Book building in an IPO is a method for determining the share price based on investor interest. Underwriters, typically investment banks, gather bids from institutional investors like fund managers. These bids specify the number of shares desired and the price investors are willing to pay. This process helps uncover the fair market value of the shares, balancing potential overpricing or undervaluing.
Book building is how underwriters determine the IPO share price. They collect bids from institutional investors, such as fund managers, to establish the optimal price. However, this process carries the risk of setting the price too high or too low, impacting investor interest and market perception. During this phase, investors submit bids indicating how much they want to buy and the price they're willing to pay, which influences the final pricing of the securities.
How does book building work?
Let us break down the process step-by-step for better understanding:
- Partnering with the underwriter
Companies enlist investment banks as underwriters for their IPOs. These experts guide the company in setting the IPO's size (number of shares offered) and price range. - Bidding frenzy
The underwriter and the company invite investors to participate. Investors then submit bids for the IPO shares within the announced price range. - The price puzzle
The underwriter keeps a close eye on all bids, compiling them in an order book. This book serves as a roadmap to determine the most suitable IPO price using methods like the weighted average. - Allocation allure
Once the final IPO price is set, shares are allocated to investors whose bids were accepted. If you bid higher than the cut-off price, the extra amount you paid will be refunded.
Why do companies opt for the book-building process?
Indian companies opt for the book building process when determining the IPO share price for several compelling reasons:
- Market-driven pricing
The book building process allows the share price to be determined based on investor demand and market conditions rather than a fixed price set by the company. This ensures that the IPO price reflects the true market value of the shares, leading to a more accurate and fair valuation. - Investor confidence
The transparency and fairness of the book building process can boost investor confidence. Knowing that the price is market-driven and not arbitrarily set by the company, investors are more likely to participate. - Reduced underpricing
Fixed price offerings often lead to underpricing or overpricing, which can result in significant price volatility post-IPO. Book building tends to minimise these risks by aligning the issue price more closely with market demand, leading to more stable post-IPO performance. - Better allocation of shares
The process allows companies to allocate shares more efficiently among different types of investors. Institutional investors, who generally have better market insights and investment strategies, are more involved in the book building process, leading to a more balanced and strategic allocation of shares. - Regulatory support
The Securities and Exchange Board of India (SEBI) has laid down clear guidelines for the book building process, making it a well-regulated and structured method for pricing IPOs. This regulatory framework ensures the process is conducted fairly and transparently. - Market feedback
Companies receive valuable feedback from potential investors during the book building process. This feedback can provide insights into investor expectations and market sentiment, which can be crucial for the company’s future strategies and decision-making.
In summary, companies prefer the book building process for IPO pricing due to its market-driven approach, transparency, efficiency in capital raising, and ability to better align the share price with investor demand and market conditions.
Types of book building
Let us explore the types of book building:
1. Accelerated book building
Accelerated book building is a swift process used primarily by companies to raise capital quickly. It is characterised by a shortened timeline, often completed within one to two days. Here's how it works:
- Speed and efficiency: The process is expedited to quickly gauge investor interest and secure funds. This is particularly useful in volatile market conditions or when the company needs funds urgently.
- Targeted investors: The process mainly targets institutional investors who can make quick decisions and commit large sums of money. These investors are typically contacted directly by the underwriters.
- Limited publicity: Unlike traditional book building, accelerated book building involves less public marketing. Instead, it relies on direct communication with a select group of investors.
- Pricing and allocation: Given the rapid nature of this method, the pricing and allocation decisions are made swiftly based on the bids received within a very short timeframe.
2. Partial book building
Partial book building, also known as partial subscription book building, allows for a combination of both fixed-price offerings and book building elements. Here's a breakdown:
- Fixed and variable components: A portion of the shares is offered at a fixed price, while the remaining shares are subject to the book building process. This hybrid approach allows the company to secure a base level of funding while still benefiting from market-driven pricing.
- Investor segmentation: Typically, the fixed-price component is targeted at retail investors, while the book building portion is aimed at institutional investors. This segmentation can help balance the investor base and ensure broader participation.
- Price discovery: The book building part of the process helps in discovering the market price for the shares, ensuring that the final IPO price reflects actual demand.
- Flexibility: This method offers more flexibility in terms of pricing and allocation, allowing the company to adjust based on market conditions and investor interest.
Both accelerated and partial book building methods provide companies with alternative ways to approach the IPO process, catering to different needs for speed, investor engagement, and pricing strategies.
What is the book-building process of IPO?
The book-building process typically involves the following steps:
- Appointment of intermediaries
The issuer appoints lead managers or book runners to manage the book-building process. These intermediaries assist in determining the offer price, marketing the issue, and allocating securities. - Filing of draft offer document
The issuer files a draft offer document with the regulatory authority, providing details about the company, its operations, financial performance, and the proposed offering. - Marketing and roadshows
The lead managers conduct marketing activities and roadshows to generate investor interest and educate potential investors about the offering. - Bidding period
The issuer specifies a bidding period during which investors submit bids for the securities, indicating the quantity they wish to purchase and the price they are willing to pay. - Price discovery
Based on the bids received, the lead managers assess investor demand and determine the final offer price within the price band specified in the offer document. - Allocation of securities
Once the offer price is finalised, securities are allocated to investors based on their bids, with preference given to institutional investors and high-net-worth individuals. - Listing and trading
Upon completion of the allotment process, the securities are listed on the stock exchange, allowing investors to trade them in the secondary market.
Advantages of book building
Book building offers several advantages over traditional fixed-price offerings:
Price discovery
Book building facilitates the discovery of the optimal price for securities by assessing investor demand. This ensures that the securities are priced competitively, maximising the issuer's proceeds.
Efficient capital allocation
By allowing investors to indicate their willingness to pay for the securities, book building ensures efficient capital allocation, as the securities are allocated to those investors who value them the most.
Flexibility
Book building provides flexibility to adjust the offering price within a predetermined range based on investor demand, thereby accommodating market conditions and maximising investor participation.
Reduced price fluctuations
Since the offering price is determined through a consensus of investor bids, book building can help mitigate price volatility in the secondary market post-listing.
Enhanced transparency
The book building process enhances transparency by providing investors with insights into demand dynamics and pricing considerations, enabling informed investment decisions.
Additional read: Difference between FIIs and DIIs
Disadvantages of book building
While book building offers advantages such as price discovery and flexibility, it also presents several challenges and disadvantages as follows:
1. Limited transparency for retail investors:
- Book building primarily involves institutional investors and high-net-worth individuals who have access to detailed information and can participate actively in the bidding process. This can disadvantage retail investors who may not have the same level of access or understanding, leading to a perceived lack of transparency in the pricing mechanism.
2. Potential for price manipulation:
- There is a risk that sophisticated investors or underwriters could manipulate the bidding process to artificially inflate or deflate the IPO price. This can disadvantage other investors and lead to pricing that does not accurately reflect market demand.
3. Exclusion of small investors:
- Retail investors, particularly those with limited financial resources or expertise, may feel excluded from participating effectively in the book building process. This can limit their ability to acquire shares at a fair price or to participate in IPOs of potentially promising companies.
4. Higher costs and fees:
- ·Engaging underwriters and investment banks for book building can incur higher costs for the issuing company compared to other methods, such as a fixed-price offering. These costs may include underwriting fees, legal fees, and marketing expenses, which can reduce the net proceeds received from the IPO.
5. Market volatility and uncertainty:
- The book building process can lead to uncertainty in pricing and market volatility, especially if there is significant variation in investor bids or if market conditions change rapidly during the IPO period. This volatility can affect investor confidence and the post-IPO performance of the company's shares.
6. Complexity in pricing:
- Determining the final IPO price through book building involves analysing a wide range of bids from different investors. This complexity can sometimes result in delays or disagreements between the issuer and underwriters, potentially impacting the overall success of the IPO.
7. Risk of underpricing or overpricing:
- Despite efforts to set a fair IPO price through book building, there is still a risk of underpricing (selling shares at a lower than optimal price) or overpricing (selling shares at a higher than optimal price). Both scenarios can affect the company's valuation and investor perceptions post-listing.
Difference between fixed-pricing and book-building
Below is a comparison between fixed-pricing and book-building mechanisms:
Fixed-pricing |
Book building |
The offer price is predetermined by the issuer |
The offer price is determined based on investor demand |
Limited scope for price discovery |
Facilitates price discovery through investor bidding |
Fixed allocation of securities |
Securities allocated based on investor bids |
Less flexibility in adjusting pricing |
Offers flexibility to adjust pricing within a price band |
May result in underpricing or overpricing |
Helps mitigate pricing risks through market participation |
Conclusion
In conclusion, book building has become a preferred method for pricing IPOs in the Indian securities market due to its ability to facilitate price discovery, enhance investor participation, and accommodate market dynamics. By allowing issuers to gauge investor demand and set offer prices competitively, book building contributes to efficient capital allocation and market transparency. However, it is essential for market participants to carefully assess pricing risks and ensure that offerings are priced appropriately to mitigate adverse outcomes. As the Indian securities market continues to evolve, book building is expected to remain a prominent feature, shaping the landscape of capital raising and investment activities.
