The prospect of a new market is always attractive for bankers, but it is often a challenge to achieve its full potential. For ECM bankers Eastern Europe certainly had a lot of promise and has had some success, but this has not been easy and activity in several local markets remains patchy at best. Poland and Turkey have become established markets with a relatively stable flow of transactions, but countries such as the Baltic states and Romania have not been able to turn a pipeline into genuine deal flow.
The development of ECM activity in the Middle East is expected to get a boost after September 26, when the Dubai International Financial Exchange opens. The new exchange, part of the legally independent Dubai International Financial Centre, will for the first time provide unlimited international access to Middle Eastern companies. At present there many exchanges across the Middle East, but their success has been limited by the fact that they operate on national lines, with their fortunes tightly linked to their national economies.
“The existing exchanges in the Middle East are fairly young but have fulfilled their need. Usually exchanges are formed as national exchanges and are therefore tied to the local economy, before then internationalising,” said Steffen Schubert, chief executive of the Dubai International Financial Exchange (DIFX). “Ordinarily this is a gradual process but we didn’t want to wait. The government of Dubai decided to leave the Dubai exchange as it was and create a separate international exchange to complement markets in the region.”
Until recently the Middle Eastern equity markets have been closed to foreigners, and operated under very different rules from those elsewhere. International investors have been very limited in what they can buy and when they can buy it.
Even investors within the region are restricted as to where they can invest, leaving most exchanges dependent on local demand from oil-rich institutions and individuals. Recently this has not been a problem, but such investors are keen to divest their interests beyond oil-related stocks, and internationalisation of exchanges would help this.
Another unique quality is that traditionally IPOs have followed what many consider an outdated approach to new issues, being completed at a fixed price which is the stock’s par value. As a result demand is often extremely high, exacerbated by banks offering retail investors leverage to finance larger orders.
“The phenomenon of borrowing is quite something. Companies on some markets can only issue at par or close to it so there is zero valuation by them, ensuring there is a built-in unreality to the first price,” said Schubert.
The result has been multiple oversubscription on many IPOs, and that, plus the amount of money made by banks from these financing loans, has led regulators to request that banks take more responsibility.
The IPO of ADDAR Real Estate served to prompt intervention due to the fees banks were earning from this practice. Banks offered leverage of up to 20 times, boosting demand for ADDAR’s US$225m-equivalent IPO to a stratospheric US$103bn and leaving the book over 450x covered. Investors in the UAE deal had to pay for the stock they ordered in advance and were not due to receive their funds back, based on their final allocation, until almost a month later. In the end, the UAE government stepped in to impose a 15-day limit on the resulting interest charges, though banks were still rumoured to have made more than US$400m on the US$225m deal.
The result has been guidance from the UAE Central Bank warning banks not to offer such substantial leverage, and a similar move across the region to try and reduce this, although it is expected to continue on certain deals.
“The trouble is that this is self-fulfilling, as deals tend to be so oversubscribed that people over-inflate their own orders. This can make things difficult when completing a bookbuild as one wants to take the best price based on demand, but allocations are also very important as investors will be unhappy if allocated too little stock,” said Deutsche Bank's Chris Laing, who covers emerging markets. The result can be the stock trading down as those unhappy with their small allocations sell out as the initial demand disappears.
Change on the way
But changes in hand are expected to relieve these problems. The IPO of Saudi consumer dairy company Almarai in July 2005 saw subscription at a relatively low 3.5 times in the absence of leveraged orders. In addition the IPO pioneered the use of ATMs to collect orders from investors, a move designed to make it easier for retail accounts to come into deals.
Indeed retail has led several efforts in the region, as exchanges attempt to create a more educated investor base. DIFX has done this through the DIFX Academy, which launched its first courses in May 2005. The academy operates courses for both finance professionals and members of the public that wish to improve their capital markets knowledge. The courses cover equities, equity analysis, fixed income and derivatives. Courses also look at Islamic finance, market ethics and corporate governance, which are crucial to the DIFX’s success at marking itself out from other emerging market exchanges. Many of the courses are tailored to the DIFX and are available for all levels of expertise from beginners to experts. This is crucial in the Middle East as many stock prices are not based on fundamentals, so investors need to be clear on valuation themselves.
“In local markets there is often a level of uncertainty to pricing as there is a lack of clarity over how companies are run and consistency of market disclosure,” said DIFX’s Schubert. “The DIFX hopes to avoid this by being very harsh on non-disclosure and by encouraging research from investment banks. This will allow investors to 'kick the tyres' of companies.”
Another significant development in the region has been the first use of bookbuilding in Saudi Arabia. Until 2005 all IPOs had been completed at the par value of shares, but a new capital markets law – passed in 2004 – came into force early this year. The first use of a bookbuild followed just three months later, when National Commercial Bank launched the IPO of Saudia Dairy & Foodstuff (SADAFCO). Prior to this deal all offers were so oversubscribed that there was no need for underwriting by lead banks.
Despite the bookbuild, investor appetite was still high, but the final figure of a book 6.5x subscribed reflected the significant difference the new method could have on IPOs. Bankers involved worked on the new deal structure for around eight months before launch. They said it was very challenging but the Saudi authorities were supportive and the deal had reached a successful conclusion.
There are expected to be many more IPOs completed at par due to the ease of the process and the lack of need to underwrite the deals, as seen with Almarai which followed SADAFCO by two months. But with speculation that the Saudi market could soon open up, new entrants to the market may be keen to follow a bookbuild approach.
“Saudi Arabia is currently a closed market, but there is talk of integration with other markets,” said Oscar Silva, head of corporate and structured finance at National Commercial Bank in Saudi Arabia. "There is also talk of allowing Gulf Cooperation Council (GCC) investors into deals. This is significant as some transactions may require more than one listing.”
The Gulf Cooperation Council is made up of Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. Individually these markets are small as the national basis is limiting, but the DIFX is expected to influence them.
“The creation of the Dubai International Financial Centre has already impacted on other markets. Markets are beginning to open up to international investors and we would expect two other things to also change,” Schubert suggested. “Companies have been required to float more than 50% of their share capital and complete offers at par, both of which are likely to change.”
Another limitation on international interest, were the markets to open up, is the lack of clarity regarding companies on the exchanges and the significant difference in corporate governance. With the introduction of the DIFX comes an international level of corporate governance that includes protection against newly formed companies that may attempt to exploit the new market.
Thanks to the huge level of oversubscription seen on domestic UAE deals such as ADDAR there have been several newly formed companies looking to list. Due to concerns about the suitability of these companies, the UAE Ministry of Economy and Planning formed a feasibility committee to assess companies planning to list on the Dubai or Abu Dhabi exchanges. This assesses all new companies looking to do an IPO on the local exchanges to ensure that they are not bogus.
However, some new firms will be allowed to complete IPOs without having to go through this procedure, such as Taqa, which listed in August. The energy investment company was excluded from the new requirements as it was a government company formed with government-proven assets. The DIFX will avoid these concerns by not allowing new companies to list.
“DIFX listing rules require companies to have records for a minimum of three years and a US$50m market capitalisation, so start-up risk will not be an issue. In around one year we would like to add start-ups, but the initial focus will be the main list,” said Schubert of DIFX. “Some established companies have recently formed joint ventures and so it is possible these might be allowed on the main list if there was a clear view of the parent’s history and accounts.”
DIFX has been marketing itself widely over the past year in both the Middle East and beyond. As the exchange has a central location between Asian and European markets it hopes to capture companies from markets in between.
“There has been good interest from South African mining companies, unsurprisingly as Dubai is the third largest gold market, and companies in Turkey, the Lebanon and Egypt are also keen,” said Schubert. “The exchange is looking to see listings from across sectors, despite initial concerns by some that there would be an oil and gas bias. At present companies range from an expected market capitalisation of US$100m to around US$1.5bn.”
The exchange will start by listing equities, bonds and sukuks, while Indian companies are expected to list GDRs to gain wider access to capital. This roster is expected to expand over time with the addition of derivatives as the exchange matures.
The initial launch will be small with a handful of brokers in place but there are over 40 firms authorised to operate in the DIFC and up to 70 brokers and banks looking to connect with the exchange. At present remote members are only able to connect from London, but further remote members are likely in the future. With 10 to 15 IPOs expected by the end of 2006 the expansion could be rapid and bankers could soon find a new market living up to its promise.