Companies in the Middle East region who want to expand their business have historically looked to bank loans to meet their requirements for extra capital. While equity and debt financing are usually complementary, nevertheless, over dependency on bank loans can be a costly burden to business. A company operating under a very high debt to equity ratio may find that its profits are being depleted by its debt service bill. Contrary to debt financing, injecting fresh capital into the company, either by going public or drawing on private equity funds, brings financing on a long term basis with no interest payments to be made and without the risks and restrictions associated with debt. A company with a higher net worth (i.e. equity) will be able to increase its borrowing capacity in the future and obtain more favorable terms. Nevertheless, the cost of equity is typically much higher than the cost of debt and the way to maximize return is to have the right mix of debt and equity.
Private companies who want to raise equity have a choice today between going public on one of the region’s stock exchanges or drawing on the resources of the growing number of private equity funds targeting investment opportunities in the region. There is also the option of pre-IPO funds, where private companies with the goal of going public in few years can divest part of their business to a private equity fund. To be eligible for private equity finance, a company should not be a publicly listed one. Start-ups and companies in distress should not bother applying either.
For companies who choose to raise capital through an IPO they will have to accept undergoing changes to their structure and the way business is to be conducted. For a family business, the process could take several dimensions. Corporate governance will replace the paternalistic vision of the business. The board, which is normally made up of family members, will be replaced by one that includes top management, new shareholders and independent members. The accounting methods of the family business will have to become more open and transparent, with a clear separation of accounts between family and company expenses.
Start up companies could also choose to go public through an IPO or through a reverse merger, but they need to have an experienced management team in place and a strong group of founding members committed to the business. A key ingredient to the success of an IPO for a start up company is a well crafted and documented business plan that allows investors to assess the company’s future potential. The reverse merger approach could be faster than the IPO. It works by having the company who is planning to go public acquire a shell company that is publically traded. The old board of the shell company then resigns, a new board takes over, changes the company’s name and issues new stocks to potential investors raising fresh capital. The professional advise of an investment bank is needed to execute the transaction and help arrange a scheme to finance it.
Private equity funds have been growing at a fast pace in the last two to three years. According to the Gulf Venture Capital Association, close to $10 billion has been raised by Middle Eastern private equity funds in 2006 targeting investment opportunity in the region, up from $5.7 billion in 2005. This provides an alternative source of capital to family owned and private shareholding companies who seek expansion. There is also now the option of drawing on these funds for pre-IPO financing. This will give the private company a strategic focus, a diversified shareholders base, the expertise of the private equity team (smart capital), better corporate governance and compliance structure and increased likelihood of a successful IPO down the road. At least seven regional and international players have or are currently raising funds of more than $500 million. These include Investcorp, Global Investment House, Abraj Capital, Dubai International Capital, Istithmar of Dubai, Black Stone Equity Partners and Carlyle Group.
Middle East IPO activities in 2006 raised more than $8.2 billion in capital, compared to $6.5 billion in 2005 and less than $4 billion in 2004. This represented 2.7 percent of the total amount of $302 billion raised in initial public offerings worldwide last year. Out of the total 1,419 IPOs floated globally in 2006, 23 offerings were conducted in the Gulf region with a combined value of $7.5 billion, and another 17 in the other Arab countries with a total value exceeding $700 million. IPO offerings raising more than $500 million each were recorded for companies based in the UAE (du), Saudi Arabia, (Emaar Economic City, Saudi International Petrochemical Co.), Bahrain (Albaraka Banking), and Qatar (Al Rayan Bank). Most of the region’s IPO activity centered on utilities, telecom, real estate, travel, consumer goods, banking and financial services with very few in the petrochemical, oil and gas sectors.
The oversubscription value raised by the region’s new IPOs last year represent $345.6 billion or 46 times the size of the floatation. The UAE stock market witnessed the most oversubscriptions among the regional bourses with the IPO for the Dubai Financial Market being oversubscribed by 300 times, followed by Emirates Integrated Telecommunications Company (du) 167 times. The need to borrow in order to obtain a reasonable allocation in an IPO provided an important source of revenues for banks in the region but imposed a high cost to investors. Only a small fraction of the amount subscribed for has, been allocated, raising the cost of subscribing to double or triple the official floatation price. In most cases, investors rushed to sell their holdings in the first few days of trading.
Two IPOs in the region actually opened below their offer price, reversing a long trend of first day multiple jumps. These two IPOs were Saudi International Petrochemical Co. and the Saudi retailer Fawaz Alhokair.
A steady stream of initial public offerings (IPOs) are expected to come to the stock markets of the region in the months ahead, continuing the strong trend that stared in 2004. However, the boom we have seen in the region’s IPO markets in the last two years is likely to subside, and a flight to quality will take hold. As banks reduce their excessive IPO financing, estimated to have reached 70 percent of these offerings in 2005-2006, overall demand per IPO will drop and oversubscription rates are bound to fall. Equally important, the performance of the share price post its IPO date will become more realistic, and prices are less likely to double or quadruple in the first few days of trading. Going forward, the successful IPOs will be those of solid companies with good growth potential that are floated at fair prices. Subscribing to newly issued IPOs will no more be a guaranteed recipe for quick profits. On the contrary, the risk that the share price of newly listed companies will drop below their IPO price has now become a distinct possibility.
(Henry T. Azzam is founder & CEO of Amwal Invest.)
