Understanding and Examples of Making Books
Used by investment banks, book building is a price discovery process that determines demand for a public offering of a company’s common stock or other securities.
When a company considers going public, it usually hires an investment bank to advise it, and guide the company through the lengthy and expensive IPO process. The investment bank, as the primary underwriter, commits to purchase all shares from the issuer at a certain price, assuming the risk of carrying it. Then the bank resells the shares to the market.
The creation of books makes companies (publishers) and investment banks more confident in the success of the offering.
With book development, the investment bank garners various offers from its client base of institutional and large-capital investors. This initial offer gave bankers and the company’s management team an idea of the market’s appetite for stocks.
Affirm, an online financial services company, is an example of a company using book building when it went public on January 13, 2021. The IPO was underwritten by Morgan Stanley, Goldman Sachs & Co. LLC and Allen & Company LLC, and has an initial offering range of $41 to $44 per share. However, after the roadshow, the final offering was priced at $49 per share. Affirm closed at $97.24 on the opening day of trading on the NASDAQ.
How Book Creation Works
Bookmaking begins with the bank holding a series of roadshows that help promote the offering and create enthusiasm.
Roadshows may include conference calls with multiple investors, face-to-face meetings, and publication of material on the internet about the issuer’s business and offerings. There is a question-and-answer session at each roadshow, giving investors insight into management strategies and the future potential of the business leading up to the IPO.
The most important roadshow is face-to-face meetings with investment bank networks of institutional and large investors. These meetings provide an opportunity for investors to interact directly with the company’s management.
Indication of Interest
During the roadshow, investment bankers ask for “indications of interest” from potential investors and clients. Indication of interest is an offer that is not binding on the offer, including interest in price and quantity.
The interest indication is then built by the investment banker into the order book. The order book lists the number of shares and the price offered by each potential investor. Investment bankers use the order book to recommend the final bid price to the issuer.
Immediately prior to trading new shares on the exchange, investment bankers allocate shares at the final offering price to their network of clients and investors. Bankers allocate shares based on indications of interest and their relationship with investors.
The bankers’ discretion to allocate shares is an incentive for investors to provide accurate bids, because investors who underbid or overstate their interests may not get an allocation.
Book Building Type
Apart from the typical IPO, there are two special forms of book building.
Accelerated Book Creation
Accelerated book building offers are used to sell large amounts of stock or to raise capital quickly. The underwriting investment bank must create an order book, set a final price, and allocate shares within a short period of time, usually 48 hours or less. No roadshows.
Reverse Book Building
Reverse book building is used by issuers to buy back shares. The underwriter requests quotes from existing shareholders and uses the order book to determine the final offering price for the shares.
Alternatives to Book Creation
The creation of a book is an integral part of the price finding process for most initial public offerings. However, there is another alternative.
With auctions, the public bidding process is used to determine the bid price. Instead of a roadshow and indication of interest from a select group of investors, all interested investors are given the opportunity to bid for shares prior to the IPO. Google took the auction route with an IPO in 2004.
With direct listing, shares are offered directly to investors by the issuer on the first day of trading. In direct listing, the initial share price is only determined by the demand and supply of shares in the market. The underwriters are not involved in the direct listing sales process. Cryptocurrency exchange Coinbase went public using live listing in April 2021.
Pros and Cons of Book Making
- Pre-market price discovery: Roadshows and interest indications provide issuers and bankers with a clear picture of stock prices and demand from experienced and professional investors with large amounts of capital to invest.
- Adapted to the issuer: Investment banks specialize in a wide range of sectors and industries, offering the expertise and credibility of the issuer to their network of investors.
- Lower risk for underwriters: The book creation process reduces subscription risk. When the offer is undersubscribed, the bank is responsible for any unsold shares at the offer price.
- Fees: The costs of auctioning and listing directly to the issuer are much lower, as shares are sold directly to investors and there are no brokerage fees.
- Potential underpricing: Potential underpricing is a major disadvantage for issuers. Underpricing is the difference between the stock’s pre-market subscription price and the price on the opening day of trading. This is considered “money left on the table” for publishers. Underpricing is one of the reasons why pre-IPO shares are attractive to investors.
- Book generation is a method of finding pre-market prices for initial and secondary offers.
- Underpricing is the main potential disadvantage of book building to publishers. This is also the reason why pre-IPO shares are attractive to investors.
- Book creation, customized for each publisher, is the most commonly used method for public offerings in the US