Dutch Auction: Understanding How It’s Used in Public Offerings (2024)

What Is a Dutch Auction?

A Dutch auction (also called a descending price auction) refers to a type of auction in which an auctioneer starts with a very high price, incrementally lowering the price until someone places a bid. That first bid wins the auction (assuming the price is above the reserve price), avoiding any bidding wars. This contrasts with typical auction markets, where the price starts low and then rises as multiple bidders compete to be the successful buyer.

Financial markets employ a slightly different variant. There, a Dutch auction happens when investors place bids for a security offering, specifying what they are willing to buy in terms of quantity and price. The price of the offering is then determined after taking in all bids to arrive at the highest price at which the total offering can be sold. Dutch auctions can be used to sell Treasury securities, initial public offerings (IPOs), floating-rate debt instruments, and other securities.

The term “Dutch auction” dates to 17th century Holland, when the method was used to improve the efficiency of the competitive Dutch tulip market.

Understanding Dutch Auctions for Initial Public Offerings (IPOs)

If a company is using a Dutch auction for an 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 stock 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 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, then you will only have to pay $80 for your 1,000 shares.

How the U.S. Treasury Uses Dutch Auctions

The U.S. Treasury uses a Dutch auction to sell its securities. To help finance the country’s debt, the U.S. 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 an 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%

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.

Lowest-Bidding Dutch Auction

At a lowest-bidding Dutch auction, prices start high and are dropped successively until a bidder accepts the going price. Once a bid is accepted, the auction ends.

For example, say an auctioneer starts at $2,000 for an item. The bidders watch the price decline until it reaches a price that one of the bidders accepts. No bidder sees the others’ bids until after their own bid is formulated, and the winning bidder is the one with the highest bid. So, if there are no bidders at $2,000, the price is lowered by $100 to $1,900, and the bidding moves lower from there if no one bids at $1,900. If a bidder accepts the item of interest at, say, the $1,500 mark, the auction ends.

Benefits and Drawbacks of Dutch Auctions

The use of Dutch auctions for initial public offerings offers benefits as well as drawbacks.

Benefits

• Democratization of public offerings. The process for conducting a typical IPO is mostly controlled by investment banks. They act as underwriters to the offering and shepherd it through road shows, enabling institutional investors to purchase securities of the issuing company at a discount. They are also responsible for setting the IPO’s price. A Dutch auction allows small investors to take part in the offering.
• Increased transparency. Institutional investors take advantage of this difference to rake in profits by purchasing shares at a discount and selling them immediately after the stock is listed. Dutch auction prices are set by a fairer and more transparent method in which an array of bids from multiple types of customers are invited. This practice is meant to ensure that the market arrives at a reasonable estimate of the firm’s value and that the initial “pop” that accompanies the listing of a hot company is muted.

Drawbacks

• Less price control. Because the auction is open to investors of all stripes, there is a danger that they may perform less rigorous analysis compared to investment bankers and come with a price estimate that may not accurately reflect the company’s prospects.
• Potential price volatility. Another drawback of Dutch auctions is known as the winner’s curse. In this, a stock’s price may crash immediately after listing when investors, who had bid a higher price earlier, realize that they may have miscalculated or overbid. Such investors may try to sell the stock to get out of their holding, leading to a crash in the share’s price.

Example of Dutch Auction

The most prominent example of a Dutch auction in recent times was Google’s IPO in August 2004. The company opted for this type of offering to prevent a “pop” in its prices on the first day of trading.

While the increase in share prices is a standard phenomenon in stock markets, it had escalated to bubble territory for tech stocks during the internet bubble of 2000. From 1980 to 2001, the pop in first-day trading was 18.8%. That figure jumped to 77% in 1999 and in the first half of 2000.

Google’s initial estimate for its offering was 25.9 million shares in the range of $108 to $135. But the company revised its expectations about a week before the actual offering after analysts questioned the reasoning behind those figures and suggested that Google was overpricing its shares. In the revised estimate, Google offered to sell 19.6 million shares to the public at a price range of $85 to $95.

The response to the offering was considered a disappointment. Although Google was considered a hot company and offering, investors priced its shares at $85, the lower range of its estimates. By the end of the day, the shares were exchanging hands at $100.34, a pop of 17.6% during the first day of trading.

Observers blamed the poor performance on negative press reports about the company leading up to its IPO. A U.S. Securities and Exchange Commission (SEC) inquiry into its executive share allocation further dampened enthusiasm for Google’s offering. The company was also said to be secretive about its use of raised funds, making it difficult to evaluate its offering, especially for small investors not aware of the emerging market for search engines and organizing information on the web.

The Bottom Line

Dutch auctions can provide an opportunity for individual investors to get involved in the IPO process. Usually, only clients of the underwriting bank have dibs on IPO shares. But with a Dutch auction, anyone can bid, democratizing the process.

Before participating in any IPO, be sure you understand the company and the auction process—and consider your own financial situation and risk tolerance.