Equity pipeline or pipedream?

Turkey has weathered the financial crisis better than any had expected and it has emerged the other side with its reputation enhanced. In a neighbourhood where much has gone wrong, Turkey has seemingly done everything right. Much of Turkey’s current success stems from how it rebuilt its financial system after the collapse of 2001. It eschewed foreign debt, tamed inflation, strengthened the local banking system and created strong, independent regulators. All these factors have allowed the country to escape the fate that so many other Eastern European and Central Asian states have suffered during this crisis. Yet standing alone is only half the battle. Turkey has still to establish itself in the minds of international capital markets investors. Its problem is one of definition. For too long the country has been defined by what it is not: it is not European, nor Middle Eastern; it is not investment grade and yet its debt doesn’t trade like an emerging market; its companies are some of the biggest in Europe but they have very few international investors. So as Turkey stands out from the rest of the region, its task is to find a way that it can define itself for what it is, not what it is not. Definitions matter, not least because they give something concrete to hang on to. Despite Turkey being a macro success, at a micro level it is very hard for international investors to access. On the equity side, large family companies dominate the landscape, and yet these companies have ample internal cash and low appetite for fresh capital. On the debt side, international bond deals from Turkish companies are rare. Turkish issuers are dissuaded by the price that investors demand and the currency risk offshore issuance entails. On the bank side, annual syndications are yet to give way to longer-dated international bonds, not least because of pressure from regulators. The lack of international activity in the capital markets is in inverse proportion to the appetite for Turkish exposure by international investors. These investors make up more than 70% of the volume of the Istanbul Stock Exchange. Bank deals and sovereign bonds deals are likewise snapped up by international fixed income investors. Demand outstrips supply of good Turkish exposure – again the emphasis is on what is missing rather than what is there. The local markets are relatively sophisticated, but they are not developed. A clever, educated workforce is not matched by a deep and liquid local market: a financing culture is missing and the companies and individuals rely on the local bank market to the exclusion of the development of the local bond and equity markets. Until this changes, Turkey will not have what it takes to really become the international financial centre that it so wants to be. It will be in the development of these local capital markets that Turkey will find its capital markets identity. Necessity is the mother of invention and Turkey needs money, especially to finance the government’s ambitious privatisation programme. This will see the creation of new companies that need to raise long-term local debt and equity, especially in the energy and real estate sectors. This process could create the beginnings of a local equity culture while also providing the basis for the development of long-term domestic debt markets. Ally this to the fast growing (but still tiny) domestic institutional investor base and you have the makings of an investment story that finally works at both a macro and micro level. This process will take time – most bankers talk about four to five years at a minimum. In that time much can go wrong. But the opportunity has never been more propitious for the country to finally establish itself at the top table of international markets.

Turkey is unlikely to become a major player in the international capital markets until it manages to develop its domestic capital markets. In the local equity markets, serious efforts are underway to improve liquidity and sophistication. However, entrenched obstacles need to be overcome before meaningful progress can take place. One statistic perhaps best sums up the dichotomy at the heart of Turkey’s domestic capital markets: foreign investors own 70% of the domestic equity market. This shows that foreign, institutional investors approve the Turkish investment thesis and the country’s macro prospects. But it also confirms that the investable opportunity is small: there is just not enough investment product to go around. It also shows how underdeveloped the local investor base is compared to what is needed. No market that is so dominated by foreign investors can claim developed status. And so what is needed, perhaps more than anything in Turkey’s drive to modernise its financial system, is the development of a statistically significant onshore institutional investor base. “Turkey’s capital markets are dominated by commercial banks and not by institutional investors as happens in other European countries,” said Ercan Uysal, chief economist at Unicredit in Istanbul. “The amount that is invested by these institutions in equities is miniscule. Over the next 5-10 years we really have to see public ownership increasing dramatically.” Looking at the makeup of the domestic equity investor base, it is largely high net worth individuals with some participation by insurance companies and a fast growing public pension system. But the overall numbers are small. For instance, in 2008 the total amount of assets in the insurance sector was TL24.7bn, with new premiums being written for a value of TL11.8bn, according to the Association of Insurance and Reinsurance Companies of Turkey. However these figures, while small, stem from a base of only TL4bn of total assets and TL2.5bn of new premiums in 2001. In the pension system, the growth has been equally rapid, but as a whole the numbers are still small. According to the Pension Monitoring Centre of the Under-secretariat of the Treasury, on April 30 2010 there were 2.1m people in Turkey who had private pensions. These pensions contained total assets of TL9.6b, up from virtually zero in 2001. This rapid growth is a cause for hope among many in the market. It is seen as evidence that a major structural shift is taking place. “I believe that in ten years time the private pension providers will be the biggest institutional investors in the market,” said Uysal. “The private pension market really is growing exponentially at the moment.” Nevertheless, compared to the massively overcapitalised banking system, these institutional investors make up a tiny proportion of the domestic capital markets. Moreover these investors tend to only invest in either government securities or very rarely into other fixed income products. With inflation and interest rates running around the 8% mark, there has been very little incentive to take the added risk of exposure to equities. “These pension providers will be very cautious about going into the equity market,” said Uysal. Others agree that not only does the investor base need to expand, but also the mentality of those investors needs to shift from fixed income to equity. “We need to create an equity culture here,” said Ugur Bayar, CEO of Credit Suisse Turkey in Turkey.It is important to help Turkish institutional investors gain access to the equity markets.” The lack of institutional investing in the equities market is best seen by the activities in the mutual fund market. The market is divided into A and B fund structures, where A type funds carry a minimum of 25% in Turkish equities and B type funds have no obligation to invest in equities at all. It is estimated that 97% of the TL 26bn mutual fund market are B type funds – essentially money market funds, issued by

Turkey underlined its intent to use 2010 as a year to build credibility in the international markets, by becoming the first emerging market bond issuer of the year. The Republic of Turkey (Ba2/BB–/BB+) issued a blockbuster US$2bn, 30-year deal in the first week of January that was very well received by all in the market. The deal was led by HSBC, JPMorgan and UBS who generated demand of US$7.3bn from 260 accounts, covering the book within hours of the deal being announced. As a result of this demand, the Republic was able to price this deal with a 6.75% coupon and a 98.655 reoffer price to yield 6.85%. This equated to a spread of 224.7bps over 30-year US treasuries. The deal was a record-equaling size which perfectly tapped into investor demand for liquid emerging market credits that offered a yield pick-up over developed market debt. But more importantly the deal allowed the Republic to regain some of the credibility that its past few years funding activities had damaged. Bankers report that in 2008 and 2009, the Republic missed opportunities to tap the market and as a result ended up with smaller proceeds from international Eurobond issuance than it would have liked. At heart, this issue revolves around the Republic’s stated goal of raising US$5.5bn a year from these markets (a target that was decreased in 2009 to US$3.5bn due to economic contraction of 6.5%). During these years, there was the feeling was that the Republic had left itself a hostage to fortune by not hitting those targets aggressively enough and early enough. By not completing its funding target as quickly as possible, the Republic in effect gave investors a free option to ask for higher pricing as they knew the Republic had time-pressure to complete deals. So in 2010 the strategy has changed and the Republic has proactively gone into the market to meet its goals rather than reactively wait for the market to come to it. In April the Republic returned to the market again with a €1.5bn ten-year deal in a transaction that saw it nearly complete its issuance target. The deal was lead by Commerzbank, Credit Suisse, Deutsche Bank and DZ Bank and was priced at mid-swaps plus 190bps, 10bps inside guidance. The deal was sold largely within Turkey with Turkish accounts taking 40% of the deal by geography and banks taking 64% of the deal by investor type. Even so, the deal brought Turkey’s fundraising this year up to US$5bn, just shy of the US$5.5bn target. “The republic of Turkey has done very well this year, taking advantage of the opportunity to come to the market early this year,” said Chris Tuffey, co-head of credit capital markets, EMEA at Credit Suisse in London. “At the start of the year, volumes were high and [Turkey was] particularly fast in coming to market. “ The euro deal was the first euro-denominated trade the Republic had done for three years and came after 11 successive US dollar deals. Tuffey believes that the sovereign may return to the euro-denominated market again this year, possibly by tapping existing issues as a way to improve the euro component of its debt profile. This kind of selectivity and flexibility in funding is also shown in the plan to issue a 10-year US$1bn-equivalent Samurai that will be backed by Japanese government agency JBIC. It is a sign of the strength of the sovereign credit and the flexibility given by its limited funding targets that it can choose to embark on such a deal.Show of faith While the sovereign has been buoyed up by the strength of the country’s underlying economy and its banking system, it can even be argued that the credit of the Republic is actually stronger than that of the underlying Turkish economy. Even though the overall economy contracted last year by 6.5%, this year Turkey’s credit rating was one of the very few in the world to be upgraded (to Ba2 by Moody’s in January). Moreover, the spreads that Turkey has to pay international investors to hold its sovereign paper is a fraction of that of its neighbours

Turkey’s privatisation agenda is one of the boldest of any country in the world. The government has a deep seated belief in the need to remove the state from the ownership and running of most sectors of the economy. It also needs the money to finance its on-going budget deficit. As a result, the government has honed a process that works effectively in transferring operating rights, as well as outright sales of assets. However, the high profile deals of the past, such as the privatisation of Turk Telecom into a bull market, will be hard to repeat in the future. The global recession is limiting the appetite of strategic buyers and stemming the flow of international finance, needed to pay for the huge numbers of assets on the block. That means that if the government really wants to sell these assets, it will have to develop the local capital markets. Only this will allow local buyers and their financiers to raise the sums required.Everything but the kitchen sink Looking at what is for sale, the scope of the government’s ambitions becomes clear. Everything is seemingly for sale. On its website the Privatisation Authority (PA) lists whole industries such as electricity generation and distribution as well as gas distribution that are being entirely sold off. All the country’s motorways and toll bridges are also being sold, as are its ports and ferry services. All told, bankers estimate that assets worth in excess of US$20bn are for sale in a process that will take some four to five years. “We expect the vast majority of capital market deals to come out of Turkey in the next few years will be in the energy and financial services sectors.” says Murat Demirel, head of Citi’s banking business in Turkey. “In the energy sector, for instance, the volume of deals in the pipeline cannot be funded entirely by the bank market. The privatizations, upgrades and new builds in the sector will be the main driver of the debt and equity capital markets in coming years.” The deals that the government has mentioned recently include secondary public offerings of already part-privatised companies such as Turkish Airlines or Turk Telecom. The government needs to be very careful about what it says about these deals as both are already listed, but bankers in Istanbul all say activity underway. Likewise government owned Halk Bank is receiving attention. It is already 25% listed and the government has appointed Goldman Sachs to examine whether to try and sell the remaining 75%, either publicly or to a strategic buyer. Given that most strategic buyers would be foreign banks or private equity firms, it is likely that the government would need to go the public offering route.Highly charged Most privatisation activity has so far come from the electricity sector, with 20 regional distribution companies already in the process of being sold and the sale of Turkey’s generation assets in the consultation stage. In the distribution sector, eight regional companies that are part of the Tedas group have already been sold. The two biggest of these were the Bedas (Bashkent Electricity Distribution) and Sedas (Sakarya Electricity Distribution) deals. In mid February, four more distribution companies - Uludag network, the Camlibel grid near Sivas, the Firat grid in the Eastern province of Malatya and the grid around the Eastern City of Van - were sold. From 42 pre-qualified, three Turkish companies emerged victorious: Limak Group bought the Uludag Grid for US$940m; Kolin Insaat bought the Camlibel grid for US$285m; and Aksa Elektrik Perakende Satis paid US$330m for Firat and Van. On the generation side, the privatisation authority originally put all the country’s thermal and hydro power assets into a company called EU AS. This portfolio was then divided into six smaller portfolios but none of these received much market interest. It was then decided to put them all back into portfolio containing 45 generation assets and begin a new sale process through Citi and local firm O

On May 5, Garanti Bank became the penultimate major Turkish bank to tap into the international bank loan market when it sold a one year dual currency loan deal to 41 banks. The deal saw demand of €850m, after an initial target of €600m. The books were eventually closed with the deal sized at €617m and US$116.9m. As a result of the increase in demand, the deal was able to replace two existing facilities of US$109m and €517m that were signed a year ago. Senior mandated lead arrangers on the transactions were Commerzbank and Standard Chartered, with Commerzbank also taking the roles of documentation and facility agent. Of the 41 banks in the deal, 22 joined at mandate lead arrangers, even though it was styled as a club deal and not a syndication. This was largely due to the fact that these banks wanted to get exposure to Turkish banks and so went into the trade for relationship reasons. The primacy of relationships in determining Turkish bank deals can also be seen in the pricing. Garanti -like all the banks that have come before it this year - priced its deal at 150bps, made up of a 75% coupon and 75% of fees. The fact that all Turkish banks pay the same price for this debt shows how international correspondent banks are keen to get any Turkish bank assets on to their books regardless of the credit of the underlying institution.One price fits all Garanti for instance, is currently undergoing a major shift of ownership, as GE tries to sell its 20% stake to a range of bidders. The possible new owners could include the family that owns parent company Dogus Holdings, a European banking group, or even an international private equity firm. This is clearly a material event from a credit point of view. And yet Garanti Bank, the second largest and most profitable bank in Turkey, still priced its deal at the same spread as smaller state owned bank Vakif Bank, which came out with its one year syndication in March. Vakif sold a dual tranche one year club deal comprising a US$170m and €566.5m, replacing the previous year’s deals which were US$80m and €178m, as well as taking out a three year US$197m facility that was signed in 2006. WestLB was the co-ordinator of the deal and 33 banks participated. The largest deal to have come out so far this year was Akbank’s March trade, comprising US$437.5m and €584.5m. This US$1.2bn equivalent was sold to refinance a US$600m facility taken out last year. One smaller transaction that differed from the normal structure of these deals was Bank Asya’s one year murabaha deal. Asya is Turkey’s leading Islamic bank and it mandated ABC Islamic, Noor Islamic and Standard Chartered to lead the deal which came in at US$250m, a considerable increase of the US$75m targeted. All the major banks, apart from Isbank have now tapped the international syndications market. Isbank is expected in coming weeks and has mandated WestLB to undertake the transaction. Some bankers in Istanbul suggested it is waiting to be last to see if it can break through that all important 150bps level, but international lenders say this is unlikely. “The price is the same for all the banks,“ said Barbara Berchtold, head of DCM at Commerzbank in Frankfurt, who lead the Garanti transaction. “Even though all the banks are different entities, they are rated similarly and the transactions are largely relationship-driven. As a result, in the last four years we have seen all the banks pay the same price for these deals.” It is arguably the desire of the lenders to maintain relationships with the Turkish banks that is keeping the price where it is. Without this desire, “Turkish banks would have to pay more but lenders will take a lower price for the sake of the relationship,” said Berchtold.Keeping its options open Isbank’s delay is also down to the bank exploring other options, mainly a lira denominated Eurobond. According to market sources, JPMorgan has been mandated to lead the transaction with an indicative size of TL 300m to TL700m (US$200m to