What is a Dutch Auction?

What is a Dutch Auction?

Dutch auction in finance is the process of finding the optimum price at which the government agency or company wants to sell its assets or securities. The seller establishes an opening price that steadily decreases until a bid (quantity and cost) is placed.

Unlike typical initial public offerings (IPOs), the Dutch auction strategy work without underwriters or investment banks.

The auctioneer reduces the asking price until collecting all bids to sell the total shares in this method, also known as descending or uniform price auction.

Following the submission of all bids, the price with the most bidders becomes the new offering price for the entire offering. After the price reaches an optimal level, the remaining bidders must purchase securities at that rate.

introduction of Dutch Auction for Public Offerings

If a company is using a Dutch auction initial public offering (IPO), potential investors enter their bids for the number of shares they want to purchase as well as the price they are willing to pay. For example, an investor may place a bid for 100 shares at $100 while another investor offers $95 for 500 shares.

Once all the bids are submitted, the allotted placement is assigned to the bidders from the highest bids down, until all of the allotted shares are assigned. However, the price that each bidder pays is based on the lowest price of all the allotted bidders, or essentially the last successful bid. Therefore, even if you bid $100 for your 1,000 shares, if the last successful bid is $80, you will only have to pay $80 for your 1,000 shares.

The U.S. Treasury uses a Dutch auction to sell its securities. To help finance the country’s debt, the US Treasury holds regular auctions to sell Treasury bills (T-bills), notes (T-notes), and bonds (T-bonds), collectively known as Treasuries. Prospective investors submit bids electronically through TreasuryDirect or the Treasury Automated Auction Processing System (TAAPS), which accepts bids up to 30 days in advance of the auction. Suppose the Treasury seeks to raise $9 million in two-year notes with a 5% coupon. Let’s assume the submitted bids are as follows:

  • $1 million at 4.79%
  • $2.5 million at 4.85%
  • $2 million at 4.96%
  • $1.5 million at 5%
  • $3 million at 5.07%
  • $1 million at 5.1%
  • $5 million at 5.5%
See also :  What is a Dividend?

The bids with the lowest yield will be accepted first since the issuer will prefer to pay lower yields to its bond investors. In this case, since the Treasury is looking to raise $9 million, it will accept the bids with the lowest yield up to 5.07%. At this mark, only $2 million of the $3 million bid will be approved. All bids above the 5.07% yield will be rejected, and bids below will be accepted. In effect, this auction is cleared at 5.07%, and all successful bidders receive the 5.07% yield.

The Dutch auction also provides an alternative bidding process to IPO pricing. When Google launched its public offering, it relied on a Dutch auction to earn a fair price.

How Does a Dutch Auction Work?

One of the most common uses of a Dutch auction in securities is during IPOs. In a traditional IPO, the investment banks underwriting the IPO do what is called a roadshow.

During this roadshow, they set up meetings with financial analysts, institutional investors, brokers, and more. Not only do they use these meetings to market the securities that will soon be for sale, but they also use the information they gather to appropriately price the securities.

A Dutch auction works a bit differently in that theoretically, anyone can bid on the securities. In the case of Dutch auctions, the IPO process is democratized, in that it allows individual investors to participate, rather than just the institutional and high-net-worth investors invited to participate in traditional IPOs.

Additionally, the auction process, rather than the roadshow, is used to determine the IPO price. In a Dutch auction IPO, investors submit a bid of the highest amount they’re willing to pay for the securities. As is the case in most auctions, the goal is to sell the shares for the highest price.

See also :  What is the Debt Service Coverage Ratio?

Suppose that a company planned to sell its IPO shares for as high as $100 per share using a Dutch auction. It opens the bid for 1,000 shares. The highest initial bid is $95, and that highest bidder will get first priority on the shares. The bidding continues until the final shares have accepted bids.

But that bidder won’t actually buy the shares for $95. In a Dutch auction, all bidders receive the same price. The bidding continues until all of the shares have been bid on, and all bidders pay the lowest accepted bid. So if the last of those shares sold to a bidder offering $70, then all buyers would ultimately pay $70 for their shares.

Pros and Cons of Dutch Auction

Pros

  • Anyone from individual to investors can place bids, thus democratizing public offerings.
  • Multiple investors bid for their number of shares, and each investor remains unknown of the other’s bid. They all place a bid that is favorable to them. As a result, all investors benefit when the auctioneer or seller selects the lowest bid.
  • Public bidding increases price transparency.
  • It offers firms a chance to go public without taking the help of underwriters or investment banks, thus reducing transaction costs.
  • It reduces the spread between the bid (offering) and actual market (opening/listing) prices for assets or securities.

Cons

  • As the bid is open to all types of investors, the estimated offering price might differ from the companies’ prospects from whom investors have decided to purchase shares.
  • Bidders may find they have overbid due to the higher bid pricing. As a result, they attempt to sell their stake to liquidate their holdings, causing stock prices to plummet.
  • Auction-based pricing gives investors less control.
  • Lack of information about the seller and the auction process may result in inappropriate share pricing and increased risks.
See also :  What is Technical Bankruptcy?

Example of a Dutch Auction

Let’s assume there are 10 shares of stock for sale. A bidder offers $10 per share of stock for 8 shares. The next highest bidder offers $9 per share for 10 shares. The auction will end, as there are adequate bids to sell all shares. The price paid for all shares will be the lowest successful bid of $9. The first bidder will receive 8 shares at a price of $9 (lower than her original $10 bid). The second bidder will receive the 2 remaining shares (less than her desired lot of 10 shares) at $9.