Dutch auctions, as the name suggests, have their origins in Holland during the 17th century. At the time, the Dutch tulip mania led to a range of financial innovations facilitating trading and speculating on tulips, including rudimentary derivatives and the Dutch auction.
A Dutch auction is traditionally conducted by the auctioneer starting at the highest asking price and lowering it until it reaches a price level at which the bids received cover the offer quantity. This is the price level the auction will clear at for all bidders, lending it the alternative name of a uniform price auction. This is an example of selling via Dutch auction, and is sometimes used for pricing IPOs, albeit without the presence of an auctioneer.
When conducting a tender offer to buy shares via Dutch auction, a firm will declare the intention to repurchase a quantity or fixed dollar value of shares at a price within a given range. Stockholders are invited to respond with the price withing the range at which they are willing to sell their shares. The firm will aggregate these bids to form a supply curve, and the lowest price at which the desired value or number of shares will be tendered at is the price the offer will clear at.
All participants in the offer will receive the same price; those who indicated a willingness to sell their shares at a lower price will still receive the price at which the offer clears. Those who indicated a higher price will be left holding their shares, taking the risk of the share price falling after the offer expires. On the above graph, a tender for 50,000 shares would clear at $850.
Participants should therefore offer at the lowest amount they are willing to part with their shares for; if buying at market price in the hopes of getting a higher price when tendering the shares this could be the market price as any clearing price above this will result in a profit, which participating if the auction clears at a lower price is undesirable as it would incur a loss. A participant is still subject to price risk on the shares should their offer not be accepted and the price subsequently falls, although this risk can be managed by hedging.
Example
Say a company offers to repurchase 50,000 of its shares at a price between $825 and $875 dollars. The offer prices for shareholders come in as follows:
Investor A: offers 30,000 shares at $850
Investor B: offers 99 shares at $860
Investor C: offers 30,000 shares at $865
Investor D: offers 20,000 shares at $870
In this example, enough shares are offered to fill the offer at $865 per share (60,099 in total). Investors A, B and C will have their shares taken off them at $865. As more shares are offered at this price than the target size of the offer, these investors will each be subject to proration as have approximately 83% of their shares bought.
If the offer contains an odd lot priority provision, investor B as the holder of an odd lot will not be prorated, selling all 99 shares at the clearing price of $865, while investors A & C will be subject to slightly higher proration and sell slightly fewer shares than before to keep the total sold at 50,000. This means investor B will likely receive a higher average sale price for their total holding than large investors A & C – the arbitrage opportunity we track here at oddlotarbitrage.com.
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