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A. Market Overview

  The UAE equity markets are a fairly recent development. Until 2000, stocks were traded over an un-regulated over-the-counter market. In May and November 2000, the Dubai Financial Market (DFM) and Abu Dhabi Securities Market (ADSM) began trading. Existing over-the counter stocks were gradually transitioned to the formal exchanges. Stock market performance has been nothing short of spectacular and value traded has increased substantially.

B. History of IPOs

  The first IPO on an organized exchange, Dubai Islamic Insurance and Re-Insurance ("Aman"), occurred in October 2002. Since that time, the pace and size of IPOs has increased substantially and is expected to increase further as can be seen from Figure 3, despite recent measures taken by the authorities to slow the flow of new companies coming to market. The amount to be raised at IPO in 2H2005 that has been publicly disclosed amounts to 2% respectively of the existing combined estimated free float market capitalization of the DFM and ADSM.

  As the stock market has risen and IPOs have performed, so the level of interest on the part ofretail investors has increased substantially. This behavior is typical of a bull market environment.

  As issues have become progressively more over-subscribed, so investors have borrowed to improve their allocation of shares. As more investors have borrowed, so the level of oversubscription has risen, forcing investors into a vicious circle of borrowing even more so as to obtain a decent absolute allocation.

  Three benchmark IPOs have been Addar, Agthia and Aabar. After the Addar IPO, which saw oversubscription of 450x, the UAE authorities imposed limits on the maximum permissible leverage accorded to investors. Agthia, which came after Addar, was the first IPO to guarantee a minimum allocation to retail investors. As a result, the number of subscribers rose significantly and oversubscription declined significantly. Aabar was important because the return to high levels of oversubscription led the authorities to impose quantitative limits (i.e. a maximum AED amount to be lent per bank) on margin lending at banks.

C. Cost of Entry into IPOs

  The need to borrow so as to obtain a reasonable allocation at IPO imposes a high cost on investors, especially given that only a very small fraction of the amount being subscribed to is likely to be allocated. We have estimated this cost for each of the IPOs that has been carried out to date.

  i) Our assumptions are as follows: i) An equity capital amount of AED100,000. It is important to specify this as later offerings guaranteed a minimum allocation to retail investors.

  ii) Cost of bank funding of 5.5% per annum and a loan arrangement fee of 1.0%. Here it is important to bear in mind that as there is more than one bank at which investors can subscribe to shares and borrow and competition between banks has meant that interest rates have tended to decline with loan size in later IPOs.

  iii) An opportunity cost for the equity portion of approximately 1.5% reflecting the interest foregone on a time deposit.

  iv) Subscription at the end of the subscription period rather than at the beginning, thereby minimizing both the opportunity cost and the interest due on any loan.

  We calculate the estimated cost as a percentage of the value of the eventual allocation given the above assumptions.

D. Returns on IPOs

  While the cost of entry is high, this has been more than compensated in almost all cases by the performance of the stocks from the first day of issue onwards, as is illustrated in Figure 1.

  While subscribers to the earlier IPOs had to wait almost two years from the end of the subscription period to listing, subscribers to the four most recent IPOs have had to wait between 91 and 134 days between the close of the IPO and the listing of their shares. An active grey market has provided liquidity in the interim.

E. Valuation of companies coming to IPO

  Companies issuing their shares on the exchange have to comply with regulations of the Emirates Securities and Commodities Authority (ESCA). There are currently two ways for the shareholders of an existing company ("Old Co") to bring it to market:

  i) They can establish a new Public Joint Stock Company (PJSC or "New Co"). New Co can then acquire the assets of Old Co prior to the IPO with New Co stock as consideration. A valuation committee is appointed by the Ministry of Economics and Planning to compare the valuation of the company and goodwill relative to Book Value historically. The "un-written" rule is that valuation should not exceed 1.5x book value.

  ii) They can establish a New Co. that would acquire the LLC for cash post-IPO. The ministry requires a report to validate the valuation of "Old Co" at acquisition. There is no regulation/restriction regarding valuation under this structure.

  Furthermore, under the current regulations, the shares in the New Co must be offered to investors at par, and a minimum of 55% of paid in capital should be offered at the IPO. However, according to the new law which is expected to be implemented at some point in 2H2005, companies will no longer be obliged i) to offer a minimum of 55% of paid-in capital at IPO or ii) to create a new company for the purpose of listing.

  Part of the reason that there has been such intense interest in IPOs is that they have been priced, on the whole, at valuations that are markedly below the prevailing market valuations, as is illustrated in Figure 8. Furthermore, there seems to have been a difference between the valuations of private sector companies and public sector companies being brought to market, with public companies being offered at lower multiples. Lower than market valuations for IPOs have helped to fuel jumps in share prices on the first day of trading and sustain them thereafter, as was illustrated in Figure 2.

F. Sensitivity of IPO Returns

  In this section, we examine the sensitivity of IPO returns to leverage employed by investors. We find that there have been increasing returns to utilizing higher levels of leverage, especially before the Agthia offering, when offerings did not provide a minimum allocation to retail investors. Minimum allocations to retail investors have reduced the proportionate allocation to investors subscribing to more than the minimum amount.

G. Inefficiencies of the Current System

  As we discussed earlier, the fact that a UAE company has to list at a “ reasonable” valuation has led to tremendous demand and oversubscription. The pro-ration of subscriptions has led to an incentive to over-subscribe and with the banks being more than willing to lend, a competitive dynamic among investors has led to increasing and ultimately massive levels of loanfinanced oversubscription. As a result, a portion of the discount to market value has gone to the banks as arrangement fees, interest and zero cost deposits (although, as a result of competition, banks have started to pay interest). The impact has been significant on banks' financial performance with a tremendous rise in non-interest income.

  Ultimately, the current IPO system is inefficient with companies unable to price their shares in line with the market and investors having to pay high transaction costs so as to obtain a reasonable allocation. The authorities are in the process of tackling both inefficiencies, first by not imposing onerous terms on issuers and second by imposing limits on leverage provided by banks so as to reduce subscription costs for investors. 


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