricing Factors
A few other factors come into play that may deviate from what markets impute. Off-late, numerous IPOs follow a process of deliberately underpricing their offerings, resulting in oversubscription and a substantial rally on the first day of listing.
This is often done to boost demand but can also be used to generate buzz and impact the minds of investors and institutional finance companies. It is a way to showcase a stock's arrival by having a blast on the first day of trading.
It is better to ensure stocks rally on their first trading day than witness a contraction. In line with this, promoters and bankers tend to underprice their offerings in general to achieve good listing gains.
Understanding the nuances and complexities of book building is crucial to generating strong returns from IPO investing.
Diving deep into the prospectus, process, and mindsets of promoters and bankers is key to understanding the intent of an IPO, and this is an art learned with experience.