Everything that you need to know about Book Building System! Know the new process on which IPO will be issued and its impact!

SEBON has been trying to introduce new policies and techniques in stock market. However, the consequences of these policies and techniques are often determined by investors’ reaction. Recently, SEBON announced to introduce Book Building System in the process of IPO issuance. The new mechanism has been a topic of debate among investors. The announcement gained a lot of attention from investors because the new mechanism is likely to impact the primary investors. Further paragraphs will revolve around the topic “Book Building System”. However, before proceeding into the main issue, let us understand the current functioning of the market.

In the absence of Book Building System, licensed companies have been issuing IPOs at par value of Rs 100. Most of the companies are obliged to issue shares at par value even if they have outstanding financial reports. Moreover, investors are forced to buy shares of weak company at par value.  In some cases, companies set a premium value to the price of the IPO. Hence, the process of price discovery is not efficient in the Nepalese primary market.

 For instance, Shivam Cement Limited is issuing its 41,20,000 units IPO shares at Rs 300 per unit to the general public from 6th to 9th Falgun, 2075.The set price i.e. Rs 300. Here, investors, the real buyers, don’t have any role in price discovery.  So far, all the IPO prices that were set in the Nepalese primary market have been decided on the basis of par value or premium.

However, on the 27^th anniversary of SEBON, the regulatory body decided to introduce Book Building System.

What exactly is a book building system?

Book Building System is the process of price discovery in which a company hires a merchant bank to decide a price range at which shares are to be issued instead of a specific price.  The merchant bank is known as an underwriter or a book runner. The bank is responsible to research about the issuing company and come up with a price range for its IPO shares. Once the price range is decided, the merchant bank then prepares a prospectus calling out investors to apply the shares. Taking reference from our earlier example, the issue price of Shivam at Rs 300 was considered unusually high by most of the primary investors. In the presence of Book Building System, companies like Shivam can now specify a price range such as Rs 200 to Rs 300. Such price range is called as price band.

Here, the minimum price i.e Rs 200 is called as floor price. Similarly, the maximum price i.e. Rs 300 is called as cap price. Here, the final price or the cut off price that will be decided in the upcoming step will fall in between fall price and cap price i.e. Rs 200 and Rs 300. In addition to floor price and cap price, tick price is also determined. The tick price refers to the extent to which the share price can change. For example, if the tick price in the provided example is determined to be Rs 5, the price of Shivam will change from Rs 200 to Rs 205, Rs 205 to Rs 210, Rs 210 to Rs 215. However, there will be no such bid price as Rs 201,Rs 202, Rs 207, Rs 223, etc. The next major step will be in the hands of investors.

Source: NYSE social media page

This is a photo of how companies celebrate their IPO issuance day in New York Stock Exchange. This is a company named CCO that listed its share in NYSE post IPO issuance. In United States, the price of an IPO is determined a night before. The next day, the share is traded in the secondary market. The floor price for this listed share is then determined on the floor of New York Stock Exchange (NYSE). However, before that, the issuing company rings an opening bell in NYSE to symbolize their inclusion in the stock market.

How is the price of an IPO determined in Book Building System?

Going back to our previous example, the investors will then bid for the share. For instance, 150000 applicants applied at Rs 210, 180000 at Rs 220, 2,00000 at for Rs 230, 190000 units for Rs 240 and finally, 140000 at Rs 250.

In this case, the bid price of Rs 230 has the maximum applicants. So, the cut off price will be determined at Rs 230. This means the buying price of the share will be Rs 230. Moreover, the applicants who bid at Rs 210 and Rs 220 (i.e. below the cut off price) will not be allocated the shares. However, those applicants who applied at the cut off price or above will be allocated with the shares. Therefore, all 530000 applicants will be allocated with the shares.

What happens if the shares are undersubscribed?

In the cases where shares of the companies are undersubscribed, merchant banks (underwriters or book runners) are obliged to buy these shares.

What roles do institutional investors, large buyers, mutual funds play in the book building system?

First and foremost, an IPO issued under Book Building System is simply not carried out by the issuing company alone. The issuing company hires an investment bank often called as underwriter or book runner. The merchant bank reads all the aspects of the issuing company in order to determine the price band.

Secondly, the book runner invites large scale buyers, mutual funds, other institutional banks along with retail investors to submit bid price along with the number of shares they are interested in buying.

Thirdly, a “book is built” enlisting the aggregate demand for the IPO by analyzing the submitted bids. The book runner or underwriter then determines the cut off price for the IPO. In the process, the book runner requires to make all the information of bids public in order to keep the process unbiased. Finally, the shares are allocated to the eligible bidders.

What significance does Book Building System play in the capital market?

Book Building System of price discovery mechanism dominates the IPO and FPO issuance worldwide. Among several other IPO issuance mechanisms such as fixed price, tender, auction, public offer method, Book Building System is considered to be the most efficient method. Several developed countries have adopted Book Building System. This method helps to raise large amount of capital, gain price relevant information from potential buyers, brings in higher net revenue, provides riskier projects an access to stock market and provides liquidity to investors. Besides, the mechanism also broadens the functions of institutional investors as it broadens the scope of services before and after IPO issuance. Besides this, the mechanism encourages local and international companies to float IPOs as it involves a fair process. Nepal government’s one year old policy to introduce more manufacturing companies in the stock market has been a failure as most of the manufacturing and tech related companies are hesitant to enter the stock market. So, book building process might be a helping hand to attain this goal as companies will no more be forced to issue shares at par value.

How will Book Building System impact retail investors?

The Book Building System clearly favors the large buyers and institutional investors. These large buyers and institutional investors have access to resources and market information so, they can analyse the bidding price accurately. However, the retail investors do not have access to the same amount of information and resources. Besides, large investors have a good financial back up in order to purchase primary shares however, the small investors have a limited fund available. Thus, retail investors might be totally out casted from primary market and the stock market might look like a platform for only the elite individuals. Moreover, government recently encouraged brokers and banks to expand their brokerage services in rural areas. This was primarily done in order to provide retail rural investors with a better access to capital market. However, the Book Building System might contradict government’s plan to expand the access of stock market among retail investors.

What measures can be implemented to build an inclusive primary market?

Primary market can be a major means to retail investors in order to construct their investment portfolio. In this context, SEBON can instead bring a regulation in which both book building system and lottery or pro rata system can go hand in hand. Such system is adopted even in developed countries like USA. The book building mechanism can be used for larger issues whereas lottery or pro rata system can be used for smaller issues. Besides, a regulation can be introduced that mandates the IPO issuing company to allocate certain percentage of shares to retail investors. A hybrid system to include both book building system and public offer system can also be implemented.

Dear investors, let us know about your perception on this new mechanism. Do you favor this mechanism? Do you believe this system will make the market efficient? Let us know in the comment section.