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Dutch Auctions

May 12th, 2004 · No Comments

NYTimes writes about Dutch Auctions in the context of Google’s forthcoming IPO:

Google is going to use a variation on what is known as a Dutch auction, called that because it was created in the early flower markets of the Netherlands to sell multiple identical items. In the classic Dutch auction, a seller indicates how many items are available for sale and sets the minimum bid price.

Bidders indicate the number of items they want to buy and the price per item they are willing to pay. All winning bidders pay the same price per item – which is the lowest successful bid, called the clearing price. Those who bid above the clearing price, however, earn the right to buy the number of items they want, while those who bid at the clearing price have to divide the remainder.

Google’s shares would be sold in a modified Dutch auction because it has reserved the right to set the final sale price, the allocation of shares and other auction terms. It said in its public offering statement that its goal was to eliminate the first day “pop” in prices that was built into most initial stock offerings.

[A] potential problem with Dutch auctions is that investors have an incentive to bid higher than the fair value of a stock so that they can be assured of getting shares to buy. If only a few people bid high, they would still only pay the market clearing price determined by the vast number of presumably more rational investors, since the price would be set by the lowest bid. But if lots of investors take up this strategy, the price would be driven above sustainable levels.

Another factor, called the “winner’s curse,” can potentially lead to depressed prices after the initial offering. The top bidders may realize that they bid more than what other bidders believe the shares are worth. If the winners start to worry about the share price paid, they may sell shares immediately after the auction, causing a drop in the price. For more thoughtful investors, the fear of the winner’s curse could lead them to moderate their bids in advance – a move that might lead to lower prices in an auction than in a traditional offering in which the price is set by investment bankers.

Adds the Economist:

Paul Klemperer, an economics professor at Oxford University and a designer of Britain’s 3G auction, explains in a new book (Auctions: Theory and Practice) that the details of auctions can make all the difference. In essence, auctions can fail in two main ways: by setting a price that is too high, or one that is too low. The latter failure has been more common recently. Collusion between bidders can reduce the price paid, as happened in one American auction of radio spectrum in the 1990s. Alternatively, the costs of entering an auction can be prohibitive, as with one British television franchise. The government had imposed such high costs by requiring detailed programming plans that only one bidder bothered.

Given the large number of expected bidders and the relatively low costs, Google’s IPO runs a bigger risk of setting a price that is unsustainably high. That would be the result of what economists call the winner’s curse: high bidding by naive punters that allows them to win an auction, but only by overpaying.

Mr Klemperer says that Google needs to do more to save its auction from this fate. Ensuring that small investors have the same information provided to big investors would help. So would simply explaining to unsophisticated bidders how the Google auction will work.

One concrete idea proposed by Mr Klemperer is to start by auctioning a small fraction, say 10%, of the shares to institutions. This would allow more sophisticated investors to give their view of the fair price, before unsophisticated individuals place their bets. Another option is to hold an English (ascending-bid) auction in which institutional shareholders’ bids can be observed. Again, inexperienced investors could keep a close eye on what the smart money is doing, and adjust their bets accordingly. This could diminish the risk that over-eager punters bid up the price too high, which would put a damper on the use of such auctions in the future.

Tags: Management

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