IPO's and Auctions

New working paper from the Kellog School of Management and Notre Dame:

At Issue: Firms which list on a stock exchange may use various methods to sell their shares. There are two which are most frequently used: “bookbuilding”, the active pursuit of subscribers through direct contact by an underwriter, and “fixed-price offers”. Auctions are rarely employed, despite the clear potential for raising more revenue for the issuing firm. Why is it so? Are there factors preventing auctions from performing as well as other methods?

Findings: Auctions suffer from two major problems when used in IPOs. The first one is the "free-rider" problem: since the price is determined by the best non-winning offer, investors have no incentives to acquire information on the firm's fair value, and this makes the stock's selling price very volatile. The second problem is the "winner's curse": as the winner is usually a bidder among an unknown number who overestimates the value of the shares, each investor finds it very difficult to formulate an appropriate bidding strategy. These problems deter wide participation at IPO auctions and make them perform poorly in comparison to IPOs with fixed-price offers and bookbuilding.