Wednesday, January 18, 2006

Fixing the IPO process

The financial establishment in India is in a tizzy about the "IPO Scam". This involves multiple applications in order to capture the shares reserved for "individual investors". As Jayanth Varma has pointed out, this problem is ultimately caused by mistakes in the design of the IPO.

I wrote a column for Business Standard titled Why track down Roopalben?, where I argue that the problem in the IPO process can best be solved by shifting the IPO market to a pure uniform-price auction, where there is no special treatment of individual investors, there is no `Syndicate', and only a trivial role for the merchant banker.

Oddly enough, I had written essentially the same idea in November 1999 in the context of the IPO of Hughes Software Systems. The basic issue is the same: Should India use some kind of messy computerised IPO process, or should there be a clean pure-auction that is run by computers?

The litmus test of the soundness of the IPO mechanism is the size of IPO underpricing, i.e. the returns from IPO date to listing date. As documented in my 1995 paper, in the bad old days, we had enormous underpricing. The screen-based bookbuilding has helped reduce the size of underpricing, but it is still very large. This suggests that there is a need to improve the IPO mechanism so as to acheive pricing efficiency. The tight "price band" that is set by the investment banker today violates the notion of price discovery by the auction and not by the investment banker, as was the case in the fixed-price offerings which used to take place in the bad old days.

The issue of multiple applications at the IPO by individual investors is sometimes linked up to the (lack of) the Mapin database which will allow a clarity of identifying each investor. I believe that whether or not Mapin is up and running, the only meaningful notion of finance is where every security has a single price, regardless of the identity of the buyer. Whether I'm an indvidual or a mutual fund, I pay the identical price for a Maruti car or a share on the secondary market. There is no reason why the IPO market should violate such a rule. (I believe we need the Mapin database for other reasons, but not for this one).

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