Why Have IPO Auctions Failed the Market Test?

Abstract:     
We document a somewhat surprising regularity: of the many countries that have used auctions to place IPOs, most have abandoned them. We examine why this may be so, illustrating with suitably calibrated examples that: (a) bidding in auctions is difficult and even sophisticated investors can make mistakes, especially in face of uncertainty about the number and type of other bidders; (b) such mistakes can be costly not only for those who make them but also for other participants; (c) bidders who try to free ride on the efforts of others make bidding in auctions risky for everyone; and (d) rewarding price discovery requires restricting entry. We provide empirical evidence showing that, in countries that abandoned the auction method, IPO auctions were indeed plagued by unexpectedly large fluctuations in the number of participants, irrational return chasers, and free riders. Based on theoretical arguments, we develop a revenue-maximizing IPO mechanism that encourages price discovery, while at the same time allows participation by unsophisticated investors. Our empirical findings suggest that such a mechanism, which looks like a transparent version of book building, will have more desirable properties when compared to standard as well as hybrid auctions.

JEL Classifications: G24, G28, G32

Working Paper Series