A wave of successful IPOs has swept the T.A Stock Exchange - the rise of the Book Building method

A wave of more successful IPOs has swept the Tel Aviv Stock Exchange, and with that we can see the rise of the issuance method used throughout the Western world - except in Israel - the non-uniform offer method, "Book Building".

In Israel, the common used issue method for raising funds in an Initial Public Offer (IPO) is the Fixed Price Mechanism, in which the issue takes place in a tender and the underwriter cannot allocate the goods or change the tender price. Over the period of time, and all over the world stock exchanges, the fixed price mechanism has become obsolete and book building has become the de-facto mechanism used in pricing shares while conducting an IPO.

What is Book Building ?

Book building is a price discovery mechanism that is used in the stock markets while pricing securities for the first time. When shares are being offered for sale in an IPO, it can either be done at a fixed price. However, if the company is not sure about the exact price at which to market its shares, it can decide a price range instead of an exact figure. This process of discovering the price by providing the investors with a price range and then asking them to bid on it is called the book building process. It is considered to be one of the most efficient mechanisms of pricing securities in the primary market. This is the preferred method which is recommended by all major stock exchanges and as a result is followed in all major developed countries in the world.

Book Building Process

The detailed process of book building is as follows:

1. Appointment of Investment Banker: The first step starts with appointing the lead investment banker. The lead investment banker conducts due diligence. They propose the size of the capital issue that must be conducted by the company. Then they also propose a price band for the shares to be sold. If the management agrees with the propositions of the investment banker, the prospectus is issued with the price range as suggested by the investment banker. The lower end of the price range is known as the floor price whereas the higher end is known as the ceiling price. The final price at which securities are indeed offered for sale after the entire book building process is called the cut-off price.

2. Collecting Bids: Investors in the market are requested to bid to buy the shares. They are requested to bid the number of shares that they are willing to buy at varying price levels. These bids along with the application money are supposed to be submitted to the investment bankers. It must be noted that it is not a single investment banker who is engaged in the collection of bids. Rather, the lead investment banker can appoint sub-agents to tap into their network especially for receiving the bids from a larger group of individuals.

3. Price Discovery: Once all the bids have been aggregated by the lead investment banker, they begin the process of price discovery. The final price chosen in simply the weighted average of all the bids that have been received by the investment banker. This price is declared as the cut-off price. For any issue which has received substantial publicity and which is being anticipated by the public, the ceiling price is usually the cut-off price.

4. Publicizing: In the interest of transparency, stock exchanges all over the world require that companies make public the details of the bids that were received by them. It is the lead investment banker’s duty to run advertisements containing the details of the bids received for the purchase of shares for a given period of time (let’s say a week). The regulators in many markets are also entitled to physically verify the bid applications if they wish to.

5. Settlement: Lastly, the application amount received from the various bidders has to be adjusted and shares have to be allotted. For instance, if a bidder has bid a lower price than the cut-off price then a call letter has to be sent asking for the balance money to be paid. On the other hand, if a bidder has bid a higher price than the cut-off, a refund cheque needs to be processed for them. The settlement process ensures that only the cut-off amount is collected from the investors in lieu of the shares sold to them.

Advantage and disadvantage of the Book Building (Vs Fixed Price Mechanism)

• First of all, the book building process brings flexibility to the pricing of IPO’s. Prior to the introduction of book building, a lot of IPO’s were either underpriced or overpriced. This created problems because if the issue was underpriced, the company was losing possible capital. On the other hand, if the issue was overpriced it would not be fully subscribed. In fact, if it was subscribed below a given percentage, the issue of securities had to be cancelled and the substantial costs incurred over the issue would simply have to be written off. With the introduction of book building process, such events no longer happen and the primary market functions more efficiently.

In the Israely Market:

• Trading stability can be carefully marked by the book building method of the fresh stock. In this method the Institutionals Investors buy the goods and invest in the long term, so there is no one who will flood the market with stocks and may bring them down. Of course there are no guarantees on the stock exchange for stable trading, but preliminary data show that this claim may turn out to be true.

• On the Fixed Price Mechanism when the bid phase arrives, the Institutionals Investors orders shares and submits a bid like the whole market. As they are not sure they will get the slice they wanted, they will maximize the price and increase the demand, to try to score to the extent they wanted. It inflates demand and price, and in the end that Institutionals Investor still gets a partial share. Moreover, in its place come all sorts of speculators who order stocks and then sell in the market after the IPO ends. This process creates instability, and more than once leads to a decline in the stock after the IPO.

• In the Book Building method, the undertaker holds the cards close to the chest. It decides to what extent to allocate to each of the institutional investors, produces for itself a closed list of investors and also determines the timing of the IPO. He could theoretically close it in one day and end the process, or leave the 'book' open and manage it over several weeks. He is the only one who sees the real demand from the institutional investors and private investors who want to participate. And when he closes the demand book, he completes the offering.

Sources:

1. Calcalist: https://bit.ly/2WYA0cs (Hebrew article)

2. MSG - Managament Study Guide: https://bit.ly/2JA3SbW