book-building system will it really help

Journal of Business Research, Vol. 8, June 2006

BOOK-BUILDING SYSTEM: WILL IT REALLY HELP TO BUILD THE MARKET?

K. M. Zahidul Islam*

Mohammad Moniruzzaman Siddiquee** Masud Ibn Rahman***

ABSTRACT There are three widely practiced approaches in pricing the initial public offerings (IPOs), such as public offer, tender or auction and book-building. The key difference between book-building and other IPO methods is that the book-building method gives underwriters control over the allocation of shares whereas others do not. Apart from the differences, all the mechanisms have one thing in common that is, pricing-relevant information is obtained directly from potential buyers in the primary market. Book-building, primarily used in North America in the 1980s, got momentum by the end of the 1990s, touched Europe, Asia and Latin America. However, public offer method is becoming less common worldwide except in smaller countries that rely mainly on retail investors. Auctions are rare these days. Book-building dominates the IPO pricing mechanisms because it results in higher net proceeds, enables smaller and riskier firms to access public equity markets, enables issuers to raise larger amounts of capital, provides liquidity for early investors, places shares with preferred types of investors, and encourages underwriters to provide important aftermarket services, although book-building is widely believed to be an expensive process compared to other alternatives. However, only cost differences between book-building and other approaches are not sufficient to outweigh the benefits investors perceive. Recently the Securities and Exchange Commission (SEC) of Bangladesh is planning to introduce book-building system replacing the year old fixed price method. The SEC thinks that this will encourage good-performing local and foreign companies to float IPOs as they are ensured to have fair price for their shares. The critics, on the other hand, think that book-building will permanently throw out general investors from the capital market making the market fully �elite class.� From the public policy point of view, SEC should not introduce such a system. In such a situation, SEC may continue with both the existing �lottery� method and the book-building in parallel as it is in the US, where book-building is used for larger IPOs and auction/public offer method for smaller issues or there can be a hybrid system of book-building and other IPO pricing mechanisms.

1.0 INTRODUCTION There is an international trend toward increasing use of the U.S. book-building (firm commitment) method for IPOs (Sherman, 2000b). Book-building has been listed as an allowed method for pricing and allocating IPOs in many countries. To * Lecturer, Dept. of Business Administration, Jahangirnagar University, Savar, Dhaka ** Lecturer, Faculty of Business and Economics, Daffodil International University, Dhaka *** Assistant Professor, Faculty of Business and Economics, Daffodil International University, Dhaka

Book-Building System: Will It Really Help to Build the Market?

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keep pace with the global trend, Bangladesh is going to introduce this method replacing the existing year old �lottery method�. However, the concept originated from the recommendation of the Project Performance Audit Report for Bangladesh of Asian Development Bank for introducing a market-based pricing mechanism of IPOs (ADB, 2005). Like other IPO methods, book-building has its merits and demerits, discussed in Section 4.3. In the context of Bangladesh, it is assumed that the book-building system will attract good-performing local and foreign companies as they are ensured to have fair price for their shares. However, the critics have strongly opposed the idea as they believe the new system will drive away general investors from the capital market and will serve the interest of the issuing companies only that may jeopardize the capital market's growth severely, which is evidenced from the recent scandals in the allocation of heavily underpriced offerings in the United States, where book-building is widely practiced (Pons-Sanz, 2005). The Securities and Exchange Commission (SEC) alleged that most of the small investors who get allotment of primary shares dispose them immediately after the commencement of trading in the bourses which has a negative impact on the market. Defending the SEC�s allegation, the critics have responded that if the existing IPO floatation method continues, chances are high that these small and new investors will, someday, play into the secondary market against their institutional counterparts. But the proposed new method is likely to destroy the investors� confidence in the recently developed primary market. The supporters of the book-building, on the other hand, think if the new method is so obviously flawed, anyone who believes in the power of markets to wring out inefficiency must ask why this practice has not only survived (at least in some form) for over two centuries, but has in fact gained considerable market share worldwide in recent years. This paper is an attempt to focus on the different IPO pricing and allocating mechanisms, their advantages and disadvantages for issuers, underwriters, and investors. We emphasize particularly on the book-building system and whether the new system would be able to play a role in strengthening the capital market of Bangladesh. We have tried to shed some lights on the IPOs scenarios, the institutional settings, allotment / placement procedure, and offer price determination under the existing IPO pricing and allocating mechanism � fixed price method. 2.0 METHODOLOGY The article is written in the form of a literature review, totally based on past IPO pricing and allocating mechanisms related works from both the developed (the United States, Canada and Europe) and developing (Japan, South Korea) capital markets so that we can share their experiences with book-building before introducing the new method in capital market of Bangladesh. We have tried to summarize the findings of several popular articles and working papers in this area. Instead of summarizing paper-by-paper, we rather deal with some themes that we think relevant to capital market of Bangladesh, and then draw results from several papers for each theme. For example, IPOs are heavily underpriced in the capital market of Bangladesh. This because investors have so much


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interest in primary market. We have selected underpricing as a theme and have tried to summarize the findings regarding the contribution of different IPO pricing mechanism in underpricing. Moreover, we have surveyed the companies that go public since 2005 till date to understand how they determine offer price for their companies� shares. However, to suggest the �only� suitable or feasible IPO pricing and allocating mechanism for the capital market of Bangladesh is beyond the scope of this paper. 3.0 IPO� A WAY OF SELLING STOCK IPO is an acronym for �Initial Public Offering,� where the issuer sells securities for which there does not yet exist a secondary market price. This is the first sale of stock by a company to the public. Recently we, in Bangladesh just like other developed economies have been bombarded with so many jargons like �BO Accounts�, �Depository Participants�, �Central Depository System,� etc. IPO or participating in an IPO becomes our everyday talk now-a-days. As most of the investors do not understand fully how an IPO has been floated, or how an IPO got on the road, we have tried to briefly describe the total IPO flotation process for our readers.

1. The issuing company begins the process by retaining a law firm to assist in producing a detailed firm disclosure, which will be the main content for the IPO prospectus, and which must be filed with the SEC prior to going public with the stock on the exchange.

2. While the prospectus preparation is in process, the company interviews various investment banks and then selects one (or more) to handle the underwriting of the IPO, such as setting the offering price of the stock, and then disseminating the shares among a wide range of investors in the public capital market.

3. Prior to the IPO date, the company and the underwriter typically head out to do a �road show,� meeting with mutual fund managers, analysts and other stock portfolio managers in several large cities during the weeks leading up to the IPO date.

4. On the IPO date, the company and its team do their last-minute edits and negotiate the final offer price, and the last version of the prospectus is filed with the SEC, usually within the half hour prior to the opening of trading on the exchange. Once the SEC gives the "green signal" that the prospectus meets the minimum filing requirements � the investment bank opens up trading at its chosen asking price, and the selling begins.

4.0 MECHANISMS FOR PRICING AND ALLOCATING IPOs In an IPO, the issuers not only market and distribute the shares, but also determine a price at which the securities can be sold. There are three globally practiced methods for IPOs pricing, such as (1) tender or auction, (2) public offer (a.k.a. fixed price, open offer or universal offer), and (3) book-building. The following section discusses three methods along with a few variations. 4. 1 Auction Auction requires the allocation of shares to be based on bids, without regard to any past relationship between certain bidders and the auctioneer. Then securities are priced and allocated according to explicit rules. Under auction or the open offer system, underwriters are free to do �road shows� and to ask for indications of interest. However, the auction�s discriminatory pricing structure discourage


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bidding, making it difficult for underwriters to assess demand and limiting offering size; and due to low institutional involvement, pricing in the auctions was more heavily affected by market conditions than by fundamental value. Extensive theoretical research has established the superiority of auctions as a selling method in a wide range of circumstances. Sherman (2004) has identified the following situations where auction is most likely to be optimal for (1) large, well established companies; (2) companies with a large, dispersed customer or employee base; and (3) industries that are well established and widely understood. Auctions were a well established selling method for IPOs in most parts of the world long before book-building was introduced. The two countries in which auctions are still the primary IPO method are Israel and Taiwan. Book-building is banned in Israel and it is restricted in Taiwan (Sherman, 2004). Among the several types of auctions, Brazil, Japan, the Netherlands, Singapore, Taiwan and the U.K. have used discriminatory auctions (pay what you bid), while Argentina, Australia, Brazil, Finland, France, Israel, New Zealand, Norway, Peru, Portugal, Singapore, Turkey, the U.K. and the U.S. have used uniform price auctions. Chile uses an auction on the exchange, which is similar to an English auction (open, ascending bid). Dirty auctions (where the price is set below market-clearing) have been used in Australia, Belgium, Finland, France, Hungary, New Zealand, the United Kingdom and the United States, and have been especially common for IPOs in Belgium, France and the U.K. (Biais and Faugeron-Crouzet 2002). 4.2 Public/Open Offer/Fixed Price Method By fixed price mechanisms, we mean contracts where the offer price is set relatively early, before much information about the state of demand is known. Then orders are taken from investors who typically pay in advance for part or all of the shares that are ordered. In public offer, the issuer is allowed to price the shares as he/she wishes. The basis for the price is explained in an offer document (e.g., prospectus) through qualitative and quantitative statements. This offer document is filed with the stock exchanges and the registrar of companies. The open offer normally includes �fairness rules� which allow discrimination only on the basis of order size that may increase the cost of financing for issuers. The fixed price method is widely used in Europe and Asia as can be seen from Appendix A, but losing ground recently to book-building, particularly in larger issues, and in larger, more active markets. However, countries where this method is the only or at least has traditionally been the primary method include Australia, Barbados, Finland, Germany, Hong Kong, India, Indonesia, Jordan, Malaysia, Singapore, South Korea, Sri Lanka, Taiwan, Thailand, and the United Kingdom. Many of these countries now allow book-building besides open offer method. Fixed price/universal offer/open offer is not used in the United States. However, Bangladesh uses public offer system in pricing IPOs (see Table 1). 4.3 Book-Building Method Book-building is a process by which an underwriter attempts to determine at what price an IPO should be offered based on demand from institutional investors. An underwriter �builds a book� by accepting orders from fund managers indicating the number of shares they desire and the price they are


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willing to pay � hence the name. The �book� normally includes each bid submitted, the identity of the bidder, the number of shares (or dollar amount) requested, and any limit price. The book also shows the date when the bid was entered and any subsequent revision (or cancellation) of the bid. Underwriter retains sole discretion over allocation of the shares to investors. In this procedure, before setting the issue price for an equity offering, the investment bank sets a base price and a band within which the investor is allowed to bid for shares. Each bid is a request for a quantity of shares, and may include a limit price. In the U.S., book-building typically starts with the setting of a file price range, say $14-16 per share, and the commencement of a road show that might last two weeks (Loughran and Ritter, 2002). The difference between the minimum and maximum price is almost always $2. During the road show, institutional investors are canvassed in regard to the state of their demand. If there is unusually weak or strong demand, a revised price range might be filed with the SEC, say $16-$18 (in case of strong demand). At the pricing meeting, which typically occurs in the late afternoon prior to the start of trading, the offer price can be set at up to 20% above or 20% below the most recent price range. For example, with a price range of $16-18, the offer price can be between $12.80 and $21.60 without a further pricing amendment. The final offer price is set within the original file price range about 50% of the time, with about 25% of IPOs priced below the range and 25% above the range. This initial range is only indicative and the final issue price may be outside the band. Once the book-building process is concluded, the investment bank aggregates the bids into a demand curve and chooses the issue price. Thus, the investment banker has a considerable amount of information available at the time he chooses the price. The price is not set according to any pre-specified rule, but at the discretion of the investment banker in consultation with the issuing firm (Cornelli and Goldreich, 2003). The institutional investor(s) who submits the most aggressive bids to the book generally receive the largest initial share allocations at the offering price and thus are in the best position to profit from a secondary market price increase. The book-building method has traditionally been used primarily in the United States and Canada. It is now often used in Argentina, Brazil, Finland, France, Germany, Japan, New Zealand (with some variations), and Poland. It is allowed and is used at least occasionally (for instance, for larger issues, privatizations, international IPOs) in Australia, Austria, Hong Kong, India, Iceland, Thailand, Sri Lanka, and Switzerland (Sherman, 2004). Actually two types of book-building procedures are available: one is strictly equivalent to the American procedure, the other is a mixed book-building/fixed-price procedure (hybrid) in which the price and allocation rules are the same as in the book-building, except for a small fraction of the shares. Those shares, which are reserved for retail investors, are sold via a fixed-price procedure, at the price chosen in the book-building part of the offering. Hybrid book-building/public offer is perhaps even more popular than �pure� book-building. Hybrid offerings have been used by France, Hong Kong, Hungary, Indonesia, Malaysia, and the Philippines, among others.


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Table 1: Country Patterns in IPO Methods Book-Building Public Offer Auction

Used at least sometimes

Dominant or gaining popularity

Hybrid BB/PO Used

Used in past

Used today (not incl. hybrids)

Used today

Europe Austria Yes Yes Yes Yes n.a. Czech Republic

Yes Yes

Finland Yes Yes Yes Yes Yes France Yes Yes Yes Yes Occasionally Germany Yes Yes Yes Yes Hungary Yes Yes Yes Yes Yes Ireland Yes Yes Yes Yes Italy Yes Yes Yes Yes Netherlands Yes Yes Yes Yes Norway Yes Yes Yes Yes Occasionally Portugal Yes Yes Yes Yes Yes Spain Yes Yes Yes Sweden Yes Yes Yes Yes Yes Switzerland Yes Yes Yes Yes United Kingdom

Yes Yes Yes Yes Yes

N. & S. America Argentina Yes Yes Yes Barbados Yes Yes Brazil Yes Yes n.a. Yes Yes Canada Yes Yes Yes Chile Yes Yes Hybrid Mexico Yes Yes n.a. Paraguay Yes Yes Peru Yes Yes Yes Yes Yes Occasionally United States Yes Yes Yes Occasionally Asia/Pacific Australia Yes Yes Yes Yes BANGLADESH Yes Yes China Yes Yes Yes Yes Yes Hong Kong Yes Yes Yes Yes Yes India Yes Yes Yes Yes Indonesia Yes Yes Japan Yes Yes Yes Korea Yes Yes Yes Yes Malaysia Yes Yes New Zealand Yes Yes Yes Yes Yes Philippines Yes Yes Yes ? Singapore Yes Yes Yes Yes Sri Lanka Yes Yes Taiwan Yes Yes Yes Thailand Yes Yes Africa/Middle East Kenya Yes Yes Israel Yes Yes Yes Jordan Yes Yes South Africa Yes Yes Yes Turkey Yes Yes

Source: Sherman, Ann E. (2004). Global Trends in IPO Methods: Book-building vs. Auctions. Journal of Financial Economics (forthcoming). 4.3.1 The Rise of Book-Building The book-building procedure for selling IPOs to investors has captured significant market share from auction alternatives in recent years, despite significantly lower costs in both direct fees and initial underpricing when using the auction


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mechanism. A number of papers have documented the decline of fixed-price mechanisms and auctions for selling IPOs in Europe, and the growth of book-building, such as Biais and Faugeron-Crouzet (2002), Sherman (2001), and Ljungqvist, Jenkinson, and Wilhelm (2003). Ljungqvist, Jenkinson, and Wilhelm (2003) examined 2,143 IPOs brought to market in 65 countries outside the U.S. between 1992 and mid-1999, of which about 1,300 involved a book-building effort, that is, there is an international trend toward increased use of book-building method. By the end of the decade book-building had largely displaced traditional methods. What�s more, this displacement took place even though the direct costs of book-building were about double those of local alternatives (Wilhelm, 2005). Sherman (2000a) reports that in 40 countries the book-building method of selling IPOs has increased and dominates other selling regimes. Sherman (2004) has provided a broader list of countries regarding IPO pricing patterns (Please see Table 1). The initial impetus for the spread of book-building was the wave of privatizations, which were first made fashionable by Margaret Thatcher of the United Kingdom. Privatization became popular in most parts of the world (including formerly communist Eastern Europe) in the late 1980s and the 1990s (Dewenter and Malatesta, 1997). Moreover, Sherman (2000a) concludes that book-building �gives underwriter/issuer greater flexibility in designing a solution that reflects the individual issuer�s preferences, generally leading to a more efficient outcome. Book-building also reduces uncertainty for both issuers and investors.� The allocational discretion given to underwriters in the book-building method is also what makes it possible for underwriters to have long-term relationships with regular investors. Benveniste and Spindt (1989) have illustrated the importance of long-term relationships to book-building IPOs. However, Sherman (2000b) shows that with costly information, a repeated setting allows the underwriter to lower the excess returns of uninformed investors, thus lowering the required level of underpricing and in this way discriminating in favor of a particular group of regular investors who will still receive abnormally large returns. 5.0 BOOK-BUILDING Vs. OTHER MECHANISMS: THE DEBATE There is a growing literature, both theoretical and empirical, that studies and compares the methods for marketing and pricing IPOs. At the center of this literature are two commonly used methods (e.g., book-building and fixed price) that differ mainly in whether or not a �price-discovery� effort is undertaken prior to setting the offer price. However, book-building and auctions are distinguished by different sets of rules, with each set presumably designed to be optimal for the company and set of circumstances at hand. Fixed price offerings are priced without first soliciting investor demand, with price discovery taking place mainly in the aftermarket. In contrast, book-building involves road shows and one-to-one meetings with potential investors that allow the underwriter to �discover� investor valuations prior to setting the offer price. Moreover, if there is an oversubscription, allocation is pro rata in fixed price method and underwriter does not have any control over allocation like book-building. However, fixed price method has some similarities to book-building. For example, in both the methods, underwriter judges market conditions and underwriter/issuer set offering price.


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Both book-building and auction appear to be equivalent in terms of their expected proceeds, but the apparent similarities mask two key differences. First, the issuer/underwriter has substantial control over information acquisition through book-building, but little or no control in an auction. Second, the expected number of shares sold is higher for book-building, because there is a greater chance of under subscription in an auction. With book-building, the underwriter co-ordinates the number of investors that will participate, guaranteeing that a sufficient number (but not too many) are involved. With an auction, an issuer simply sets the reservation price and waits to see what happens. Because auctions sell fewer shares on average, expected IPO proceeds are strictly higher for book-building, holding constant the amount spent on information acquisition. Regarding rules, book-building has its own too. But the difference is that the auction rules are explicit, whereas the book-building rules are implicit and provide considerable latitude for exercising human judgment (Benveniste and Wilhelm, 1997). Book-building methods have resulted in a major change in the types of investors. The auction system requires a wide distribution of new IPO shares among general investors, whereas under the book-building regime, the underwriter exclusively selects all investors without restriction as to their relationship to the firm or a limit as to the amount of new shares purchased. Thus, the auction method�s objective of a wide distribution of shares among investors was dropped in favor of a more exclusive and underwriter-selected group of investors following book-building. This may be more efficient from an underwriter perspective, but the public policy objectives of a wide distribution of new shareholders and lower levels of initial return levels have not been achieved by the adoption of book-building methods in Japan (Kaneko and Pettway, 2001). The riskiness of auctions, relative to book-building, is a major factor in their lack of popularity. Book-building allows the underwriter to co-ordinate the number of both informed and uninformed investors, ensuring that enough investors have an incentive to participate in and scrutinize the issue, and preventing random free riders from overwhelming the process. The reduced risk of book-building may be attractive even if it comes at the cost of greater underpricing (and it�s not clear, based on the empirical evidence so far, that auctions automatically lead to less underpricing). Underpricing is an almost universal feature of the IPO market. Loughran, Ritter, and Rydqvist (1994) report that underpricing generally occurs in virtually all of the IPO markets around the world. In effect, IPO underpricing appears to be an obligatory cost to the issuer. However, some positive amount of underpricing appears to have positive benefits (Habib and Ljungqvist, 2001). Several studies have confirmed that there is a difference in underpricing between auction and book-building system. Kutsuna and Smith (2001) shows that book-building may allow issuers to reveal their quality credibly to investors. Thus book-building allows them to obtain a higher price for their shares, but also entails a revelation cost that might take the form of higher underpricing. However, with respect to total issue cost, Kutsuna and Smith (2004) show that for large issues (by large, well-established firms), book-building is less costly than auctioning. For small issues (by small and young firms), auctioning is less costly.


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Allen and Faulhaber (1989), Grinblatt and Hwang (1989), and Welch (1989) propose that the issuing firm in book-building, underprices IPOs to signal its quality so that the firm can subsequently issue �seasoned equity� at a higher price than would be the case without the underpricing signal. Rock (1986) and Beatty and Ritter (1986) show that the underwriter underprices IPOs to induce uninformed investors to purchase IPO shares. Baron (1982) and Muscarella and Vetsuypens (1989) show that the issuing firm lets the underwriter underprice IPOs to compensate itself for the use of its superior information about investor demand. Benveniste and Spindt (1989) shows that the underwriter uses underpricing and rationing as devices to entice selected investors in a road show to truthfully reveal their information. Regarding initial returns, Kaneko and Pettway (2001) shows in the Japanese capital market that auction pricing system produces significantly lower initial returns than does the book-building regime. The move from auction-priced to underwriter-priced IPOs in Japan has significantly reduced the wealth of issuing companies while increasing the wealth to underwriter-selected investors. The reason is � initial price of the auction offerings incorporates more information about the current and recent past market conditions than in the book-building offerings (Derrien and Womack, 2003). Finally, in a regime where all the methods are available, every issuer may select book-building even though collectively they would prefer an auction regime. Kutsuna and Smith (2001) demonstrated in Japanese market that if book-building and auction are both available, and firms differ sufficiently in unobservable quality, some, and potentially all, will select book-building, even if doing so results in higher average total issue cost and does not reduce underinvestment by enough to offset the higher cost. 6.0 BOOK-BUILDING SYSTEM IN BANGLADESH Before discussing the book-building system in the context of Bangladesh, we would like to have a look at the present IPO situation in Bangladesh, the institutional settings, the allotment and placement procedure, and the approaches to determine the offer price. Then we would like to show how the new method would play a vital role in strengthening the capital market of Bangladesh through some real examples. 6.1 IPO Scenarios in Bangladesh The capital market in Bangladesh gains momentum only in late 1980s, although the history of the organized exchange (East Pakistan Stock Exchange Association Ltd. the predecessor of Dhaka Stock Exchange) can be traced back to 1954. There were only 9 companies listed in Dhaka Stock Exchange (DSE) in 1976, the first year of operation since independence of the country in 1971. The interest and related activity in the stock market started to grow very gradually during the period 1976 through 1982. At the end of 1982, the number of listed companies was 29. IPO flow in Bangladesh has no specific pattern. The number of IPOs was in the range of 9-14 during 2000-2003 compared with 2-26 during 1993-1996 and 6-16 during 1997-2000, and there were only three IPOs in 2004. Investors� interest and activity in the local stock market peaked during the period of 1991-1996 primarily due to the liberalized economic policies initiated by the government during the 1990s. Total capital mobilized through DSE in 2004 was the lowest recorded since 2000 (ADB, 2005).


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Table 2: No. of IPOs during the Year � Dhaka Stock Exchange (DSE) and Chittagong Stock Exchange (CSE)

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 (Feb)

11 5 18 27 3 16 6 5 10 9 10 14 3 17 2 Source: www.dsebd.org and www.csebd.com

As of 30th September 2005 the total issued capital of all listed securities of Dhaka Stock Exchange was TK. 68,684 million (US$ 1,047 million) which was TK. 66,392 million (US$ 1,107 million) on 30th June 2005. In Chittagong Stock Exchange the total issued capital on 30th September 2005 was TK. 52,258.03 million (US$ 816.53 million) which was TK. 49,988.40 million (US$ 833.14 million) on 30th June 2005 (SEC Quarterly Report, July-September, 2005). 6.2 The Institutional Settings According to the Company Act of 1994, a public limited company or set up under a statute with a minimum paid-up capital of TK. 10 million are eligible to apply for listing in the stock markets. Companies wanting to go public applied for approval from the SEC under the Securities and Exchange Commission Public Issue Rules, 1998. After getting the approval, the issuing company contracts underwriters on a �firm commitment� basis (that is, the underwriters take up shares not subscribed by the public) to ensure a successful public offering. Then an independent third party or a member of the underwriting consortium is designated as the �Manager to the Issue�. The Manager to the Issue serves as the middleman between the issuing company and the SEC and helps the issuer going public (such as, determining the number of shares to be issued and offer price, developing the prospectus in conformity with the SEC regulations, etc.) for a stated percentage of the public offer as fee. The issuing company also designates a number of financial institutions, mostly commercial banks, as �Banker to the Issue�. The Banker to the Issue handles share applications and collects money from the investors. One of the problems in pricing of shares is that many of the merchant banks are not capable of pricing of shares and of using �firm commitment� underwriting. Since book-building mechanism is not available to the underwriters in setting issue prices, in effect the prices of securities are still set at par or at a premium with the approval from the SEC. However, the SEC does not allow issues at a discount, and requires proof of asset backing to approve issues at a premium. In this way, the SEC continues to affect the pricing of shares at IPO. In the circumstance, both a green-field company with no track record and a mature company could be priced (and reportedly are being priced) at par. Stakeholders criticized that this pricing practice discouraged quality companies with a good earning history from going public (ADB, 2005). 6.3 Allotment/Placement Procedure The Public Issue Rules, 1998 requires that any issuer may, if it so wishes, make placement with investors, both foreign and local, and the amount so placed, including the names and addresses of such investors, shall be disclosed in details in the financial structure section of the prospectus (SEC, 2006). On average, 50% of the total issued capital is retained by the insiders (directors/sponsors) of the company intending to go public and the remaining


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portion is distributed to three parties � (1) institutional investors [generally, the Investment Corporation of Bangladesh (ICB)], (2) employees of the company going public, and (3) the general investors, both non-resident Bangladeshi (NRB) and resident Bangladeshi. An interesting feature of the allocation of IPOs in Bangladesh is that the issuers favor small over large investors. After preferential allocation for the institutional investors like the ICB and company employees, allotment for general public is fixed. The Public Issue Rules, 1998 states the following guidelines in distributing the shares between individual (both resident Bangladeshi and NRB) and institutional investors.

1. 10% of all issues shall be reserved for non-resident Bangladeshi and the remaining 90% shall be open for subscription by the general public.

2. All shares as stated in sub-rule (1) shall be offered for subscription and subsequent allotment by the issue manager, subject to any restriction which may be imposed, from time to time, by the SEC.

3. In case of over-subscription of both the categories mentioned in the sub-rule (1) the issue manager shall conduct an open lottery of all the applications received under each category separately.

4. In case of under subscription of both the categories mentioned in sub-rule (1) the unsubscribed portion of share shall be taken up by the underwriters.

5. In case of under subscription under the 10% category as mentioned in sub-rule (1) the unsubscribed portion shall be added to the general public category and if after such addition there is over subscription in the general public category the issue manager shall conduct an open lottery of all the applicants added together taken up by the underwriters.

6. In case of over subscription under the 10% category as mentioned in the sub-rule (1) the over subscribed portion shall be added to the general public category and if after such addition there is over subscription in the general public category the issue manager shall conduct an open lottery of all the applicants added together.

7. The lottery as stated in sub-rule (3), (5) and (6) shall be conducted in the presence of representatives from the stock exchanges, and the applicants if present.

6.4 Offer Price Determination Under Section 2A of the SEC (Amendment) Act 2000, the SEC no longer has the power to fix the prices of new issues. Officially, the issuing company in consultation with the Manager to the Issue determines the offer price and the number of securities to be offered. But in reality, the SEC has to agree with this process before the offering is announced and often, imposes restrictions. The Public Issue Rules, 1998 requires that if common stock is being offered, the factors considered in determining the offering price shall be set forth in the prospectus. In most of cases, the offering price of the common stock of the companies concerned use Net Asset Value (NAV) or Book Value method. We have surveyed the companies that go public since 2005 till date and have found that Sonar Bangla Insurance Ltd., Summit Power Ltd., Prime Finance and Insurance Co. Ltd., Premier Leasing International Ltd., Jamuna Bank Ltd., Meghna Life Insurance Company Ltd., Asia Pacific General Insurance Company Ltd., Northern General Insurance Co. Ltd., Progressive Life Insurance Co. Ltd., Pragati Life Insurance Ltd., Islamic Finance and Investment Ltd. use Net Asset


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Value (NAV) or Book Value method in pricing their IPOs, where Berger Paints Ltd. uses Dividend Discount Model (DDM) only. Recently Beximco Pharmaceuticals has been enlisted on the London Stock Exchange and for the issue of global depository receipts (GDRs) and for determining the issue price, they have applied book building method. The guideline from the SEC dictates that the company and the Manager to the Issue determine the value of the company using a method known as the �Project Cost� basis. Project cost is determined by summing the total fixed assets and initial net working capital. Once the project cost is estimated the next step is to determine the sources of financing. The Issue Manager and the company decides how much of this cost will be financed by debt and how much through issuance of equity. The part of the project cost to be financed by issuing equity is then divided by the pre-determined number of common stocks the company intends to issue to estimate the �par� value of the IPOs. Companies going public, typically, set the offer price at �par�. If an issuing company intends set the offer price above the par, the company is said to be offering stocks at �premium�. The management of the company offering seasoned IPOs and the Issue Manager has to convince the SEC that the stock they are about to float deserves to be priced at �premium�. Officially, the issuing company (or the Manager to the Issue on its behalf) is suppose to take the average market price per share or net asset value per share or earning based value per share to the SEC to negotiate (or approval of) the �premium� on the new issue. 6.5 The Prospect of Book-Building System in Bangladesh By now, we all know the advantages as well as the disadvantages of book-building. In this section, we have tried to show how the new system can increase market capitalization which is an indication of a strong capital market, although the market capitalization had increased by 244% (compared to the previous year) and stood at TK. 276,000 million at the end of the 1996 stock market debacle. However, this is merely an exception. Derrien and Womack (2003) found in the French stock market that the average PG (book-building) offering has a larger market capitalization, compared to two other procedures. Their median market capitalization is less different from that of OPM (auction) offerings. This can simply be illustrated by taking the recent Jamuna Bank Ltd. IPO as an example. The Bank goes for IPO for 42,90,000 ordinary shares of TK.120 each including a premium of TK. 20 per share worth TK. 51,48,00,000. This is the total amount the bank got under the existing IPO pricing and allocation method. A total of 523,013 local applicants, with an amount of over TK. 317 crore (six times of the IPO amount) had applied for its IPO subscription. However, the first day trading of the bank started at a price well above TK.120. For example, on May 4, 2006, the Bank�s per share price on DSE was TK. 299.25. If we take this price as the actual price of the share (as because someone is ready to purchase at that price), then the Bank simply losses a capital of TK. 25,41,82,000 on that particular day. However, if there is book-building system, it is true that the issuer � Jamuna Bank Ltd. needs not to be worried about the fair price of their shares. This is the reason why some well performing local and foreign firms like GrameenPhone, the Telecom Malaysia


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International, the Pacific Bangladesh Telecom Ltd., Standard Chartered Bank, etc. are not showing any interest in raising capital through IPO. Someone may argue that instead of introducing book-building system, the premium may be adjusted properly. In the above example, if the SEC permitted Jamuna Bank Ltd. a premium of TK. 150 instead of mere TK. 20, definitely investors would not show much interest in the IPO. Consequently, the issue will be under subscribed. In case of under subscribed issue, all the applicants shall first be distributed with a single lot, and thereafter, for the balance amount, lottery shall be held for the applicants who have applied for multiple lots on the basis of dividing the application money by the amount of a market lot separately for both nonresident Bangladeshis (NRBs) and General Public. 7.0 CONCLUSION It is not like that book-building specifically or investment banking in general is flawless. Universal selection of book-building and mitigation of the underinvestment problem does not guarantee that issuers prefer the book-building regime or that book-building is value enhancing in aggregate. Market experts suggested that rather than using book-building solely, traditional practices may be reshaped as a consequence of recent technological advances for better IPO pricing as book-building system lacks transparency evidenced in the �spinning� allegations during the tech IPO bubble in the United States. It has already been evidenced by some studies that if book-building is available, high quality issuers will be interested to select this. Nevertheless, two facts appear indisputable regarding book-building. First of all, as a selling procedure for IPOs, it has captured most of the market share in most important global equity financing markets in the past decade. Second, and not inconsequentially, it is by far the most costly procedure available in terms of direct fees and indirect initial underpricing. Together, these points beg an important question of what benefits issuers are really receiving for paying extra. Another important issue is that in case of fixed-price or auction system, the regulatory bodies like the SEC or the bourses play a pivotal role in guaranteeing the fairness of IPO allocation. The book-building procedure, on the other hand, gives the central role to the underwriter, who presumably has the best understanding of the market as well as the desire and ability to place the shares in �good� hands. The question is how the investors, specially the small investors in Bangladesh can trust the underwriters when they had to digest the 1996 market debacle? So, book-building if not introduced properly may permanently throw out general investors from the capital market making the market fully �elite class.� From the public policy point of view, SEC should not introduce such system. Definitely there are some advantages of introducing book-building over other IPO pricing mechanisms. However, the policy decision to permit book-building as an alternative to auction or other mechanisms cannot be based solely on the observed choices of issuers� interest � as implied by the SEC that more potential issuers will come to the market if it introduces book-building. Instead, the decision must be based on estimates of the aggregate relative total issue cost of book-building and auction/fixed-price approaches to IPO pricing and the likely


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magnitude of the underinvestment problem if high quality issuers cannot distinguish themselves. In such a dilemma, SEC can run both the existing IPO system and the book-building system in parallel as it is in the United States, where book-building is used for larger IPO offerings and auction/public offer method for small issues. A hybrid system may be of some help � for example, some portions of a particular IPO may be issued by using book-building and the rest using auction/fixed price method. The handling of the IPO of Singapore Telecommunications Pte Ltd. can be a good example in this regard. Traditionally, IPOs in Singapore have been done according to British company law, which mandates that IPOs be distributed by the fixed price method (Koh and Walter, 1989). But Goldman Sachs, the global coordinator, placed approximately one-half of the issue using a book of orders. The rest was distributed domestically according to the traditional fixed price enhanced manner. REFERENCES

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