Concept of Private Exchanges

Bombay Stock Exchange (BSE), National Stock Exchange (NSE), New York Stock Exchange (NYSE), NASDAQ – We all must have heard these names, but PORTAL, Goldman Sachs Tradable Unregistered Equity OTC Market (GS TruE); probably majority of us might not have heard these names because these are exchanges which are out of bounds for retail investors, i.e. they are private exchanges.

Traditionally, whenever companies are in need of funds they hit the public markets and get listed on public exchanges. But recently there has been a trend of private exchanges being setup by big investment banks and other public exchanges as well. Goldman Sachs started its private trading platform in May this year and was followed by NASDAQ, which launched its own version, PORTAL. Many other big investment banks like Citigroup Inc., Lehman Brohers & Merrill Lynch have also established their own private exchanges.

In recent times, one of the big names in financial markets which decided to float on private exchange rather than on a public exchange is the alternative asset management firm Oaktree Capital Management LLC which raised $800 million by selling a 15% stake through GS TRuE. Furthermore Apollo Management, a private equity firm has expressed its desire to sell its shares on Goldman Sachs’ private exchange. American companies raised $221 billion last year by listing on private exchanges, which for the first time exceeded the amount raised through traditional exchanges. Globally this segment of securities market has touched $1 trillion.

Individual or retail investors are not qualified to trade on these exchanges, and are open only to large institutional investors. For example Goldman Sachs’ exchange is open only to institutional investors with assets of more than $100 million. Similarly Nasdaq’s portal is open to banks and insurance companies with at least $100 million in assets and brokers with at least $10 million in assets.

Its easy to understand why there is a rush towards private exchanges. Stocks of companies that trade in public exchanges need to be registered with Securities and Exchange Commission (SEC) and so are subjected to SEC regulations designed to protect individual investors. Additionaly such companies are open to a lot of scrutiny from regulators along with strict compliance with laws like Sarbanes-Oaxley Act (SOX), which requires numerous disclosures and adherence to other such regulations. So to save themselves from all such troubles the companies hit the private exchanges since stocks of bonds not registered with SEC (under Rule 144A) can trade on private exchanges. Many private equity firms and hedge funds which want to raise money but are reluctant to be lot more open to public prefer to be listen on private exchanges.

Though the amount of money a firm can garner is to some extent less on private exchange compared to public exchange primarily because the demand is much more on a public exchange. There is a growing criticism of private exchanges for the reason that they exclude individual investors from a growing proportion of financial market activity. Even the mutual funds that are main investment tools for individual investors, are allowed to trade in small number of unregistered securities thereby further alienating individual investors from market participation.

However still the idea that private exchanges might completely overtake public exchanges seems far fetched but its evident that they are going to snatch away a large chunk of their business. It would be interesting to watch this battle.

Dutch Auction Process of IPO Allocation

Few companies take the much less treaded path of IPO allocation through a process known as “Dutch Auction”. We will analyze here the method and its implications along-with Google’s IPO Case that used modified form of Dutch auction for its IPO allocation & pricing in 2001.

Generally the sale of shares (Allocation and Pricing) uses one (or variants) of the following methods to allocate the shares:

• Book Building
• Auction Method
• Fixed Price Public Offer

Bill Hambrecht, an American investment banker and chairman of W. R. HAMBRECHT & CO., devised the Dutch auction method of share allocation and pricing, and is known as “open IPO” model.

In a Dutch auction, a company reveals the maximum amount of shares being sold and sometimes a potential price for those shares. Investors then bid for the number of shares they want and the price they are willing to pay. Once a minimum clearing price is determined, investors who bid at least that price are awarded shares.

Let us take an example to understand the mechanism of Dutch auction. Let the company XYZ wants to offload 100 shares in the market. 5 investors (A, B, C, D and E) have submitted their bids (price and no. of shares applied for) as per the table below:

Investor No. of Shares Applied for Bid Price per Share (Rs.)
A 15 500
B 30 480
C 25 470
D 35 465
E 20 462

Now we start accounting for all the shares starting from the highest bid received and stop when the total count reaches 100 (i.e. no. of shares on offer). The price at which we account for 100 shares is 465.

Investor No. of Shares Applied Cumulative Total Bid Price per Share (Rs.)
A 15 15 500
B 30 45 480
C 25 70 470
D 35 105 465
E 20 125 462

So the allotment price would be Rs. 465 and A, B, C will be allotted the shared they applied for, D will be allotted 30 shares (100-70) and E won’t get any share.

Though there hasn’t been a clear-cut proof but a Dutch auction method is supposed to have following benefits over traditional method of IPO allocation:

Minimization in “Spike” or “Pop”:
The increase between the offer price and the opening price is termed as “spike”. In the traditional IPO allocation process, investment banks handling the IPO process determine the appropriate price by taking the IPO through “roadshows” to possible investors (large mutual funds, or clients of investment banks) and gauging the demand. As a consequence these investors often receive the initial allotment of IPO shares and benefit from the price appreciation, which happens on listing. By Dutch auction method the spike can be reduced since the demand level has already been gauged and the price has been arrived at by market mechanisms of demand and supply.

Small investor participation:
Enables small investors to participate in the pricing by mentioning the price that they are willing to pay and the number of shares they are interested in buying. Thus it is supposed to democratize the process of share allocation.

Role of investment banks:
Since the investment banks are not involved in pricing of the IPO, the price is the lowest price at which all of the shares are sold; it minimizes the influence of investment banks. The value of IPO goes to the public rather than to the favored client of investment banks.

However there are few shortcomings in the Dutch auction process:

Lack of information to small investors:
Small investors who are supposed to be primary participant in this type of IPO allocation method may not have sufficient detailed information to price the shares based on fundamentals, as a result they tend to do it on basis of name recognition (brand of the company). On the contrary in traditional method of IPO allocation the price range is arrived at my investment banks that have access to detailed information and are experts in their respective fields. Moreover contrary to traditional method the online auction method is not required by law to disclose as much information as required in the traditional method

Mispricing:
Due to lack of rigorous scrutiny by investment banks there happens to be a mismatch on the pricing front. At times due to initial risk aversion by retail investors may lead to under pricing of the initial offer price.

Minimum Price Spike:
The price spike, which happens in traditional IPO allocation methods infact, does well for the stock. It imparts an aura of success to the stock, which in turn will boost the stock higher leading to the gains for investors. This doesn’t generally happen in case of auction method.

Dutch Auction: Google’s Case

Few companies like Salon.com, Overstock.com & Ravenswood winery have earlier adopted the Dutch auction method, however the IPO that brought a lot of limelight on this method was that of Google, the Internet search giant.

However one of the supposed advantages of Dutch auction method of having minimum spike didn’t stand ground in case of Google. Google's initial public offering took place on August 19, 2004. Total of 19,605,052 shares were offered at a price of $85 per share. The sale raised $1.67 billion, and gave Google a market capitalization of more than $23 billion. Google’s offer price was $85, but it opened at $ 100, a 17.6% increase. Thus the increase between offer price and open price was much greater than the increase for typical IPOs during that period. So the supposedly advantage of minimum price spike didn’t stand ground. And also it means that Google didn’t raise the full amount, which it could have, that means it left a substantial amount of money “on table”.

Lets see if there are other firms who follow in Google’s footsteps and embrace this lesser used method of IPO Share allocation. The more the number of companies use this method, the clearer the implications will be for each of us to observe and understand.

Further Reading: As per a research study conducted the book building is less risky then a sealed bid-auction. The study was conducted for two methods of IPO allocation. (Global trends in IPO methods: Book building versus auctions with endogenous entry Journal of Financial Economics, Volume 78, Issue 3, December 2005, Pages 615-649 by Ann E. Sherman)