© Evanston Photographic Ravi Jagannathan

Faculty Research: Ravi Jagannathan, Finance

Ripe for reform
Ravi Jagannathan, Kellogg School professor of finance, makes a bid to improve the way initial public offerings are structured

Money "left on the table" after an initial public offering (IPO) of equities can be staggering, particularly when companies making the IPO use bookbuilding — the mechanism of generating investor interest and attention prior to pricing the issue in preparation of the offering, says Ravi Jagannathan, the Chicago Mercantile Exchange Distinguished Professor of Finance and co-director of the Center for Financial Institutions and Markets at the Kellogg School.

He suggests that the solution to this problem is to restructure the bookbuilding system to suit the needs of companies going public and their prospective investors.

Money left on the table, defined as the difference between the first day's closing price and the offering price multiplied by the number of shares sold, dwarfs direct costs, Jagannathan says. From 1980-2001, about $488 billion was raised in 6,249 new equity issues, leaving $106 billion, or 22 percent, of the amount raised on the table. (1) In 1999 alone, $38 billion out of $67 billion was left on the table.

"Some money needs to be left on the table and IPO shares offered at a discount to fair value to encourage price discovery and induce an investor to participate in the issue," he says, lest the investor waits to buy shares in the after market.

But "if everyone waits," Jagannathan says, "the issue would be a failure." Under the current bookbuilding method, when a large amount of money is left on the table inadequate oversight can lead to potential abuses by issue managers when allocating shares among investors in an IPO.

Jagannathan, an expert in the areas of asset pricing, capital markets, financial institutions and portfolio performance evaluation, says auctions may not be any better at reducing money left on the table and in fact have a poor track record. In his work with Ann Sherman (2) , professor of finance at the University of Notre Dame, Jagannathan documents that auctions have been tried in many countries, then abandoned in almost all of them in favor of bookbuilding. Of the 46 countries examined in their study, IPO auctions of one type or another have been used in 20 countries. Of those, at most four (including the United States) currently use auctions, which play a small role even in these nations.

Abandoning the auction method doesn't necessarily mean issuers are hesitant to try new methods. Auctions were tried in Italy, Portugal, Sweden, Switzerland and the United Kingdom in the 1980s, and in Singapore, Taiwan and Turkey in the 1990s, before bookbuilding was introduced.

"Hence, the rarity of IPO auctions is not due to unfamiliarity," notes Jagannathan, who has contributed his thought leadership, as both writer and editor, to several top finance and management journals.

"The main problem with standard auctions," says Jagannathan, "is that they do not adequately reward those who devote time and effort to serious evaluation of an unlisted company." In a non-discriminatory uniform price or "Dutch" auction, where everyone who receives an allocation pays the same price, "there is the temptation to bid high, even by those without valuable information on the fair value."

When uninformed investors try to "free ride" on the back of sophisticated investors, the sophisticated investors start avoiding IPO auctions, Jagannathan says. The result is scant price discovery during the auction and little liquidity in the market for the stock after the issue starts trading.

"Auctions in which people pay the price they bid don't suffer as much from the free-rider problem as do non-discriminatory auctions," he says.

However, such auctions will dissuade investors who may not have an informed opinion about the fair value of an issue, but whose participation is necessary to reduce the price risk and increase the liquidity in the market when the issuer's stock starts trading following the IPO.

Jagannathan's work with Sherman suggests that, while it may be possible to devise a nonstandard auction that will overcome these problems, such an auction may not look very different from bookbuilding.

The key to reducing money left on the table after an IPO, Jagannathan says, is to modify the process of bookbuilding by making the allocation process more transparent and subject to oversight, while at the same time maintaining confidentiality.

"These strategies may be more productive than a radical shift to an IPO auction method that has failed repeatedly around the globe," says Jagannathan.

1 Excludes issues with an offer price of less than $5,000, ADRs, unit offers, closed end funds, REITs, partnerships, banks and S&Ls, and foreign firms going public in the United States without ADRs. See Ritter and Welch, Journal of Finance, Aug. 2002, Table I.

2 "Why do IPO auctions fail?" manuscript, 2004.