Ready for another IPO frenzy?

The region’s insatiable appetite for new listings is something all companies, bankers, and investors examine closely. While their attractiveness is not a mystery, Imad Ghandour, the head of strategy and research at Gulf Capital, a regional private equity firm, very succinctly explains investors’ rationale. According to his analysis, GCC markets have decreased by 32% during 2006 and the first half of 2007. On the other hand, IPOs launched during the same timeframe appreciated by 156%.

Furthermore, by mid 2006, IPOs launched in 2005 were still up by 177% when the overall GCC index was down by 12%. Imad Awad, the head of equity capital markets at the NBD Investment Bank (NBDIB), also highlights this demand. “Air Arabia and Deyaar were listed over the past few months in the UAE.

Air Arabia was oversubscribed but it opened at a 20% gain, which was excellent – that means that there is a lot of demand in the equities market.” The difference in performance between new listings and existing stocks is so striking that any investor can discern that the safe bet is to get in on the IPO. The problem is that over the past 18 months, new offerings have markedly decreased.

Private equity firms tend to keep an eye on equity markets because IPOs serve as a good option to exit investments, and Ghandour is no exception. His research shows that US$13.5bn was raised in initial public offerings in the GCC in 2005 and 2006, but new offerings in the three year period between 2007 and 2010 will only raise US$15.3bn. The reasons for the decrease are complex, and Ghandour says that to properly understand the decline one must look at each individual GCC marketplace. However, almost everyone agrees that market conditions, or the severe correction of the past 14 months, affects both the supply and demand of new listings.

It is necessary here to clarify some semantics. Market experts in region still refrain from using the word ‘crash’ but Dr John Sfakianakis, chief economist at the Saudi British Bank (SABB), does not shy away from using the term.

He explains that the International Monetary Fund (IMF) defines the term “when the market goes down more than 34%”, and given the Saudi Tadawul’s decline of 61%, the use of the term ‘crash’ is more appropriate than correction. By agreeing that a crash occurred, it is likely that expectations about future performance will be adjusted and investors will become more patient. Dr Sfakianakis says: “Empirical evidence shows that when you have a crash, usually people will come back to the market after four or five years, and if it is a real estate crash it might take even longer for those people to come back.”

Using historical data is not always the best gauge of future performance, but in this case it can shed light on the severity of the crash and how long the recovery will take. The Gulf is not alone in engaging in the debate over terminology. In the last four months, finance experts argued about the subprime lending crisis, the stock market shock and a global liquidity crunch. The consensus seems to be that the dip marks an era of ‘increased volatility’. GCC bankers are quick to point out that the global market turmoil did not affect regional markets, and they are right. Equity markets rebounded across the GCC this summer; conditions seem ripe for new listings.

A few weeks ago, an announcement from Saudi Arabia seemed to confirm this sentiment. PetroRabigh, a US$9.8bn petrochemical joint venture between Saudi Aramco and Japan’s Sumitomo Chemicals, said that it was planning to float a 25% stake before the end of the year. Dr Sfakianakis says that the PetroRabigh IPO will be “one of the biggest in the history of Saudi, well over US$2bn”. He believes that the Saudi market will see more listings “coming on stream in Saudi Arabia… 2008 looks like a good year for IPOs”.

NBDIB’s Awad sings a similar tune about the UAE, and says that “there are a few IPOs coming up on the Abu Dhabi stock market and that they should soon be announced.”

The simple (and rather nebulous) reason for the drop in new listings is an oft-repeated phrase: ‘due to undesirable market conditions’. While it is certainly true that the market crashed, the demand for IPOs remained somewhat robust. A quick glance at more of Ghandour’s research shows that the average oversubscription rate in the first half of 2006 was 60, and dropped in the first half of 2007 to 6.5, which signifies weakened demand, but nevertheless, offerings were still oversubscribed. If companies were successfully listing during the crash, why then are things going to pick up now? And with more robust equity markets, why aren’t projections for future fund raising higher?

When Arabian Business reached out to the experts to explain this phenomenon, we did not expect to find that everyone agreed with the answers to these questions. The main reasons for the decline in new listings (and some would say the decline in the markets) are mostly regulatory. The good news is that governments are enacting sweeping changes in record time. The three most promising reforms are in the valuation process, the facilitation of the listing process for family owned businesses, and the increased participation of institutional investors.

Book Building

When the Capital Market Authority (CMA) in Saudi Arabia began adjusting its pricing mechanism and introduced the book building and price discovery mechanisms, Calyon’s Momdjian was very pleased. He explains the significance of this development. “In normal markets you have three ways of deciding the valuation of a company. You have the corporate finance valuation, the research valuation, and the market valuation.

“The most important one is the market valuation. As corporate financiers, we prepare a company and package it to go to the market, then we sell the story to research analysts, and then at the end of the day it is up to the management and the market to decide if they want to pay a premium or not on the company,” he adds.
This type of pricing has not been completely implemented yet, but regulators have set the necessary mechanism for tomorrow’s IPO. “I think that the CMA has been extremely responsive on this issue. I am sure there are a lot of things that can be improved, but Rome was not built in a day,” Momdjian continues.

The changes are also welcomed by Awad. “For IPOs, specifically in the UAE and Saudi Arabia, there is a high level of involvement from the regulators. Basically, although you go through a book building process for some of these entities, the price is still up to the discretion of the regulator.” He explains that advisers come up with a certain price range, and “then you have to come up with a convincing argument to dispute the regulators’ finding”. This is not an ideal situation for the companies looking to raise capital based on a fair valuation, and this also artificially deflates the price of IPOs which increases demand for the initial listing and inflates secondary trading prices.

Gulf Capital’s Ghandour agrees that the book building mechanism is a positive change, but reminds us of the most basic economic model. “If you look at Air Arabia, where it was priced at 22 times earnings, it got a very low oversubscription, and you look at other IPOs such as Deyaar, which was priced at seven times earnings, it was oversubscribed 10 times. You see there is a tradeoff – the normal supply and demand curves.” These types of capital market reforms are most visible in Saudi Arabia. As Ghandour puts it, “Saudi by far is the most advanced. The CMA has advanced to a point that is much more advanced than any other regulator.” He believes that the regulations and the book building capability are coming very close to Western practices.

“The other countries in the Arab world are catching up.”

As the biggest economy in the region, Saudi is well positioned to take the lead. Yet Awad believes that Dubai is also on the right track. “I think that more corporations are going to look at entertaining a listing on the Dubai International Financial Exchange (DIFX) because the pricing is more of a pure book building process, where the regulator is not involved – it is up to market supply and demand.”

He recognises that there is a caveat and adds, “liquidity is a problem, but not an unsolvable one. NBD provides solutions to carry out dual listing so companies can list on the DIFX and AIM (the London Stock Exchange’s growth market) as well”.

Family owned Businesses

The improved valuation process is an important incentive for family owned businesses to seriously consider the transformation to public companies. Privately held companies contribute a significant portion of economic activity in the region, but many are reluctant to list because it dilutes the owner’s control.

Yet these businesses understand the need to change in order to remain viable players in the economy of the future. Awad expects that change will likely be due to demographic, corporate governance, and regulatory reasons. He explains that taking a family business public introduces corporate governance structures that “separate ownership from management”. This makes it possible for a business to survive through generations, and also “allows families to exit the business 30 or 100 years in the future”.

Awad highlights the dire need to go public by sighting a sobering statistic: “Around 60% of family businesses disappear within three generations.”

Vanessa Abernathy, a Dubai-based lawyer specialising in securities law, IPOs and M&As at international law firm Clyde & Co, says: “The IPO market has been flat and I believe that it will continue to be flat for some time.” She observes that there has been a “pushback from some family owned business when they became aware of the implications that come with going public – mainly, losing control of their companies.” But the laws are changing, and this could be the catalysts for a very large number of listings within the next three years.

In Saudi Arabia and the UAE, the bar has been lowered which means that a family business can IPO and retain control over their companies. According to Abernathy, previously, if a family did an IPO, the maximum stake they could retain was 45% (and the minimum they had to keep was 20%).

However, now the maximum stake they can keep is 70%. So basically the threshold has dropped from 55% to 30%. This makes the prospect of an IPO more attractive, allowing family businesses to go into the market and raise money gradually, thereby moving onto a corporate footing without the fear of losing control of their company.

This development is stirring up the finance community. Awad says “the family business IPOs are the next big boom. We are working with many family businesses now, helping them with restructuring, employee compensation – a complete solution to transform the business for an IPO.” He thinks that the lowered threshold is a major reason why interest has perked up, and owners may list in order to “realise some of the value that is locked in the business”. NBD is currently dealing with many family owned companies in the UAE, but Awad warns that these businesses “are going to take a lot of time to turn around to become companies that are good candidates for an IPO.”

SABB’s Dr Sfakianakis is extremely optimistic about the developments and believes that the new regulations in Saudi Arabian and the UAE have “has become more conducive for family owned businesses to enter into the capital market.”

Enter the Institutional Investor

The increased participation of institutional investors is very important to the development of capital markets, and will induce more listings.

Dr Sfakianakis explains the significance: “If institutional investors come in to Saudi Arabia that will really help restructure the market, because the stock market in Saudi Arabia is very much retail based – 95% of the trading activity that we see on the Tadawul is from retail investors.”
The difference is that institutional investors do not get out when the market is down by 10%, they stay there, they know how to adjust; retail investors panic, because they are not experienced. As Dr Sfakianakis puts it, retail investors “are not supposed to be experienced”.

In the UAE, institutional investors have already been part of the IPO process as Awad notes. “In the UAE, there are some companies that are pre-sold to institutional investors; in addition to that, you have an institutional tranche at the IPO level as well.”

Momdjian echoes this optimism. He believes that the participation of more asset management companies and mutual funds in Saudi Arabia “is going to be an extremely important element in the transformation of the Saudi market and hopefully for the rest of the markets in the GCC.”

Of course institutional investors are not the panacea; Dr Sfakianakis insists that they like to see transparency.

When transparency is not there then foreign investors disappear, as “we have recently seen with the case of the Dubai Financial Market – particularly with Emaar’s stock”.

It seems that everyone dealing with capital markets in the region is pleased with the recent reforms, and is cautiously optimistic about the future of the stock markets and increased listing.

From a legal standpoint, Abernathy, from Clyde & Co, says that authorities in Saudi Arabia and the UAE “have been stepping up the levels of corporate governance, which is actually really pleasing and I think that will continue.”

Private equity players are also encouraged, but Ghandour observes another shift in the making. “The trend is that IPOs are getting bigger and if you don’t have critical size, you will not get the attention of investors. There will be exceptions, but this is the trend.”

He believes that “investors are becoming more discerning about which company to invest in at the IPO stage, and unless you are big and strong, they will not risk it… They have learned that the GCC stock markets, like their counterparts worldwide, may go up as well as down.”

Powerful international investment banks are aggressively expanding in the region. They must share Momdjian’s view. “When I look at the two markets I am very optimistic about the mix of elements and events that are present today which can be the right mix for the development of equity capital markets and IPOs in Saudi and the United Arab Emirates.”

He says that “big offerings are coming up in Saudi Arabia; we are going to be talking about several deals in the US$1.5 – 2bn range next year.”

But SABB’s economist, Dr Sfakianakis, is more cautious. “I think we have some time to go. You have to understand that the capital markets here are still at their early stage of development. “They have changed a lot over the past two years. They will adapt and change.” It is safe to say that the post-crash era could be characterised as a transitional phase. But it is up to regulators and investors to make the reformed GCC markets deeper and more transparent.