A Dutch auction, also called a reverse auction, is the process of selling goods through an auctioneer who offers prices starting above the expected purchase price and then lowers prices until a buyer makes a bid. If no buyers place a bid and the price drops to a predetermined reserve amount, then there is no sale. This process is typically quicker than a traditional auction because only one bid is required for purchase. Dutch auctions have been adapted and evolved in the financial world as a method for selling securities.
U.S. Treasury Auctions
The US Treasury Department uses Dutch auctions to raise funds for the US Government through the sale of Treasuries.
For example, if the Treasury would like to raise $10 billion through the sale of ten-year notes with a 2.9% coupon, an offering would be posted, and large banks and broker-dealers would submit bids via an electronic platform. Bids take the form of a dollar amount at a certain coupon percent and could look like
$1.0 billion at 2.800% (highest bid)
$2.0 billion at 2.850%
$3.0 billion at 2.900%
$2.5 billion at 2.950%
$3.0 billion at 3.000%
$1.0 billion at 3.050% (lowest bid)
In this example, the Treasury accepts the lowest bid yields up until the yield where entire dollar amount is filled, or 3.000%. This is the lowest rate the treasury can pay while securing the total amount of $10 billion. Only half of the order will be filled for the bidders at 3.000%. This type of auction is set up to create aggressive bids in a timely manner.
IPO Pricing
There is an alternative to the standard Initial Public Offering (IPO) process called an OpenIPO. Rather than the standard Wall Street book-building process, OpenIPOs conduct an offering through a Dutch auction type process.
A private auction is opened for three to five weeks, and potential buyers place bids that are used to find the intersection of supply and demand. The lowest price that will sell all the shares in the offering becomes the clearing price. After considering all other business and market conditions, the company and underwriter use the clearing price as a maximum to decide where to price shares. At this point, shares are impartially allocated, based solely on the bids.
In addition to theoretically obtaining the highest possible IPO price, auctions and OpenIPOs may be used to allow smaller companies to go public sooner. However, even after Google (now Alphabet) used an auction process to price their 2004 IPO, few companies have used auctions or OpenIPOs to go public over the past decade.
While the Dutch auction has proven to be a viable method for selling goods and commodities, the process has not been widely adopted among Wall Street banks as the best method for offering securities. In a future blog post, we will look at the traditional book-building process, further compare the methodologies and understand the pros and cons of each. In the meantime, contact us to learn more about the IPO process and pricing methodologies.
Philip Taylor, Associate
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