Financial Daily from THE HINDU group of publications
Monday, Mar 29, 2004
Columns - Mark To Market
Why selling equity privately is optimal
Public offer: Companies take advantage of information asymmetry while pricing offers. Information asymmetry refers to the condition that the insiders have more information about the company than the public does.
In such a condition, companies can price equity at higher than intrinsic value. The reason is that non-institutional investors are not well informed about the "true value" of the company.
Such aggressive pricing is not possible in private placement because institutional investors have a fair idea of a stock's intrinsic value. Companies hence prefer public offers to private placements. But this argument does not hold in the book-building design.
Book-building model: In this model, institutional investors place a bid stating the price and the quantity of shares they will buy at that price. The retail investors, who are the uninformed ones, can simply agree to buy the shares at the cut-off price.
Take Patni Computer, for instance. Institutional investors placed bids ranging from Rs 200 to Rs 230.
A retail investor who bid at the cut-off price would have been allotted shares at Rs 230, the offer price. The important point is that the uninformed investors do not indulge in noise trading. This reduces the pricing advantage that the companies can derive from information asymmetry.
One may argue that in a book-building design, companies only provide information required under law. Selling private equity would mean providing additional information, for institutional investors may demand as much.
And that may increase the implicit cost for companies. As a simple example, revealing more information to the institutional investors could mean lower offer price for the company making the offer.
This is equivalent to saying that the institutional investors will bid in a public offer but may demand more information if the same company were to privately place equity. Such an argument does not seem correct. The reason is that institutional investors are not compelled to invest in any stock.
If for some reason, institutional investors are apprehensive of the company's valuation, they may choose not to invest. And that may have a negative effect on the public offer.
A book-building model in its current form therefore does not help the company in aggressively pricing its public offer. So, why should companies not sell private equity?
Private equity: A private offer can be at a fixed price. A better design, however, would be to have either the book-building system or a price discriminatory auction. For ease of exposition, assume that companies follow pricing under the book-building design.
Because companies do not have to sell the issue to investors at large, there is substantial savings on issue costs. Besides, revealing more information to the institutional investors may sometimes help the company. When information is not freely available, investors are wary of aggressively bidding up prices. Often, they tend to bid at the lower end of the spectrum if the company provides a price range in a book-building design. More information could prompt institutional investors to bid above the floor price set by the company.
Then, there is the positive effect on the secondary market. For instance, private equity could lower the principal-agent problem.
A company management does not always act in the best interest of the shareholders. If a company sells private equity, fewer investors will hold large chunk of the shares. Such concentration of ownership could prevent the management from taking important decisions detrimental to the shareholders. This would improve a company's corporate governance practice.
And that, in turn, may have a positive effect on the stock valuation. This could be beneficial for a company management that holds sizable stock options.Of course, successful bidders in the private placement later offload their holdings in the secondary market to retail and other investors. Essentially then, the market for equity will be styled in the same way as the government bond market.
In the bond market, only primary dealers and banks make competitive bids at the primary auction. These investors later sell the bonds to other banks, institutions and mutual funds. This way, allotment process is easier and costs, lower.
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