IPO in UAE

TNI Market Insight

INVESTMENT RESEARCH COUNTRY STRATEGY | July 3, 2007 UNITED ARAB EMIRATES

Initial Public Offerings: The end of easy money

Amer Halawi

Tel: +971 (2) 619 2300

[email protected]

Brian Davidson

Tel: +971 (2) 619 2322

[email protected]

Disclaimer

July 3, 2007 | 02

Disclaimer

“TNI Market Insight” (TNI means “The National Investor” wherever mentioned) is solely for the general information of named recipients and should not be reproduced or distributed without prior written consent from TNI. The observations in this report are solely based on research and analysis performed by our investment research department using the information currently available which we believe to be reliable. They do not represent an opinion or recommendation prepared by TNI Investment Research or should not be construed as a solicitation or offer, to buy or sell securities of any of the companies mentioned in this report. Any action based on the information in this material shall solely be at your own risk without any obligation or responsibility on the part of TNI, its directors or any of its employees. TNI does and seeks to do business with the companies mentioned in this research report. TNI and/or its directors or any of its employees may, from time to time, own, buy, or sell securities of the companies mentioned in this report (including derivatives linked to such securities) and investors should therefore be aware that such activities may be a source of conflict of interest.

July 3, 2007 | 03

Contents

The rise and fall of Emirati IPOs 4

The UAE IPO process is unique 6

A reminder on Western IPO practise 6 Four major differences with the “West” 8 Historical reasons for such differences? 10

SWOT of the current IPO system 11

Going public for the wrong reasons 12 The re-distribution of private wealth 13 Risk and reward are skewed 16 Leverage is breaking the market 18 An inefficient money-raising instrument 22

Unprecedented UAE IPO boom 24

Impressive performance 24 Disappointing after market 24 No more steam 25

The DFM case study 28

The end of easy money? 28 You shouldn’t have subscribed! 28 For whom the bell tolls 31

The way forward 33

Consequences of the market slowdown 33 The pipeline is still generous 35

Seven recommendations for a “better IPO world” 37

Contents

July 3, 2007 | 04

The rise and fall of Emirati IPOs

In the UAE, the first official stock market trades took place on DFM and ADSM in 2000, barely 7 years ago. This highlights how young the UAE capital markets are. However, due to very favourable economic conditions fuelled by oil surpluses, the development of local markets has been extremely fast. Aggregate market capitalisation today amounts to c. $200bn, and daily turnover may at times exceed AED5bn ($1.35bn). Market growth has largely been based on wealthy retail investors looking for fast capital gains, and often believing that “the only way is up”. Table 1: UAE stock markets summary

DFM ADSM

Date of first trade 26-Mar-00 15-Nov-00

Total market cap AED (m) 357,485 349,140

Total market cap USD (m) 97,407 95,133

Total number of listed stocks 51 64

Average daily turnover AED (m) 843 250

Average daily turnover USD (m) 230 68 Source: TNI Investment Research, Reuters, Bloomberg

One of the biggest drivers of the UAE capital markets boom has been the IPO activity. 2005 and 2006 saw the largest ever number of public offerings. It seemed there was no limit to capital markets financing, even as the stock market fell from its historical peak. Individuals and corporations annually poured some USD 1.77bn to finance the growth of existing companies or start-ups. Subscribers invested aggressively in what seemed to be an endless, virtuous fortune. Every IPO was a chance to get richer. Like the Californian gold rush of the 1840s, anywhere you dug you found gold. All along, the gigantic capital gains which were being generated concealed a sub-optimal, overly regulated IPO process. Contrary to popular belief, the market correction which started in November 2005 did not bring about a dry-up of deals – there was about as many of them in 2006. However, it was accompanied by a wave of public offering disappointments: deals barely subscribed, and leverage costs overshadowing early trading gains. Today we see increasing hope of resurgence in IPO activity, and we feel it is the right time to “go back to basics” – understanding the subtleties, inner workings and flaws of the Emirati IPO process. In particular, are local public offerings an efficient money-raising instrument? Do they warrant appropriate valuations? Who benefits from them? How do they contribute to the re-distribution of public wealth? The objective of this piece is to make sense of the UAE IPO process, and to understand ways in which it should evolve. We dedicate the last part to making seven recommendations for a “better IPO world”.

The rise and fall of Emirati IPOs

UAE stock markets are nascent but growing fast. They are largely retail-driven

IPOs pulled markets up. They have been viewed as a way to get rich fast

The IPO process is sub-optimal and overly regulated

Now is the right time to better understand IPOs, and to encourage change

The ris

e a

nd fa

ll of E

mira

ti IPO

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Table 2: UAE initial public offerings since 1995

Issuer Market

Sub.

open

date

Sub.

Close

date

List

date

Shares

offered

(m)

IPO

type

Issue price

per share

AED (m)*

Offer

size

US$ (m)

%

Equity

offered

Over

sub-

scrip

Total raised

US$ (m)

Lead

manager Eligibility

Deyaar DFM 6-May-07 16-May-07 n/a 3,178 Primary 1.02 866 55% 14 12,123 Shuaa/MFC GCC

Air Arabia DFM 18-Mar-07 27-Mar-07 n/a 2,567 Primary 1.02 699 55% 1.5 1,049 Shuaa All

DFM DFM 12-Nov-06 23-Nov-06 7-Mar-07 1,600 Secondary 1.03 436 20% 308 134,278 DB All

Gulf Navigation DFM 24-Jul-06 7-Aug-06 7-Feb-07 910 Primary 1.02 248 55% 3.5 868 Shuaa GCC

Arkan ADSM 6-May-06 16-May-06 8-Jan-07 858 Primary 1.25 292 49% 7.5 2,189 HSBC UAE

Tamweel DFM 27-Feb-06 8-Mar-06 10-Jul-06 550 Primary 1.02 150 55% 484 72,479 TNI All

DU DFM 4-Mar-06 13-Mar-06 22-Apr-06 800 Secondary 3.03 660 20% 167 110,207 EFG UAE

Sorouh ADSM 22-May-05 6-Jun-05 20-Dec-05 1,375 Primary 1.01 375 55% 176 65,940 TNI/FGB UAE

Dana Gas ADSM 20-Sep-05 3-Oct-05 6-Dec-05 2,006 Primary 1.01 561 34% 140 78,512 HSBC n/a

Aabar ADSM 9-Apr-05 21Apr-05 19-Nov-05 495 Primary 1.02 135 55% 800 107,816 TNI UAE

RAK Properties ADSM 30-Mar-05 12-Apr-05 30-Oct-05 1,100 Primary 1.01 299 55% 57 17,070 NBAD GCC

Taqa ADSM 23-Jul-05 1-Aug-05 10-Sep-05 600 Secondary 1.00 163 14% n/a n/a NBAD UAE

Aramex DFM 3-Mar-05 12-Mar-05 13-Jul-05 550 Primary 1.02 150 55% 80 11,979 TNI/Shuaa All

Finance House ADSM 10-Apr-04 22-Apr-04 27-Jun-05 110 Primary 1.00 30 55% 75 2,250 TNI n/a

AGTHIA ADSM 27-Dec-04 13-Jan-05 10-May-05 294 Secondary 1.03 80 49% 8 640 HSBC/ADIC UAE

Aldar ADSM 30-Oct-04 26-Nov-04 5-Apr-05 825 Primary 1.03 225 55% 448 100,710 TNI/ADIC UAE

Arabtec DFM 14-Aug-04 23-Aug-04 5-Jan-05 220 Primary 1.01 60 55% 65 3,900 Shuaa All

Dubai Islamic Ins. DFM 19-Oct-02 31-Oct-02 20-Jul-04 3 Primary 10.30 9 55% 5 45 DIB UAE

Amlak DFM 18-Jan-04 28-Jan-04 21-Mar-04 413 Primary 1.00 112 55% 34 3,808 Shuaa All

National Gen. Ins. DFM 2001 n/a n/a n/a Primary n/a 9 55% 0.81 7 EFS n/a

Manasek OTC 1998 n/a n/a n/a Primary n/a 15 55% 6 90 TNI n/a

Int. Fish Farming ADSM 1998 n/a n/a n/a Primary n/a 45 55% 1 45 TNI n/a

Tabreed DFM 1998 n/a n/a n/a Primary n/a 75 55% 5 375 TNI n/a

AD Islamic Bank ADSM 1997 n/a n/a n/a Primary n/a 150 55% 19 2,850 TNI n/a

Oasis Int. Leasing ADSM 1997 n/a n/a n/a Primary n/a 75 55% 6 450 TNI n/a

AD Shipbuilding ADSM 1995 n/a n/a n/a Primary n/a 11 55% 5 55 TNI n/a

Total 729,735 Source: Zawya, Reuters, TNI Investment Research

*Share issue price including all issuance costs and premia

July 3, 2007 | 06

The UAE IPO process is unique

A reminder on Western IPO practise

Not all mature markets have the exact same IPO rules and procedures. For instance, there may be slight differences in the way public offerings are conducted in Europe versus the United States. However, they share the same underlying principle: the appetite and the timing for the capital raising are determined by the market. Market-defined valuation A Western company in need of capital for its growth goes to the public, asking for financing. The offering price is based on a valuation range for the company, which is proposed by the placing agent (usually an investment bank) in consultation with the issuer. Such valuation is normally based on prevailing market conditions, and on the pricing given by the market to comparable assets. Ultimately, the market may “refuse” a proposed valuation, by deciding not to bid for the asset at the offered price. Generally however, every effort is made by the issuer and its placing agent to propose an “acceptable” price range. Book-building as an offer-supply balance check Once the offering price-range is determined, the company goes to the market via a book-building process. An under-subscribed book often means that the offered price of the asset is too expensive, and vice versa. In most cases, there is room to adjust the final issue price within the range (and sometimes outside the range), after the close of the book and in response to market feedback. Timing at the issuer’s choice Throughout the process, it is understood that the issuer as well as its advisor (the placing agent or investment bank), are total masters of the timing. It is the issuer, with the advice of the investment bank, who decides when to offer the shares. The issuer is therefore entirely free to opportunistically choose the timing of his stock offering. Underwriting to mitigate risk Stock offerings may comprise total or partial underwriting, where the advising bank guarantees purchase on its books of a portion of the deal. This ensures the issuer that the underwritten portion will be taken up by the bank, regardless of market demand for the remaining portion. The bank, on the other hand, exchanges a balance sheet risk with the possibility of greater profitability. It “intermediates” the placement transaction.


“Western” IPOs are driven by offer and demand

Proposed valuation is based on the market price of, and appetite for, similar assets

Price adjustment is possible, depending on the appetite of the market

The issuer and his advisor remain masters of the timing

The U

AE

IPO

pro

cess is

uniq

ue

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Chart 1: The UAE IPO process

Source: TNI Investment Research

Note: Timings based on historical evidence and publicly available information – May be subject to change at ESCA’s discretion

Regulator approves or

rejects application and

valuation

File application with

regulator including

valuation

IPO announced in local

newspapers and

prospectus released

Subscription

opens

Subscription

closes

Shares allocated and

surplus funds returned

Company holds

first AGM for

official

incorporation

Company files listing

application with

ESCA

Publish financial

statements and board of

directors’ report in local

newspapers

Company lists on

stock market

1 – 2 months 1 – 6 months

At least

5 days Normally 10 days

(Must be between 10

and 90 days by law)

14 days (Previously 21

and 30 days)

1 week –

2 months

10 days

At company’s

discretion

Up to 3

months

Company obtains official

incorporation approval from

ESCA and economic

department

Up to 1 month

Listing application

accepted by ESCA, admin

processed and time of

listing decided

Approach

ESCA for

approval to

file

July 3, 2007 | 08


Four major differences with the “West”

The UAE IPO practise is similar to that of other Gulf countries. It bears significant differences with the West, however. Regulator-defined valuation Firstly, the valuation of a company going public has historically been approved by the Ministry of Economy, and has essentially been based on accounting value rather than an assessment of market value. This has recently changed, and the Emirates Securities and Commodities Authority (ESCA) currently allows the valuation to be determined by an accounting firm (usually one of the “Big 4”), but insists on vetting it and has the ability to impose a counter-valuation. No book-building Secondly, while there has historically been a book-building period during public offerings in the UAE, it has generally been an invitation to subscribe at the offered conditions, but not a consultation with the market. In other words, local book-buildings have seldom (if ever) aimed at fine-tuning the offered price. The assumption has naturally been that “any IPO will fly”. Indeed, until the Gulf Navigation IPO, every IPO made its issuer and subscribers substantially richer. Timing at the regulator’s choice Thirdly, while the IPO pipeline is constituted of companies filing with the ministry for floating authorisation; such authorisations have largely been at the discretion of the Ministry. In other words, the timing of the IPOs has been artificially driven, not market driven. One of the reasons why the Ministry has tried to constrain the supply of IPOs is to regulate the market – fears that multiple issues coming to market simultaneously might drag the markets lower, through a liquidity squeeze. No underwriting Finally, UAE IPOs have essentially been a direct offering exercise between the issuer and the market. This is to say that there has been no underwriting to date. Underwriting is an important missing link, because it would allow specialised institutions to intermediate the IPO process, and to share the upside and the risk. Minor differences also exist

Going deeper into the detail, one might find further particularities to UAE IPOs.

IPO valuations have been approved by the Ministry of Economy

There has been no market consultation on price

IPO timing has also been controlled by the Ministry

Underwriting is an important missing link

July 3, 2007 | 09


No sell-down of shares To date and to the exception of privatisations such the DFM IPO, no company going public has been authorised to sell down any of its shares, and the IPO has essentially been a capital raising exercise. The regulation allows companies to finance their growth, but not existing managers to take profits along the way. While this may stem from a good intention to provide stable shareholding, it also discourages entrepreneurs who are no longer free to monetise their stakes. No Greenshoe A related issue to the lack of underwriting is the inexistence of a Greenshoe, or over-allotment option. Such option is a provision which allows the underwriters to put together a stabilisation mechanism, with the agreement and participation of the issuer. Typically, 15% of the total deal size offered to investors is reserved as a supplementary capital increase to cushion strong under/over-subscriptions and their potential impact in the secondary market. Founder Shares as lock-up proxies The current UAE regulation demands, in most cases, that a company going public lists at least 55% of its capital. The remaining, privately-held 45% must belong to a special type of investors called “Founders”. The latter are meant to be core long-term shareholders, hence the regulatory lock-up on their stake, which spans two Ordinary General Meetings (OGMs) post-IPO – roughly two years. On paper, this is the equivalent of a traditional lock-up on the stakes of company insiders. In reality, founder shares constitute a separate class of shares which are tradable OTC between founders only, generally at a discount to the listed price. Becoming a founder in a UAE corporation is considered to be a privilege. However, it is unclear if such privilege is related to the status of core shareholder, or to the knowledge that such shares have generally traded at improbable premia to IPO prices (up to 22 times). IPOs that look like European privatisations

Taking a step back and looking at UAE IPOs reveals a few important takeaways:

1 The regulator defines the IPO framework and has a hands-on approach throughout the listing process;

2 The timing of the application to the money-raising exercise may correspond to a genuine corporate financial need, but the allocation of IPO authorisations by the regulatory authorities seem to be managed with wider, macro-economic objectives in mind (investor protection, market stability and proper wealth distribution);

3 The IPO pricing, which is controlled by the regulator, has empirically been verified to be significantly lower than the prevailing market

Four particularities of UAE IPOs make them resemble European privatisations

July 3, 2007 | 10


value of the asset. This has created unprecedented investment opportunities to subscribers;

4 Special tranches have traditionally given preferential allocation to UAE nationals, or to employees of the firm being taken to market. Roughly 25% of IPOs (mostly privatizations of government institutions such as DFM) had special tranches for company employees and/or civil servants. Of the IPOs open to foreign investors, one-third had preferential tranches.

With the four particularities above, UAE IPOs increasingly look like the privatisations which have historically taken place in Europe. As is generally documented, the principal aim of such privatisations is to raise money for the government while keeping in mind broad macro-economic objectives.

Historical reasons for such differences?

Multiple reasons explain the particularities of UAE IPOs:

1 The process is quite young. The first formal IPO took place in 1995 and the Commercial Law regulating IPOs dates back to 1984;

2 The UAE market characteristics during the early days of local IPOs were different from now, and much different from any Western market mechanism. They needed a specific IPO framework, which looks outdated when applied to the current markets;

3 The process currently in place has proven right until 2006. After all, every IPO was indeed flying, and everyone was making too much money to even question the process – if it ain’t broke, don’t fix it;

4 It appears that the government also sees its mission as one of proper wealth distribution, guidance and protection of minority rights. After all, this market has been largely retail driven, with most IPO subscribers to date having very little stock market or financial education. We have seen instances where some investors believed that the nominal share price provided a stock’s valuation. In other words, a stock listing at AED 3 would be understood to be more expensive than a stock listing at AED 1, hence the psychological importance of listings at AED 1.

The UAE are emerging fast and having to deal with a significant amount of change, across the board and in a very short period of time. It is difficult to implement all changes at once. However, the Great Correction is now behind us, and we have a large number of operational and regulatory modifications under our belt. The new Companies Law is under way. We feel that today is the right time to look at improvements in the IPO market. We make “recommendations for a better IPO world” at the end of this piece. But first, let’s take a closer look at the advantages and drawbacks of UAE IPOs.

Four reasons explain the difference between Western and UAE IPOs, most of them are related to the country’s history

The UAE are changing fast. It is now time to make “recommendations for a better IPO world”

July 3, 2007 | 11

SWOT of the current IPO system

We feel that the best way to understand properly the advantages and drawbacks of the UAE IPO process is to lay down a SWOT analysis (Strengths, Weaknesses, Opportunities and Threats), as per the table below.

Table 3: SWOT analysis of the UAE IPO process

Strengths Weaknesses

Protection of retail investors: The subscription and

allocation methods imposed by the regulator are favourable to retail investors.

Valuation gap: Ministry-defined valuation has resulted in

distortions to the real prices of listed assets. While this may have helped some people get richer faster, we believe this may also have provoked the bubble and ensuing correction.

Protection of banks: The regulation and lack of

underwriting has created an opportunity for banks to generate substantial profits with very little risk.

Pre-funding: The obligation by the subscriber to physically

pay the amount of his subscription to the receiving bank has created much feared “liquidity drains”, which have weighted on the markets.

Capital markets driver: The IPO boom has allowed a very

fast and significant development of UAE capital markets.

Timing uncertainty: Because the timing of issuance is

controlled by the Ministry, corporate finance needs are not being catered to in the most appropriate way. A company seeking market financing could be delayed by up to one year.

Micro-economic driver: The focus by the Ministry on

capital raising (as opposed to sell-downs) has allowed the proliferation of greenfield businesses, thus pushing renewed economic dynamism into the economy.

No sell downs: Companies are only allowed to raise new

capital and not allowed to sell down. This has often lead to overcapitalised companies.

Lower issuance fees: In the absence of underwriting,

fees to the issuer are low compared to Western practise. We believe such fees to be in the region of 1% of total deal size.

Outdated Companies Law: As explained earlier, the law

dating back to 1984 no longer captures the current market needs, and needs a long awaited overhaul.

No underwriting: The lack of underwriting means a lack of

intermediation. This translates into a skewed distribution of risk and reward, notably resulting in very high profitability to receiving banks with very little balance sheet risk.

Over-regulation: The government’s initial intent to protect

the investors has resulted in a sub-optimal process, driven by forces other than offer and demand. Those who stand most to gain are no longer the subscribers.

Opportunities Threats

Regulatory overhaul: Most of the weaknesses and threats

highlighted can be readily addressed, with the appropriate regulatory changes. We cover those in detail in the last section of the report.

Financial leverage: The leverage extended by banks is a

direct consequence of the flawed IPO process. The latter has created an economic opportunity (high profitability at low risk), in which banks are naturally engaging.

Attracting foreign institutional investors: Admittedly,

the best way to significantly enhance local market standards is to provide a sound investment platform to foreign institutions. This needs straight-forward, transparent procedures. Again, regulatory change is key.

Liquidity drain: This is a direct consequence of pre-

funding and the resulting leverage extended by banks. It creates significant, artificial volatility and constitutes a very significant threat to local markets.



July 3, 2007 | 12


The immediate SWOT analysis takeaway is that weaknesses outweigh strengths. This results in a significant volatility risk, best illustrated by the “liquidity drain” scenarios, which have been highly speculated about by the market in the past. On the other hand, the opportunity to overhaul and rationalise the process remains very much intact, and depends entirely on the regulator. We have grouped the above items into four topics, discussed below.

Going public for the wrong reasons

Corporations go public for many reasons – from gaining corporate visibility to monetising a stake, creating acquisition currency or changing ownership. The most common and obvious reason for going public, however, is to raise capital in order to finance the growth of business. In some circumstances – such as the dotcom bubble or the “UAE bubble”, companies have resorted to IPOs to raise initial capital. The purpose is no longer to finance the growth of an existing concern, but rather to finance a greenfield operation on the basis of a strong business model and economic prospects. As we have seen with the dotcom era, starting up businesses with IPOs is not a sustainable trend. Table 4 illustrates the start-up trend in the UAE. Between late 2004 and early 2006, business and stock market confidence were such that one-third to one-half of all IPOs was new ventures. We have distinguished between the “Legal” and “Commercial” definition of brown/greenfield. The former corresponds to a new legal structure hosting an already existing business. The latter corresponds to a new legal entity hosting a brand-new commercial activity. Du, the alternative mobile telecoms operator, is an unambiguous example of greenfield or start-up operation – one year after the listing of its shares on the DFM, the company was yet to launch its mobile network. Air Arabia represents a typical brownfield IPO (an existing company going to market to finance its growth). Aabar is an example of a legal start-up which acquired existing commercial assets (Delma Energy). We suspect that the unbelievable amounts raised in a very short period of time have encouraged UAE business-owners to get into “IPO mode”, regardless of the fundamental need to raise money – in other words, going public just to get rich, or richer. Since the deflation of the UAE stock market bubble, the market seems to be back to a more reasonable trend. Most of the IPOs which we have seen since mid-2006 are by companies with established businesses looking to finance the growth of their commercial operations. By early 2006, start-ups had disappeared from the IPO pipeline, mostly because the regulator had decided to prevent them from coming to market.

The most universal reason to go public is to raise capital, in order to finance the growth of an existing business

In the UAE, IPOs have been used to finance start-ups and to get rich faster

By early 2006, start-ups had disappeared from the IPO pipeline

July 3, 2007 | 13


Table 4: IPOs classified

Issuer name Subscription

period

Listing

date

Government

or private

Brownfield /

greenfield

(Legal)*

Brownfield /

greenfield

(Commercial)*

Fair value or

Book value

(Legally)

Fair value or

book value

(Commercial)

Deyaar May 07 n/a Private Brown Brown Fair Fair

Air Arabia Mar 07 n/a Government Brown Brown Fair Fair

DFM Nov 06 7-Mar-07 Government Brown Brown Fair Fair

Gulf Navigation Jul-Aug 06 7-Feb-07 Private Brown Brown Fair Fair

Arkan May-06 8-Jan-07 Government Brown Brown Fair Fair

Tamweel Feb-Mar 06 10-Jul-06 Private Brown Brown Book Book

DU Mar 06 22-Apr-06 Government Green Green Book Book

Sorouh May-Jun 05 20-Dec-05 Private Green Green Book Book

Dana Gas Sep-Oct 05 6-Dec-05 Government Green Green Book Book

Aabar Apr 05 19-Nov-05 Private Green Brown Book Book

RAK Properties Mar-Apr 05 30-Oct-05 Government Green Green Book Book

Taqa Jul-Aug 05 10-Sep-05 Government Brown Brown Fair Fair

Aramex Mar 05 13-Jul-05 Private Green Brown Book Fair

Finance House Apr 04 27-Jun-05 Private Green Green Book Book

AGTHIA Dec 04 -Jan 05 10-May-05 Government Brown Brown Fair Fair

Aldar Oct-Nov 04 5-Apr-05 Private Green Brown Book Book

Arabtec Aug 04 5-Jan-05 Private Green Brown Book Fair

Dubai Islamic Ins Oct 02 20-Jul-04 n/a n/a n/a n/a n/a

Amlak Jan 04 21-Mar-04 Private Brown Brown Fair Fair

National Gen. Ins. 2001 n/a n/a n/a n/a n/a n/a

Manasek 1998 n/a n/a n/a n/a n/a n/a

Int. Fish Farming 1998 n/a n/a n/a n/a n/a n/a

Tabreed 1998 n/a n/a n/a n/a n/a n/a

AD Islamic Bank 1997 n/a n/a n/a n/a n/a n/a

Oasis Int. Leasing 1997 n/a n/a n/a n/a n/a n/a

AD Shipbuilding 1995 n/a n/a n/a n/a n/a n/a Source: Zawya, TNI Investment Research

* Legal refers to the structure of the entity. Commercial refers to the underlying business operation. A greenfield, or new, company by

Legal standards may have no underlying business operations, in which case it is also a Commercial greenfield.

The re-distribution of private wealth

The way in which public issues are brought to market today in the UAE suggests that a re-distribution of wealth is taking place, away from micro-economic fundamentals. We understand that the initial purpose behind this was to protect individual investors. The example of Aramex

Aramex is a freight and logistics company which was incorporated in 1982. When it decided to go public in the UAE, the purpose was clearly

July 3, 2007 | 14


identified: raising money in order to engage in a far-reaching expansion program via acquisitions. However, due to the prevailing UAE regulation, the company could only sell primary shares at book value (par). This effectively allowed new shareholders to come into the capital structure of the firm at a comparable cost to that of the historic owners of the business, who had invested years of hard labour into creating value for themselves. It would have resulted in stealing hard-earned capital creation from the legitimate owners of the business, only to distribute it to the IPO subscribers. Such re-allocation of private resources is unseen, even in the most radically socialist of European countries, and was clearly unacceptable to Aramex. Ultimately a start-up was created and taken public, only to acquire the Aramex assets at market value. This is a situation where the regulator was overly concerned about protecting investors, to the point of distorting micro-economic fundamentals by forcing a re-distribution of private wealth. It sheds some light on one of the major flaws of the UAE Companies Law which regulates IPOs: by wanting to ensure a sound IPO process, the regulator has over-regulated and brought about other, more serious issues. Pre-funding and the wealth-transfer diagram

In a Western-type IPO, the wealth transfer process is very easy, and results in the company cashing-in the value of the shares it sells to subscribers. Net proceeds to the company are the result of the sale of shares at a given price, less advisory fees. Presumably, the company gets a reasonably accepted market price for the shares it sells. Chart 2: Wealth transfer during Western IPO process


Aramex is the example of a shift away from micro-economic fundamentals

By over regulating, the regulator has brought more serious issues to the market

Subscribers /

shareholders

Issuer

Investment

bank

Shares Cash

Fees

SW

OT

of th

e c

urre

nt IP

O s

yste

m

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Chart 3: Wealth transfer during UAE IPO process


Receiving

banks

Subscribers /

shareholders

Commercial banks

Investment

bank

Loan

Interest + loan repayment

Issuer

Subscription to

IPO

Over-

subscribed

funds

returned

Interest earned in money

market

IB Fees

Capital raised

Money market (money

held here for 15 – 30

days)

Subscribed

amount

Subscribed

amount +

interest

July 3, 2007 | 16


In the UAE, the process is made more complicated by pre-funding, which is the legacy system of a retail-driven financial market. It essentially stems from issuers wanting to remove any counterparty risk from defaulting retail subscribers, who initially place an order in the IPO book but do not honour the payment on due date. The consequence of pre-funding is that any subscription to a deal results in currency physically changing hands – from investors to banks to issuer, and back. In addition, when combining order-book inflation (quite a common practise to help increase allocation in hot deals) with pre-funding, the demand for leverage by investors soars. Commercial banks, which are often the same as receiving banks, will meet the demand for leverage and lend money to subscribers at a flat rate which accrues to the lending bank. In addition, the receiving banks will invest the (large) cash amount of the subscription in short term deposits over 14 days (down from 30 then 21 days), which will accrue interest to the issuer (Chart 3). The net result of pre-funding is a gigantic transaction cost to the subscriber, sometimes representing as much as half the total amount raised by the issuing corporation. We argue that if subscribers are ready to increase their subscription cost by multiples of the initial AED 1 unit price, then the issuing company is getting so much less per share on the stock it issues. This comes as a confirmation that the valuation process is flawed, and that wealth is being transferred away from the issuing corporation and subscribers, to the banks.

Risk and reward are skewed

Throughout the process, we believe that two categories of financial market participants have had to face larger risk and lower reward than they were entitled to, while two other categories have had it all good – high reward with little risk. Who are we kidding?

Corporations have lost value Corporations have issued stock at a price which was historically met by very large subscriptions. This suggests that issuers could have obtained a higher price for their stock, should they have tested market appetite beforehand. In other words, the differential between the nominal issue price and the net subscription price (after leverage costs) could have been cashed-in by corporations via a higher issue price. Instead, this wealth was transferred to lending banks and, to some extent, founders.

High leverage situations are due to the combination of pre-funding and order-book inflation

Leverage hikes subscription costs. Over-leverage is a result of a flaw in the valuation process

Corporations have lost value to banks and founders, during UAE IPOs

July 3, 2007 | 17


Today, as the ESCA allows third-party valuations by auditing firms, we continue to believe that two reasons stand in the way of corporations maximising the market price of their shares: 1/ the valuation exercise remains theoretical and is not completed by a consultation with potential investors, and 2/ the IPO process remains largely driven by the regulator rather than market forces, which may divert wealth from its normal economic destination. Subscribers have born the financial risk For historical reasons discussed earlier, public issues have mostly come to market with a nominal subscription price of AED 1. In reality, the subscription price has very seldom (if ever) been as little as that. Systematic leverage has always driven the cost much higher (as we will illustrate in the DFM case study). In addition, subscribers have run the risk of seeing the deal fare badly, with opening prices below their subscription cost. In short, we believe that the combination of pre-funding and leverage has: 1/ significantly increased subscription prices to investors, 2/ encouraged investors to take very large, undue personal financial risk, and 3/ has generally resulted in individual investors taking the risk on behalf of the lending banks, and paying for such risk. We argue that historically, individual subscribers have overpaid for their share of the IPOs. Who are we protecting?

Tons of cash for the banks Commercial banks have had a structural, natural interest in the UAE IPO business, due to the abnormally high profits historically generated to them by such stock issues. The role of banks in IPOs has been two-fold: 1/ leveraging their network by reaching to the millions of end retail investors and 2/ processing the very large number of deal subscriptions. Their other, optional role has been to lend money to individuals desperate to get a chunk of the IPO allocation. Presumably the lending business is a risky one – if your client becomes insolvent, you lose your capital. In the particular case of UAE IPOs, and considering the levels of leverage (up to 100 times), a subscriber would lose a lot on a sour deal, and the banks would consequently be risking significant capital. The trick is that lending banks have also often been receiving banks for a deal, which means they have had visibility over the IPO book. In such a case, it is easy to calibrate the aggregate level of leverage extended to subscribers, to the level of over-subscriptions – Whatever happens, you get back your capital, on aggregate!

Subscribers have overpaid and taken undue risk in UAE IPOs

Due to pre-funding, banks have been able to make a lot of money at little risk

July 3, 2007 | 18


In summary, due to the pre-funding regulation, UAE banks have been given phenomenal opportunities to make very large amounts of money from IPOs, at very little risk. The self-fulfilling prophecy of the Founders Founders have also historically been treated with financial respect. As they gained the critical status, they were guaranteed to be able to purchase up to 45% of company shares at book value, and to contribute this in kind to the IPO. The remaining 55% would be raised from the public. Thinking that they were acquiring shares at AED 1, subscribers would leverage themselves to get allocation, which would result in a higher unit cost and opening price for the shares. In fact, the more leverage is extended by the banks, the more profits founders stand to make!

Leverage is breaking the market

Leverage extended by banks has mobilised extraordinary amounts of cash during IPOs. For example, Du was 167 times over-subscribed and mobilised a total of USD 110bn. DFM, with an over-subscription of 308 times, collected USD 134bn.

Table 5: Liquidity drain

Issuer Subscription

open Subscription

close Offering size

US$ (m) Over-

subscription Total raised

US$ (m)

Arabtec 14-Aug-04 23-Aug-04 60 65 3,900

Aldar 30-Oct-04 26-Nov-04 225 448 100,710

AGTHIA 27-Dec-04 13-Jan-05 80 8 640

Aramex 3-Mar-05 12-Mar-05 150 80 11,979

RAK Properties 30-Mar-05 12-Apr-05 299 57 17,070

Aabar 9-Apr-05 21-Apr-05 135 800 107,816

Sorouh 22-May-05 6-Jun-05 375 176 65,940

Taqa 23-Jul-05 1-Aug-05 163 n/a n/a

Dana Gas 20-Sep-05 3-Oct-05 561 140 78,512

Tamweel 27-Feb-06 8-Mar-06 150 484 72,479

DU 4-Mar-06 13-Mar-06 660 167 110,207

Arkan 6-May-06 16-May-06 292 7.5 2,189

Gulf Navigation 24-Jul-06 7-Aug-06 248 3.5 868

Dubai Financial Market 12-Nov-06 23-Nov-06 436 308 134,278

Air Arabia 18-Mar-07 27-Mar-07 699 1.5 1,049

Deyaar 6-May-07 16-May-07 866 14 12,123

Total 719,760 Source: TNI Investment Research, Zawya

The more leverage, the more profits founders stand to make

July 3, 2007 | 19


Stock market participants (including individual and institutional investors, corporations and banks) have been understood to liquidate their positions shortly before a placement, in order to be able to subscribe in larger size. Consequently, the aggregate selling has created “liquidity drains” on the exchange, prior to public issues. In fact, the numbers are so large that we believe they must have had an impact on the country’s liquidity not just on the stock market. We have not seen any prior hard evidence of such liquidity drains, and have decided to test this hypothesis ourselves. To this end, we graphed the aggregate daily turnover of the ADSM and DFM, along with the index prices since July 2004. We then identified and added the IPO subscription periods and historic refunding dates of the over-subscribed amounts, for every issue which took place since mid-2004. Any evidence of liquidity drain would be verified by the simultaneous advent of the following events: 1/ a decrease in market turnover around subscription times, 2/ a dip in the market around subscription times, and 3/ a volume pickup after the refund. The result is visible in Chart 4. Liquidity drain is clearly visible

Most of the time, the conjunction of the three factors defined above has indeed taken place, making the liquidity drain easily visible on the chart. The following periods in particular, have been quite spectacular: April, May, July, and September 2005, August and December 2006. However, the most impressive in terms of market impact remains February/March 2006, when the Tamweel and Du subscription periods overlapped, causing the DFM to dip 1,034 points (-15%). In other instances, when investors felt that the potential allocation in a given deal was going to be too small, they went as far as arbitrating the liquidity drain. In other words, they would wait for a market dip subsequent to a liquidity drain. When they felt the dip had reached a satisfactory level, they would buy some of the most liquid names in the market and wait for a technical rebound, post IPO-refund. Some impressive examples of liquidity drain Next, we zoom-in on issues which have drawn particular interest, either highlighting a particularly visible liquidity squeeze, or showing a surprising lack thereof. Market impact is generally more visible on DFM than ADSM. The charts are classified by chronological order of listing. The impact on the smaller, zoom-in charts may seem less dramatic than on the larger chart due to the effect of re-basing.

Such huge leverage must have impacted the country’s liquidity, let alone the stock market

Three parameters make up a liquidity drain

The simultaneous IPOs of Du and Tamweel caused the DFM to dip by 15%

Investors went as far as arbitrating the liquidity drain

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Chart 4: UAE IPO liquidity drain analysis, July 2004 to April 2007

0

500

1,000

1,500

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Apr 07Feb 07Dec 06Oct 06Aug 06Jul 06May 06Mar 06Feb 06Dec 05Oct 05Sep 05Jul 05May 05Apr 05Feb 05Dec 04Nov 04Sep 04Jul 04

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Source: TNI Investment Research, Reuters, Zawya

Numerical Key:

1/ Arabtec, 2/ Aldar, 3/ AGTHIA, 4/Aramex, 5/ RAK Properties,

6/ Aabar, 7/ Sorouh, 8/ Taqa, 9/ Dana Gas, 10/ Tamweel,

11/ DU, 12/ Arkan, 13/ Gulf Navigation, 14/ DFM, 15/ Air Arabia

July 3, 2007 | 21


Chart 5: Aldar liquidity drain analysis Chart 6: Aabar liquidity drain analysis

0

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25 Jan 0527 Dec 041 Dec 0430 Oct 046 Oct 0413 Sep 04

AE

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m)

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Daily turnover, RHS Turnover during subscription period, RHS

DFMGI rebased, LHS ADSM, rebased, LHS

IPO refund date, RHS

Source: TNI Investment Research, Reuters, Zawya Source: TNI Investment Research, Reuters, Zawya

Chart 7: Dana Gas liquidity drain analysis Chart 8: Tamweel liquidity drain analysis

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Chart 9: Du liquidity drain analysis Chart 10: DFM liquidity drain analysis


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July 3, 2007 | 22


Some counter-examples exist Aldar was 448 times over-subscribed and mobilised over $100bn in cash. Surprisingly however, the market and turnover kept rallying throughout the subscription period, showing no sign of liquidity squeeze. Similarly, there was no visible market impact from the Aabar IPO despite its record size ($107.8bn), subscription level (800x), and the fact that it overlapped with RAK Properties (total cash subscribed of $17bn). Others like Arabtec, Aramex, Emirates Foodstuff and Mineral Water, and RAK Properties had no visible impact on the market. Generally, we notice that the first real liquidity drain impacts took place in mid-2005, towards the end of a phenomenal market rally. Hence the question of the correlation between market levels/activity and the liquidity drain issue. We conclude that liquidity drains are a reality. They are mostly created by the need for IPO pre-funding, and would be avoided in the case of post-funding. They are also more likely to happen when market sentiment is weak, therefore requiring a re-allocation of resources rather than the injection of fresh money into a new issue.

An inefficient money-raising instrument

Going public should help successful corporations raise money in order to sustain and expand their businesses. In the UAE however, the purpose has been different. In addition, government control of issuance timing has made it difficult for companies to obtain additional capital in a timely fashion when they needed it. We take a rather harsh stand on UAE IPOs and conclude the following:

1 Most companies have gone public for reasons not directly related to the micro-economic fundamentals of growing their business;

2 For the most part, IPOs have been perceived in the UAE as extra-ordinary liquidity events providing windfall profits;

3 IPOs have been somewhat inefficient as a money-raising instrument for corporate finance purposes;

4 The IPO process has been overly regulated;

5 The re-distribution of IPO wealth may have taken value away from some market players;

6 Protection of individual investors may have not worked properly. Other entities may have been better treated than retail investors;

7 Leverage and liquidity drain are the result of the regulatory pre-funding.

Not every situation has created a liquidity squeeze

Weak markets seem to be more prone to liquidity drains

At least seven reasons highlight the flaws of the UAE IPO system

It is the regulation which creates undue stock market volatility

July 3, 2007 | 23


For a long time, the UAE regulator has been directly involved in the public issues, with the Ministry of Economy approving the timing and valuation of IPOs. Recently, this power has officially been transferred to the ESCA. Although we believe the Ministry still has indirect operational input, this is definitely a step in the right direction – letting an independent authority regulate capital markets. However, this remains largely insufficient in light of the regulator’s will to make regional stock market investment more institutional. We believe that the time has now come for serious, in-depth regulation change. We make our recommendations for such change in the latter part of this report. Nonetheless, UAE IPO performance has been quite impressive to date, but also reserves some surprises to he who analyses its performance!

Regulatory change is on its way, but remains muted

In depth regulation changes are now needed

July 3, 2007 | 24

Unprecedented UAE IPO boom

Over the past few years, regional retail investors have repeatedly flown from across the GCC to the UAE, in order to subscribe in person to “hot issues”. In the short lifetime of our research department, we have come across IPO situations which seemed at best unreasonable – limitless profitability assumptions, infinite banking leverage, and crazy over-subscription rates. This has triggered our curiosity: what has IPO performance effectively been like, and what has historically been the best strategy for investing in IPOs?

Impressive performance

We have looked at the details of all IPO listings since 1995, and have calculated their performance against issue (subscription) price, over multiple periods up to one year. One major conclusion comes out of this exercise: the best, absolute performance was historically achieved by subscribing to the IPO and selling at the open, on the first day of trading. Such a strategy has historically yielded an average return across issues of 366%, nearly five times the investment – significantly above any administrative or leverage cost.

Disappointing after market

Another, less obvious conclusion, concerns the secondary life of UAE stocks. In aggregate and on average across the universe that we have analysed, IPOs have consistently been in negative performance territory for one year after listing. Chart 11: Average, absolute market and IPO performance post listing

-25%

-15%

-5%

5%

15%

25%

Market performance IPO performance

1D 1W 1M 3M 6M 1Y


Note: The performance compares each IPO’s opening price on the first day of trading to

the closing price at each period end - D Day, W Week, M Month, Y Year


It looks like the sky is the limit, but where does the limit really lie?

The best IPO performance comes from subscribing, and selling at the open

Secondary performance has been disappointing, up to one year after listing

July 3, 2007 | 25


This absolute performance snapshot is pretty bleak, particularly if one takes into account the corresponding market performance – on a relative basis, IPOs have under-performed their reference markets by up to 50%. Chart 12: Average IPO performance post listing, relative to market

-3.2%-5.0% -5.8%

-3.6%

-21.4%

-49.1%-50%

-40%

-30%

-20%

-10%

0%

1D 1W 1M 3M 6M 1Y


Note: The performance represents the aggregate average of the sample. Each sample

constituent was compared to the relevant market benchmark (ADSM or DFM).

No more steam

The main takeaway from the above is quite straight-forward: investors who fared best are the “IPO flippers” who subscribed only to sell on the first day of trading. They could also do it in large scale, since bank leverage was widely available, and would cost a fraction of the capital gains. But as the great UAE boom turned into a major bust, this translated into a significant loss of IPO steam. Chart 15 below presents all known IPOs in chronological order and appears quite explicit: since 2005, the profitability of new issues has dropped significantly and consistently.

These IPOs are for flippers, and their performance is eroding

July 3, 2007 | 26


Chart 13: IPO performance on first day of listing

46%

45%

215%

533%

583%

1500%

361%

780%

296%

459%

321%

563%

124%

194%

40%

20%

144%

0% 350% 700% 1050% 1400%

Amlak Finance

Dubai Islamic Ins.

Arabtec

Al Dar

AGTHIA

Finance House

ARAMEX

Taqa

RAK Properties

Aabar

Dana Gas

Sorouh

DU

Tamw eel

Arkan

Gulf Navigation

DFM

IPO

s b

y c

hro

no

log

ica

l o

rde

r o

f li

sti

ng

Listing in 2007

Listing in 2006

Listing in 2005

Listing in 2004


Note: Performance is the opening price on the first day of trading against the share

subscription cost (including issuance costs)

As a matter of fact, potential short term capital gains from IPOs have decreased to the point of making them dangerous: any leveraged IPO investment today runs the risk of making investors lose money. In order to illustrate this point, we have taken a closer look at the DFM IPO in the next section. Below we present for reference a table summarising both absolute and relative performances of all IPOs.

Watch out! You can now lose money with UAE IPOs

Unpre

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d U

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Table 6: Absolute and relative performance of IPOs post listing

Issuer 1 Day Abs

1 Day Rel

1 Week Abs

1 Week Rel

1 Month Abs

1 Month Rel

3 Month Abs

3 Month Rel

6 Month Abs

6 Month Rel

1 Year Abs

1 Year Rel

DFM -6% -6% -16% -14% -15% -6% 29% 23% n/a n/a n/a n/a

Gulf Navigation 6% 6% 2% 3% -3% -1% -9% -4% n/a n/a n/a n/a

Arkan -10% -8% -24% -20% -34% -29% -34% -27% n/a n/a n/a n/a

Tamweel -6% -5% 3% 4% -2% 1% 62% 50% 40% 45% n/a n/a

DU -9% -7% -12% -6% -15% 4% -26% 0% -3% 14% -22% 11%

Sorouh 0% 1% -10% -8% -9% -7% -24% -7% -43% -12% -62% -20%

Dana Gas 0% 2% 18% 21% 12% 18% -24% -5% -45% -14% -64% -17%

Aabar -10% -9% 6% 10% -9% -1% -32% -14% -51% -11% -56% -11%

RAK Properties 0% 0% -11% -13% 2% 3% -13% 0% -47% -16% -57% -21%

Taqa -10% -10% -15% -14% -32% -34% -37% -39% -61% -43% -68% -37%

ARAMEX -15% -13% -15% -13% -16% -21% 13% -15% 36% 3% -32% -5%

Finance House -10% -9% -31% -29% -34% -17% 20% 28% 9% 22% -38% 2%

AGTHIA 10% 9% -11% -10% -21% -17% -45% -26% -44% -41% -77% -36%

Al Dar 2% 3% 8% 9% 41% 30% 37% 27% -7% -6% 23% 35%

Arabtec 0% 0% 17% 13% 8% 9% 41% 5% 46% -98% 49% -137%

Dubai Islam Ins 0% 0% 10% 9% -4% -2% -8% -20% -9% -77% 26% -248%

Amlak Finance -8% -7% -28% -27% -10% -28% -1% -34% 8% -66% 68% -155%

Average -4% -3% -6% -5% -8% -6% -3% -4% -12% -21% -24% -49% Source: Reuters, Zawya

Note: Performances are measured against share opening prices on the day of listing. Relative performance is against the index of the home market.

July 3, 2007 | 28

The DFM case study

The end of easy money?

In November 2006, the long-awaited IPO of Dubai Financial Market (DFM) was initiated. At the time of the deal, visible anticipation was heightened by three factors: 1/ renewed appetite for share issues after a long period with no deals, 2/ the perceived high quality of the issuer and its belonging to the Dubai government, and 3/ the unusually large size of the deal. Sure enough, the result was an over-subscription multiple of 308 times for the general tranche. This was less than the maximum ever achieved by Aabar (800 times), but certainly a lot considering the size of the offering (AED 1,600m or USD 436m). With all this hype, the outcome was relatively unimpressive, as the stock opened at AED 2.51 and ranged between AED 2.22 and AED 2.60 on the first day of trading. Furthermore, the stock reached its lowest historical level of AED 1.89, only 8 calendar days after listing. Considering the large amounts of leverage extended by the banks in this transaction, we argue that many investors may have lost money in the deal. In our opinion, the days of easy money – characterised by systematic and significant capital gains at the IPO open – are long gone, and DFM is the most visible sign of that. Unsurprisingly, the waning of the IPO cycle has corresponded with two very interesting trends: 1/ a surge in fixed income issues to replace equity financing, and 2/ a very significant increase in regional private equity activity – moving up the value chain in order to sustain profitability.

You shouldn’t have subscribed!

Our argument, that some investors have lost money in the DFM IPO trade, is based on our understanding of the mechanic and economics of subscribing to the deal. Our analysis is limited to the public tranche (55% of the offering), and excludes the preferred tranche (including Dubai government employees, retired UAE nationals from Dubai, DFM accredited brokerage companies, DFM-listed companies and Dubai government-owned companies). Subscribing was easy

Subscribing was quite easy and in line with other, earlier company listings in the UAE. All it took, as per the prospectus, was for the subscriber to go to a receiving bank, fill a form, and submit it along with a check and passport copy. In addition, due to the high visibility of DFM, there was a record number of receiving banks (17 of them), which made it all the more easy.

The DFM case study

There was much anticipation before the DFM IPO

Over-subscription was very high, but the stock opened at relatively unimpressive levels

DFM is the most visible signal that the days of easy money are long gone

July 3, 2007 | 29

The DFM case study

The process was slightly different for someone wishing to invest with leverage, as one had to have an open account with the receiving bank. Upon acceptance of the loan, the latter was credited to the account and simultaneously debited towards the subscription. Due to the large number of receiving banks, and to the length of the subscription period from November 12 to 23, we believe the necessity to have an open account with a receiving bank did not come in the way of subscribing. The subscribed, unallocated amount was reimbursed fully on December 10, 2006 by crediting the account of the borrower with the receiving bank. Some delays to this deadline may have been experienced, where investors have subscribed indirectly through brokers, and where reimbursement checks were involved. Borrowing was easier

Receiving banks also loaned money at a negotiable, fixed rate for the duration of the deal, in this particular case one month. The lowest rate we have heard of in this transaction was a flat 35bp, although we believe a more normal rate must have been 50bp. In addition to lending subscription money, banks also offered to finance the 3% subscription fee. Table 7: Net DFM unit subscription price calculation

Item Unit Amount

Assumptions

Nominal price per share Dh 1.00

Commission per share Dh 0.03

Initial Capital Dh 1,000.00

Leverage factor x 1.00

Amount borrowed Dh 1,060.00

Cost of debt % 0.35%

Over-subscription x 308

Allocation factor % 0.32%

Calculation

Initial Capital Dh 1,000.00

+ Amount Borrowed 1,060.00

- Nominal Cost of Debt 3.71

= Capital available for investment 2,056.29

÷ Nominal price per share incl. commission 1.03

= Total shares subscribed 1,996

x Allocation 0.32%

= Total shares allocated 6.48

Banks financed generously principal and fees, at a flat rate

July 3, 2007 | 30

The DFM case study

x Nominal price per share incl. commission 1.03

+ Nominal Cost of Debt 3.71

= Nominal amount paid for my shares 10.39

÷ Total shares allocated 6.48

= Net price paid per share 1.60 Source: TNI Investment Research, DFM Prospectus

As was the case in a number of earlier IPOs, leverage ratios reached dizzying heights. In some instances, banks would lend the full subscription amount – meaning 100% financing. In our unit-price calculation illustration (Table 7), we take the example of a 1/1 leverage. We show that an individual investing AED 1,000 and borrowing the same amount against a 35bp interest rate, would achieve a net subscription price of AED 1.60 per DFM share. This, however, is not our central scenario. We believe that financing costs have averaged a higher 50bp, with leverage reaching on average a multiple of 10 times. Under such conditions, the unit subscription price rises to AED 2.48, turning the DFM IPO into a flat trade. Because readers may have other cost calculation assumptions, we have included the sensitivity table below.

Table 8: Sensitivity of DFM subscription unit-price to leverage and interest paid

Cost of leverage

0.30% 0.35% 0.40% 0.45% 0.50% 0.55% 0.60% 0.70%

1 1.52 1.60 1.68 1.77 1.85 1.93 2.01 2.18

2 1.68 1.78 1.89 2.00 2.11 2.21 2.32 2.54

3 1.75 1.87 1.99 2.11 2.24 2.36 2.48 2.72

4 1.80 1.93 2.06 2.18 2.31 2.44 2.57 2.83

5 1.83 1.96 2.10 2.23 2.37 2.50 2.63 2.90

10 1.90 2.05 2.19 2.34 2.48 2.63 2.77 3.07

20 1.94 2.09 2.24 2.40 2.55 2.70 2.86 3.16

30 1.95 2.11 2.26 2.42 2.57 2.73 2.88 3.20

50 1.97 2.12 2.28 2.44 2.59 2.75 2.91 3.22

Levera

ge, fa

cto

r o

f in

itia

l cap

ital

100 1.98 2.13 2.29 2.45 2.61 2.77 2.93 3.24 Source: TNI Investment Research

Leveraged, trading investors lost most

Clearly the best way to make money in this trade was to subscribe without leverage – but with a tiny resulting allocation, yielding insignificant nominal capital gains. Leveraged investors who have held onto their shares, may still have managed to make handsome profits as the shares currently trade above AED 3.00.

Our central scenario of 50bp financing and 10x leverage brings the DFM unit price to AED 2.48, a flat trade at best

July 3, 2007 | 31

The DFM case study

However, we argue that all in all, it would have been a better choice not to subscribe, and to pick-up the shares on the market after listing. In addition, we repeat our argument that the hey-days of “subscribe-and cash-in” are gone. In the future, cashing-in will certainly require some more investment skill. Nevertheless, the DFM IPO was a success… but for whom?

For whom the bell tolls

As discussed earlier in our SWOT Analysis, one breed of financial-market participants has historically had all the benefits. This continues to be the case, as DFM proves once more. Big bucks for the banks

Banks seem to be the big winners in this trade. Consider the numbers: the public tranche represented 680 million shares and was over-subscribed 308 times. At a net subscription price of AED 1.03, this means that AED 215bn were mobilised by local banks. If the lending multiple was 10/1 and average interest stood at 50bp, the local banks must have generated interest revenues of AED 975m in the space of one month – some USD 265m! Our most conservative estimate would place this figure at AED 600m, still a very generous amount – Too generous? Let’s look at this from another angle: interest revenues of USD 165m to 265m (depending on your scenario) represent 38% to 61% of the total size of the deal, to be split between 15 banks who are taking minimal credit risk. Now compare this to the traditional 2% to 5% investment-banking fee billed by underwriting banks, who take the stock-market risk of lodging issuer shares on their balance sheet. How much risk has such remuneration entailed? A common argument is that lending banks are often also receiving banks. As they take subscriptions from clients, they have visibility over the IPO books. Banks can therefore adjust their lending limits in real-time, in order to ensure that they are always, on aggregate, lending with no risk. We conclude that in the UAE, and more generally in the region, the remuneration of banks in the process of IPOs has been disproportionately large compared to the risk they have assumed. Such profits have led strong volatility in the financial accounts of regional banks, as the markets boomed then busted. Clearly, UAE IPO revenues generated by commercial banks have resulted in windfall profits, which by any accounting definition are unsustainable. As a matter of fact, with the advent of more reasonable deals such as the Air Arabia IPO, we are probably at the dawn of a new era – time for IPO regulation change?

Banks must have generated on aggregate AED 600m to 1bn in interest from the IPO!

Revenues to banks totalled about half the total deal size, according to us…

… and the credit risk taken was minimal. It’s time for regulation change

The D

FM

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Chart 14: DFM IPO – Timeline of events

3,600

3,700

3,800

3,900

4,000

4,100

4,200

4,300

4,400

4,500

4,600

Nov 06 Nov 06 Dec 06 Jan 07 Feb 07 Mar 07 Apr 07 May 07 Jun 07

1.7

1.9

2.1

2.3

2.5

2.7

2.9

3.1

3.3

3.5

DFM General Index DFM stock

November 12

Beginning of book-building:

Books open to

subscription

March 7

Listing

date

January 16

Constituent

General MeetingDecember 10

Allocation

announcement and

excess fund

reimbursement

November 23

End of book-

building:

Books closing

Source: TNI Investment Research, Reuters

July 3, 2007 | 33

The way forward

To date, the best year for IPOs seems to have been 2006, at arms’ length with 2005. 2006 saw six deals come to market with a very decent average size of AED 1.1bn, and the largest ever aggregate amount raised of AED 6.55bn. In reality, if we consider aggregate money raised, there does not seem to be a slowdown from the market bust. 2007 is off to a very good start, and promising to exceed the preceding year for total deal size.

Chart 15: Historical IPO pipeline, measured by the year in which funds were raised

0

2,000

4,000

6,000

8,000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007

YTD

AE

D (

m)

0

1

2

3

4

5

6

7

8

Total amount raised, LHS Number of deals, RHS

Source: TNI Investment Research, Bloomberg, Zawya

Consequences of the market slowdown

The market correction has had no visible impact on aggregate, nominal IPO activity. This may due to two factors:

1 The real GDP of the UAE continued to grow at a stunning rate of +9.7%;

2 Time management of IPOs by the regulatory authorities may play a role in smoothing out the cycle. In other words, in the absence of pipeline control by the regulator, we could have had more deals come to market in 2005 (no bottleneck), less deals in 2006, and significantly more in 2007.

Most surprisingly, the market slowdown has had retrospectively little impact on corporations. Companies not only continue to show significant growth, they are also engaging in significant outbound M&A activity, buying an increasing number of foreign assets.

The way forward

July 3, 2007 | 34

The way forward

Chart 16: UAE M&A activity

0

20,000

40,000

60,000

80,000

2001 2002 2003 2004 2005 2006 2007

AED

(m

)

Inbound Outbound

Source: Thomson Financial

We argue that the single, most visible impact of a stock market slowdown could be the significant boom of debt issuance – as companies continue to grow and the stock market loses steam, debt issuance soars. In 2006, debt issuance reached a record AED 69.7bn in the UAE.

Chart 17: Total debt raised by UAE companies and governmental bodies

0

15,000

30,000

45,000

60,000

75,000

2001 2002 2003 2004 2005 2006 2007

AED

(m

)

0

15

30

45

60

75

Amount raised, LHS Number of deals, RHS

Source: Bloomberg Note: 2007 figure is up to 23 May 2007

The contra-cyclical nature of bond issuance is best illustrated in the graph below.

Chart 18: Debt vs. equity raised by UAE institutions

0

2,000

4,000

6,000

8,000

2001 2002 2003 2004 2005 2006 2007 YTD

AED

(m

)

0

20,000

40,000

60,000

80,000

AED

(m

)

Equity issuance (IPOs), LHS Debt issuance, RHS

Source: TNI Investment Research, Bloomberg, Zawya

July 3, 2007 | 35

The way forward

The pipeline is still generous

Notwithstanding the glitches in the IPO process and the recent market correction, the IPO momentum is still good and share issuance is back in fashion. The visible IPO pipeline summarised below shows no less than 13 deals expected in 2007 alone, with another 8 being “whispered” for the same year. It is based on market talk, not on our proprietary information. Table 9: Expected IPO pipeline

Company Name Expected

Expected

Al Nahda International Education Sep-07

Al Qudra Holding Q3/07

Palm District Cooling Q4/07

Emirates Post Q4/07

Dubai Ports World Q4/07

RAK Petroleum 2007

Damas Jewellery 2007

Dubai Bank 2007

Abu Dhabi Holding 2007

International Petroleum Investment 2007

Nakheel 2007

Rasmala Investments 2007

Showtime Arabia 2007

Middle East Broadcasting 2008

Rotana Hotel Management 2008

Damac Holding 2009

Whispered

Abu Dhabi Vegetable Oil 2007

Abu Dhabi Securities Market 2007

Al Shafar Industries 2007

Crescent Standard Investment Bank 2007

DEPA United 2007

Emirates Central Cooling Systems 2007

Future Pipe Group 2007

Varkey Group 2007

Dubai Aerospace Enterprise 2008

Al Mansoori Specialized Engineering 2008

M'Sharie 2008 Source: Reuters, Zawya

July 3, 2007 | 36

The way forward

Such numbers are obviously quite aggressive, of course. In light of timing control by the regulator, and the fact that we have only seen two deals so far this year, it is unlikely that we will see as many deals as is expected by the market. However, we believe the IPO pipeline to be “fat” enough to provide for multiple more good years ahead. The recent history of this market tells us that indiscriminate, systematic subscription to IPOs will no longer provide the exceptional returns that we have seen in the past. Going forward, we believe a sound method would be to invest based on valuations and fundamentals. Finally, as we have started seeing with the more recent transactions, we are bound to see sustained, albeit more reasonable IPO activity in the future. As we progressively move from book valuation to market valuation for stock issuance, we expect to see over-subscription levels decrease significantly, and come more in-line with those of other, more mature markets.

The pipeline expected by the market provides many more years of IPO activity

There is evidence that we are moving towards more reasonable, more mature IPO practises

July 3, 2007 | 37

Seven recommendations for a “better IPO world”

The IPO process as we have known it in the UAE was probably a good one at inception. Considering the growth of the market however, this is no longer the case. Below we detail what we believe are the necessary changes to make the process more adequate for the UAE market, going forward. In particular, we aim at recommending changes which, in our opinion, will increase transparency and disclosure in order to reduce market volatility and risk to the retail investors. We are also quite eager to see market forces at play, because we believe this is a necessary step towards more efficient markets. In our previous publications about quarterly results publications, we have repeatedly recommended more, harsher regulation – in order to force corporations to comply with better disclosure requirements. When it comes to IPOs, we firmly believe that less, but more appropriate regulation is needed. Stopping the liquidity drain We believe that pre-funding combined with leverage creates market distortions, in the form of liquidity drains which increase market volatility. In order to avoid such incidence in the future, the market needs to see the occurrence of either leverage or pre-funding, but not both at once. This can be achieved by implementing one of the three solutions below:

1 Allowing pre-funding but legally restricting leverage, by imposing a legal leverage cap to banks.

2 Allowing pre-funding but ensuring flat allocations, in the purest form of European privatisations. Investors who are informed about the allocation cap will be pre-funding the deal, but will not be tempted to increase dramatically (unreasonably) their subscription.

3 Implementing post-funding, in particular by transferring any credit risk to the banks who would subscribe on behalf of their customers.

All three solutions have virtues. However, our recommendation would be to favour the third, for many reasons. Firstly, it simplifies the regulatory framework by easing the regulation. Secondly, it re-attributes more naturally the roles of economic agents. In particular, it imposes on banks to bear the credit risk, which is presumably what banks know best how to do. Thirdly and most importantly, it institutionalises the business by intermediating the market - encouraging subscriptions to be channelled through financial institutions.


As we highlighted throughout this note, more regulatory change is needed

Increased transparency and disclosure, as well as reduced volatility are a must

Less but more appropriate regulation is needed

Post-funding will stop liquidity drains, reduce volatility and institutionalise the market

July 3, 2007 | 38


Ensuring proper lock-ups Currently the lock-up on the stakes of the founders are only theoretical: on paper they last very long (two general assemblies post listing). In reality, founder shares consist in another class of shares which are effectively tradable OTC. This means that founders are by no means locked-up in the proper sense of the word. They can sell their shares at another founder, and at a discount to the market price. In addition, there is no disclosure requirement when a founder sells his/her stake, which makes it difficult to monitor insider trading. We recommend implementing a proper, shorter lock-up which will prohibit original shareholders of the business to sell before the expiration of a specific period. In addition, such shareholders would own regular shares, and would need to comply with strict disclosure rules. Authorising sell-downs It is currently impossible for owners of a business to sell any of their existing shares during an IPO process. Rather, IPOs are reserved for capital increases. This severely restricts the purpose of an IPO, as well as the profitability opportunities for local entrepreneurs. Allowing sell-downs means business owners can monetise some of the value they have added over the years, thus allowing a fairer allocation of private resources. In addition, allowing existing shareholders to sell down a portion of their stake would mean allowing a mix during the IPO, between the issuance of primary shares and the selling of secondary shares. Because IPOs today are systematically (and by law) constituted of a 55% capital increase, this has inflated deal sizes beyond the real financing needs of corporations. Allowing existing shareholders to sell down would therefore mechanically and significantly reduce the average IPO size, and increase proportionately the number of deals. Finally, it would allow companies to be appropriately capitalised, as opposed to the current status of structural over-capitalisation. Decreasing the minimum allowed free-float This is a topic which has been discussed and rumoured for some time, as it is expected that the new Companies Law will allow private companies to sell a minimum, minority stake of 30% as opposed to the current 55%. This has not yet transpired formally into the regulation, however. The reason why this is important is because many businesses need raise capital in order to finance their growth, but few are willing to give up majority control. Reducing the minimum float would encourage more businesses to come to market, thus participating in greater depth, breadth – and ultimately liquidity – for the market.

Founder’s shares are inefficient lock-up proxies. Proper lock-ups are required

Sell-downs would allow to reduce the size of deals and increase their number

They would also allow more appropriate capitalisation

Less stringent free-float restrictions would increase market depth

July 3, 2007 | 39


Allowing underwriting In an effort to impose more institutionalisation, we believe the regulator should impose underwriting. This would allow intermediating the market. In other words, it would force a professional intermediary to step-in between the investor and the issuer, namely investment banks. On the face of it, this would probably increase the cost to the issuer by way of higher fees. In reality, it would allow the issuer to obtain a more relevant issue price for his stock than is currently the case – raise money under better terms. The net impact, in our opinion, would be positive for corporations. It would also allow a better pricing of market risk (by professionals) and increased consultation with investors. Ultimately, the price as well as the risk/reward ratio would make more sense to everyone. Book-building with value-added Current book-building simply allows potential investors to walk to the bank and subscribe to a given public issue. Such public issue is generally offered at a fixed, non-negotiable price. We are advocates of price ranges and market consultation, which allow the issuer to test the market for a given price. Such a practise often results in adjustments to price ranges (up or down, either within or outside a range). It also allows the issuer to gain a certain degree of confidence, and to minimise mis-pricing mistakes. In our opinion, this practise will inevitably become necessary, as the market matures. It also requires more institutionalisation and market intermediation – while it may be feasible to get feedback from institutional investors, it is difficult to obtain the same from retail investors. Pre-filing should be done by the banks One detail in the IPO process consists in pre-filing with the regulator. It consists in providing basic preliminary information, for the regulator to make an early due-diligence and approve the file. We believe this process consists in filtering the deals, in order to ensure a sufficient level of quality and a minimal level of risk for the investors. As the market becomes more institutional in nature, we believe that the regulator will be able – to some extent – to delegate this task to the financial intermediary. After all, why not provide minimum requirements for investor protection and let the banks take the risk of choosing and advising the issuer. If the banks make good choices of issuers and pricing, their deals will fly. Otherwise, they will be punished by the market.

Underwriting should be imposed, in order to improve deal pricing as well as the risk/reward of market participants

Book-building also allows better pricing of deals

Banks would take a load off the regulator by being given the responsibility to screen their own deals

The National Investor TNI Tower, Zayed the 1

st Street, Khalidiya

P.O. Box 47435 – Abu Dhabi, UAE T: +971 2 619 2300 F: +971 2 619 2400

www.tni.ae

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IPO in UAE