CORPORATE FINANCE REVIEW

By Salman Shoaib,Shoaib Capital
Nov 16 - 22, 1996

The weak level of corporate finance activity in l995 was carried over into 1996. The continued fall in equity markets was indicative of overall sentiment towards corporate funding, hitting levels approximately 50% below the high of 2661 in 1994. To-date, there have been no internationally listed issues by corporates during 1996, nor have there been any substantial domesticallylisted international equity placements.

The poor performance of equity market can largely be attributed to the weak macroeconomic picture. Concerns over the budget deficit and inflation led to a postponement in disbursement of IMF funding which appears to have been restored only recently. The tough "minibudget" announcing greater taxation, lower government spending and a large devaluation was not a surprise, and is a price to be paid for past excesses. Our view is that these measures were "bitter medicine" required in order to provide a basis for improved economic fundamentals; whether they would be worthwhile depends upon the future performance of both the government and the private sector.

The domestic market

The domestic market for large wholesale corporate finance transactions remained shallow. The development of the local investment market has again been hampered by the poor stock market performance, and has limited corporates' access to funding at a time when international investor interest in Pakistan is low.

There are a variety of reasons for the continued lack of depth in the domestic market. The portfolios of domestic investors have suffered considerably since the market decline began: many have stopped new investment and are in the process of reducing the size of their portfolios. Although pension/provident funds were permitted to invest in the market, it will take some time for them to build up sizeable portfolios; this process has been further held back by the prevailing economic uncertainty since permission was granted In 1995. Also, mutual fund market remains under pressure. Many private sector mutual funds have underperformed in the market, resulting in investor scepticism.

All this means that corporates are unable to tap domestic investors in lieu of international investors when foreign interest is low. It also means that foreign investors are more hesitant to take large positions in domesticallylisted instruments. Though the government has taken various measures to increase the availability of funds to the market, they have been academic in the absence of confidence in the economy and in the performance of companies.

The international market

The lack of international issuance during the year can be attributed to a range of factors. The poor market performance has shifted investor focus from Pakistan to other regional markets. Growth remains strong in the Asian economies; Indonesia, Malaysia, Thailand, India and China are growing at between 710%. The size of these economies coupled with continued strong macroeconomic performance means that investors have many alternatives when Pakistan is not performing.

Further, it is worth highlighting that international investors prefer investing in larger, more liquid issues. Currently, there are only 6 companies with a market capitalization exceeding US$ 250 million and 11 companies over US$ 100 million, down from 10 and 22 a year ago.

Also, many international investors have suffered large capital losses since investing in the market. The main issue here remains that of PTC which was originally purchased by hundreds of fund investors, many of whom were investing in Pakistan for the first time. US dollar investors in the second tranche have lost more than 50% of the value of the investment at PTC's current market price.

Greenfields corporates' demand for funding

Corporates have generally been unwilling to approach the market in its current condition. Sponsors of companies generally value their equity at a much higher price than the market, therefore there is a perception that issues of equity to outside investors at prevailing rates will dilute earnings. In addition, many companies have been hesitant to invest in new projects given the prevailing macroeconomic uncertainty, therefore funding requirements have been reduced.

There has, however, been some degree of activity in setting up greenfield projects in sectors including cement, fertilizer and oil refining. Some of these have even come to the market, but have met with limited success. We believe that international and local investors' appetite for this type of project will remain limited, particularly due to the performance of already listed greenfields.

The power sector an exception

A number of IPPs totalling around 3000 MW in capacity have achieved or are expected to achieve financial close. Investor demand for debt and equity investment in these projects has remained robust, largely due to the government's private power policy. The guarantees provided on tariffs and fuel supply along with taxation and other benefits have acted to reduce market risk and increase projected return.

Our view is that without GoP guarantees the majority of these projects could not have been funded which at least partially explains the performance of this sector in comparison with others. Note, however, that domestic equity investors remain cautious. Other than Hubco, the remaining three listed IPPs trade at around issue price, and the recent public issue by Japan Power generation was only 3.9% subscribed.

Privatization and corporate finance activity

The programme has moved along at a reasonable pace, and a number of major privatisations are expected during the coming year including PTC, KESC, SNGPL and SSGC, and a number of generation units supported by IPPs. The completion of major privatisations is likely to boost corporate finance activity as many companies due for privatisation have large capital expenditure requirements, and they will become more financeable once they are under the control of private strategic investors. Strategic investors are also more likely to search for new investment opportunities which still further increase funding requirements. Further, the GoP will have large residual shareholdings in most of these companies: and is expected to dispose of shares through the local and international capital markets.

We expect privatisation to gather steam during the next few months, as there appears to be a strong reaffirmation of commitment to the process. The capital markets' reaction to newly privatized entities is yet to be tested, but expectations are that investors will be considerably more enthusiastic under new ownership.

Expectations for the coming year

Our view is that corporate finance activity is currently at a crossroads. The period of decline has been considerable (over two years) but it appears that economic problems have been recognised, and certain steps taken towards resolution. Since activity is closely linked to market performance, we expect volumes to track macroeconomic fundamentals.

It is essential that Pakistani companies continue to have access to the international markets through GDR, convertible and debt issuance. The lack of depth in local markets (which we expect to last for some time) means that large fundings require international participation, and these will be essential in facilitating the setup or expansion of industrial and service companies. If economic managers and businessmen are able to take advantage of recent tough measures to improve economic performance and avoid errors of the past, Pakistani corporates may become much more financeable in 1997. However, this will necessitate an improvement in economic management by the government and project management by the private sector.