On the rebound: The prospects are bright after a tough year in 2011

After outperforming many of its peers in 2010, the İMKB Borsa Istanbul (İMKB), had a challenging year in 2011. While bourses in many emerging markets declined, Turkey was particularly hard hit, mostly due to its weakening currency and the country’s exposure to the eurozone. Capital markets in Turkey remain among the most liquid in the region but are still underdeveloped and an underutilised source of financing for local businesses. However, the government has taken steps to expand the financial markets, encouraging initial public offerings and making legal changes to boost issuance of corporate bonds. Moreover, the sector’s regulator – the Capital Markets Board (CMB) – has implemented new rules that are likely to increase confidence in the market and attract investors.

SIZE & STRUCTURE: The İMKB has four main components: the stock market, the emerging companies market (ECM), the bonds and bills market, and the foreign securities market. The stock market is made up of several different sub-categories: the national market; the collective products market, including real estate investment trusts (REITs); the fund market, where exchange-traded funds (ETFs) and certain types of mutual funds are traded; the second national market, which lists small and medium-sized enterprises (SMEs) as well as companies that have been temporarily or permanently delisted from the national market; and the watchlist companies market. In January 2012 there were 244 businesses traded on the national market, 53 for the collective market, 63 on the second national market and 11 on the watchlist market. Total market capitalisation at the end of March 2012 was TL435.4bn (€185bn). The national market covers a range of sectors, with banks alone accounting for 34% of total capitalisation as of January 2012, followed by manufacturing at 27%. Most listings are small cap companies with market values of less than $1bn. The larger stocks include telecoms providers Turkcell and Türk Telekom, several banks (Akbank, Garanti Bank, Denizbank, Finansbank, Halkbank, I ş bank, Vakıfbank and Yapı Kredi), drinks manufacturer Anadolu Efes, oil refinery Tüpra ş , steel company Ere ğ li Demir Çelik, white goods producer Arçelik, construction firm Enka n ş aat and two holding companies (Koç and Sabancı).

BOURSE OWNERSHIP: At present, the İMKB, which was established in 1985, is a public corporation that operates as an autonomous institution. However, the government has signalled its intention to make the bourse a joint-stock company, possibly as a first step towards privatisation. Privatising it would make it more efficient and be beneficial to its members, Ay ş e Çolak, assistant general manager of Tera Brokers, told OBG.

Recent legal changes, implemented in January 2012, have altered the structure of the board of directors at the İMKB, increasing the number of members from five to seven, with four directors appointed by the government. While some members of the exchange have publicly expressed concern regarding the new composition, proponents of the law have said that it could hasten the privatisation process. While no target date for privatisation has been set, in January 2012 Deputy Prime Minister Ali Babacan told journalists that the necessary legal framework would be finalised before the summer and that any public offering for the exchange would depend on market conditions.

PERFORMANCE: Turkey’s stellar economic growth in 2010 helped the performance of the country’s bourse. The İMKB 100, the stock exchange’s main index, rose sharply in 2010 as the economy strongly rebounded from the global crisis. GDP increased by 8.9% that year, making it the second-fastest-growing economy among the G20 countries. The return on the İMKB 100 in 2010 was 21% as measured in dollar terms, compared to 16% growth in the MSCI emerging markets index, which covers 21 countries. The İMKB 100 hit an all-time closing high that year, reaching 71,543.3 on November 9, 2010. While the İMKB 100 climbed during the first several months of 2011, it fell steadily through the second half of 2011, ending the year down 22% (in lira terms) from December 2010, at 51,266.62. In dollar terms, the index declined by 35%. One possible explanation is that foreign investors pulled out of emerging markets across the board in light of economic challenges in their home countries, but the İMKB in fact underperformed the MSCI emerging markets index in 2011, which fell by 20.6%.

CHALLENGES: Several reasons have been suggested for the challenges faced by Turkey’s equities markets in 2011. First, sovereign debt troubles in the eurozone had a potentially larger economic impact on the country than they did on its emerging markets peers. European banks are a significant source of funding for Turkish businesses, and there was concern that, as they pulled out of emerging markets to meet their capital requirements, this could have had a negative effect on local companies. Moreover, Europe is major destination for Turkish goods, accounting for nearly half of the country’s exports in 2010 and 2011. However, as Cüneyt Demirgüre ş , the head of Turkish equity research at UniCredit, told OBG, even if total demand in Europe was shrinking, market share for Turkey’s exports actually increased as consumers turned to less expensive products coming from Turkey.

Another factor that may have discouraged foreign investors and softened the market in 2011 was increasing concern regarding Turkey’s growing current account deficit, which stood at nearly 8% of GDP in March 2011, 9% in June and almost 10% by September. With the economy largely dependent on external borrowing, investors may have shied away from Turkey for fear of a sudden stop in capital flows, a challenge that other emerging markets have faced.

However, it was the central bank’s response to the current account deficit that was perhaps the single most likely explanation for the fall in the İMKB 100 in 2011. Starting in late 2010, the Central Bank of the Republic of Turkey (CBRT) began to lower the policy interest rate to curb hot money inflows that were being used by banks to fund consumer lending, pushing up demand for imported goods. The result of this policy was, not surprisingly, a weakening of the lira, which continued to fall throughout most of 2011. This had several effects on publicly listed companies. Some, particularly in the industrial sector, carry unhedged short foreign exchange positions, exposing their balance sheets to a weaker lira. Moreover, a decline in the lira discouraged foreign investors, who would rather not hold assets in a currency that is losing strength. The departure of foreign investors can be seen in the change of their share of the market’s free float, which declined from 66.2% at year-end 2010 to 61.9% as of December 2011.

BANKS: Finally, to understand the performance of the İMKB 100 in the past few years, it is important to remember that banks account for 34% of the market cap. Therefore, to the extent that they do well – or not – this can have an impact on the market as a whole. While lending volumes at banks increased significantly over 2010 and 2011, their profitability declined (see Banking chapter). According to the IMF’s Article IV staff report for Turkey, published in January 2012, the banking sector’s return on equity and return on assets have steadily fallen since 2009, standing at 13.6% and 1.6% as of August 2011, respectively.

This trend occurred for several reasons. Banks experienced windfall profits in 2009, as the central bank reduced the policy rate by 10 percentage points between November 2008 and November 2009. Because banks hold significant portfolios of government bonds, this immediately widened their interest margins. However, from 2010 to mid-2011, bank margins steadily fell, as the central bank took steps to increase funding costs to the banks to slow the growth in credit, and competition for loans kept lending rates low, particularly during the first half of 2011.

MARKET EXPANSION: Lenders are not only an important component of the stock exchange, they also far outweigh capital markets in terms of their importance in financing the economy. As the World Bank wrote in a March 2012 report on domestic savings in Turkey, “A unique feature of Turkish financial markets is the absolute dominance of the banking system.”

The relatively small role of the İMKB is underscored by the World Bank’s ranking of countries by market capitalisation as a percentage of GDP. In 2010, Turkey, at 42%, scored quite low compared not only to more developed economies, but also to emerging markets. The average among OECD countries was around 90% in 2010, while Brazil (74%), India (93%) and Russia (68%) also all ranked higher than Turkey.

There are several explanations for the small size of the İMKB relative to the country’s GDP and Turkey’s capital markets more generally, most of which have to do with the limited role of domestic investors. First, the stock market has historically been volatile, at the very least discouraging local investors who might have a lower appetite for risk than their foreign counterparts. Moreover, in the past, the rate of return on bank deposit accounts and government bonds was high and essentially zero-risk. For this reason, domestic investors largely avoided equities funds, Mehmet Gerz, the chief investment officer of ATA Asset Management, told OBG. He noted that as long as interest rates stay above 7.5%, domestic investors will likely remain the minority in their own stock market.

PENSIONS: Finally, large institutional investors such as pension funds that might provide a mechanism for savings to be channelled into equities and corporate bond markets remain underdeveloped in Turkey. However, this is changing, as pension funds continue to become more popular, in part thanks to policy changes. In April 2012 the government announced new rules for the private pension system that should encourage higher rates of participation. The government will now match 25% of individual contributions to pension funds, replacing a previous set of incentives that involved tax breaks on contributions (see Insurance chapter). This should encourage private savings that can be directed, at least in part, towards the equities market. In another step designed to increase savings, the government also said in April that gains from investments in mutual funds would no longer be subject to a 10% withholding tax, as long as equities account for at least 75% of the mutual fund’s assets.

These changes are the latest manifestations of a shift in the government’s focus, as policymakers have turned their attention to increasing the domestic savings rate in response to a growing current account deficit that has been financed by foreign capital flows. As Vedat Akgiray, the chairman of the CMB, told OBG, “Capital markets should be a major source of financing. We are trying to do everything to make sure that they grow healthily and fast enough to catch up with the world.” This process should help transform Turkey from a bank credit-based to a capital market-based economy, which will likely enhance productivity growth.

IPOS: One way in which the authorities have tried to hasten the expansion of the İMKB is by boosting awareness of IPOs and making it easier to list on the bourse. Despite the fact that the equities market represents an opportunity for low-cost financing, many large companies in Turkey are not listed. From the list of the top 1000 Turkish companies, as compiled by the Istanbul Chamber of Industry, 414 of the largest 500 businesses are not listed. Similarly, for the next 500, 459 are not currently publicly traded.

To address this challenge, in 2008 the İMKB, the CMB, the Union of Chambers and Commodity Exchanges of Turkey, and the Association of Capital Market Intermediary Institutions of Turkey launched the IPO Campaign. Within the context of the campaign, summits were held in Istanbul and Bursa, and various seminars were organised in different cities. Changes were also made to the İMKB listing regulations, reducing the restrictions on profitability, minimum capital requirements and free-float ratio. The İMKB also discounted initial listing fees. For example, for firms with a minimum free-float rate of 25% and free-float market cap of at least TL100m (€42.5m), these charges have been reduced by 25% until the end of 2012.

Perhaps as a result of these efforts, the number of IPOs has jumped in recent years, with 22 new companies and three ETFs starting to trade on the İMKB Stock Market during 2010, compared to an average of six IPOs per year between 2001 and 2009. During 2010, six of the 22 IPOs involved REITs, including Emlak Konut REIT’s offering, which was the largest IPO of the year and the fifth-largest in the bourse’s history. During 2011, an additional 27 companies went public, mostly in the first half of the year when the market was stronger. Major IPOs included the Akfen REIT in May 2011, with 54.12m shares offered to the public and a free float of 29.4%. The longer-term goal is to have 1000 companies listed on the İMKB by 2023.

Looking ahead, additional listings could come from state-owned or formerly state-owned enterprises that have already been privatised. The energy minister, Taner Yıldız, announced in mid-August 2011 that the government intended to start work on an IPO for state oil and gas exploration firm Türkiye Petrolleri in 2012. Adding already-privatised entities, which include some energy interests and the country’s ports, to the bourse could also boost the İMKB, Hüsnü Özye ğ in, chairman of Fiba Holding, told the local press in December 2011, noting that listing privatised energy firms would increase the İMKB’s size by nearly 25%. The İMKB has also taken steps to encourage the listing of SMEs by establishing the ECM, which enables businesses with growth potential to raise funds easily and at a low cost. The listing requirements of the ECM, which has been active since January 2011, are less stringent than those of the national market. The latter requires businesses to have three years of audited financials and profits for one to two years, plus minimum requirements regarding free-float and market cap. Fees for listing on the ECM are much lower, at around one-tenth of those for other İMKB markets. In late 2011 there were two SMEs traded on the ECM, with additional applications under evaluation.

DERIVATIVES TRADING: An additional way in which activity on the İMKB could be increased would be to add derivatives such as futures and options, which are not currently available on the bourse. In December 2011 the then-CEO of the İMKB, Hüseyin Erkan, told OBG that the exchange would be introducing options on individual equities as soon as they received regulatory approval, with trading options on the İMKB indices to be added later. At present, the only exchange for trading derivatives in Turkey is the Turkish Derivatives Exchange, (TurkDEX). Futures contracts currently traded at TurkDEX include equity indices (eg, İMKB 100 Index, İMKB 30 Index), interest rates, currency (eg, lira/dollar, lira/euro), commodities (eg, cotton, wheat) and energy. By far the most heavily traded contracts are equity index futures, which accounted for 91% of volume in 2011. However, currency futures trading picked up substantially in 2011 due to volatility in the lira. Energy futures, which were introduced in 2011, could be an important product going forward. TurkDEX expects to add the trading of options by the end of 2012; it is awaiting regulatory approval to do so.

Foreign investors accounted for around 15% of trading volume in 2011. This percentage has stayed fairly constant since trading started on TurkDEX in 2005, although it did decline in 2008 and 2009, most likely as a result of the global financial crisis.

While this figure may seem low, foreign investors are larger in terms of open positions, as domestic investors trade more frequently. The primary purpose of the exchange is to provide risk management tools for domestic companies. To this end, TurkDEX personnel work with real economy companies as well as visit universities to teach market participants about the derivatives market.

MINORITY SHAREHOLDERS: While reducing free-float ratio requirements may encourage more firms to list, it could also discourage investors, particularly large foreign institutional investors, from purchasing equities on the İMKB. If only a small portion of the company – say 15% – is offered, this can mean that owners of publicly traded shares have little say over the management of the company.

The protection of minority shareholder rights has been widely discussed in 2011, in part due to an ongoing shareholder dispute at Turkcell, the country’s largest mobile phone operator. In October 2011 Murat Vargı, a founder and minority shareholder in the company, called for the resignation of Turkcell’s existing seven-member board of directors, subsequently telling Bloomberg in an interview that four independent board members should be appointed to ensure the protection of minority shareholder rights.

Recent legal changes could go some way towards alleviating foreign investor concerns when it comes to minority shareholder rights, particularly with respect to the appointment of independent directors. According to a decree issued by the CMB on October 11, 2011, for all İMKB National-30 Index companies (excluding banks), the “number of independent directors should be defined in line with free-float rate of the company”. Moreover, this number must be at least two and equivalent to at least one-third of the board members. However, if the free-float rate is above 50%, the number of independent directors need not exceed half the total number of board members. In addition, the role of the independent members was strengthened.

According to the decree, any “significant” decisions (for example the sale or purchase of material tangible assets, or delisting decisions) must be made in the presence of independent members.

While these changes seemed reasonable and brought the Turkish stock exchange into line with market regulations around the world, one element of the decree was met with less positive reaction, namely the fact that independent directors would have to be approved by the CMB, or at least this was how the regulation was initially interpreted.

However, in February 2012, the regulator clarified the rules, noting that the CMB would review appointments only to verify that they met the criteria for independence. For example, appointed independent members could not have worked as an auditor for the company in the prior five years. Rules such as this can help ensure that independent directors represent the interests of smaller shareholders and are not beholden to company management.

FIXED-INCOME: While the stock market represents one option for companies seeking financing, an alternative in many well-developed capital markets is to offer corporate bonds. However, the issuance of lira-denominated corporate debt in Turkey has been limited over the past decade, partly because in the past government borrowing may well have crowded out private sector bonds. According to an April 2011 presentation by the World Bank, government securities accounted for 99.8% of outstanding bonds in Turkey in 2011, compared to 65% in Brazil, 48% in Malaysia and 58% in Mexico. However, as the government has brought its fiscal deficit under control over the last few years and interest rates have declined, corporate bonds have gained momentum, with outstanding value growing from less than TL200m (€85m) in 2006 to more than TL2.5bn (€1.1bn) in 2010.

The market received a boost in October 2010, when the banking regulator announced that lenders would be able to issue lira-denominated bonds. Several have since floated local bonds, including Akbank, Garanti Bank, ş bank and Finansbank. In January 2012 Akbank sold TL650m (€276m) in lira-denominated bonds at an 11.6% yield, followed a week later by Garanti’s sale of TL1bn (€425m) in local bonds at 11%. The government has taken several other steps in recent years to encourage corporate debt issuance, including lowering transaction costs, removing tax distortions and reducing the costs of trading in the secondary market. In January 2012 Erdem Ba ş çı, the governor of the CBRT, told Bloomberg that promoting the market for corporate debt is a priority for the government.

According to Çolak of Tera Brokers, the market for corporate bond issuance has significant potential and is going to “boom”. A study from the World Bank has projected the market could grow as large as $70bn assuming that just 50% of foreign currency loans were refinanced using local currency fixed-income instruments. For potential issuers of bonds, the benefits include longer maturity periods vis-à-vis loans, and collateral is not required. From the perspective of investors, corporate bonds are attractive because they offer a better return than government debt and are less risky than equities. However, one factor that could constrain growth in this area is the limited amount of secondary trading, but this is expected to improve as sales increase.

ISLAMIC FINANCE: Islamic financial services are still fairly limited in Turkey, although there are several participation banks, as sharia-compliant lenders are known locally. While historically they have relied on deposits to fund their lending activity, these banks have started to sell sukuks, or Islamic bonds, as an alternative. Sukuk issuance has been allowed in Turkey only since April 2010, when the CMB promulgated a new rule regarding “leasing certificates”, as sukuks are called in Turkey. Legislation was subsequently amended in early 2011 such that the tax structure for Islamic debt has been brought into line with the rules applied to conventional bonds (see analysis).

As of March 2012, only one participation bank, Kuveyt Türk, had issued sukuks, tapping global capital markets in August 2010 with a three-year, $100m sukuk, followed by five-year, $350m Islamic bond in October 2011. Two other Turkish participation banks – Bank Al Baraka and Bank Asya – had signalled their intention to sell Islamic bonds, but in late 2011 both lenders announced that they were putting these plans on hold until market conditions improved.

One factor that could encourage more activity in the Islamic finance sector would be the issuance of a sukuk by the Turkish government, as it would provide a benchmark for the pricing of private sector Islamic bonds issued in Turkey. This could happen soon, with Deputy Prime Minister Ali Babacan announcing in January 2012 that the government plans to issue a sukuk once the necessary laws are in place.

While the trading of sukuks – or any Islamic securities – is not currently available on the İMKB, this could change, the İMKB’s chairman and CEO, İbrahim Turhan, said in early 2012. Moreover, these products could prove popular, according to Re ş at Karabıyık, a managing director at Bizim Securities. “Regulators and the İMKB are conducting ongoing studies on the nature of Islamic instruments. There is a great deal of potential for the sector over the coming years. Even if all asset classes are not accepted, over the coming five years we will see an emergence of ethical products that we expect to be quite popular,” he told OBG.

ISTANBUL FINANCE CENTRE: Adding new financial instruments such as sukuk to the İMKB is part of the strategy to transform Istanbul into a global financial centre, along the lines of New York, London or Tokyo. In September 2009 the government unveiled its “Strategy and Action Plan for Istanbul International Financial Centre”, which identified 71 action items that addressed issues as diverse as improving the judicial system, simplifying tax laws, encouraging IPOs, strengthening technology and communications infrastructure, and improving human resources in the financial services field. The government has also identified the location of the financial centre, which is to be located in Ata ş ehir on the Asian side of the Bosphorus. Major regulatory institutions such as the CMB and the Banking Regulation and Supervision Agency would be moved there from their current location in Ankara, as would the headquarters of the state-owned banks, Ziraat Bank, Halkbank and VakıfBank.

Challenges remain, however. Istanbul is certainly not alone in its hopes to become a financial centre. Moscow is sometimes considered a competitor in this, as are Johannesburg and Mumbai. Moreover, the government has been somewhat slow to implement the proposed changes. Speaking at a conference in April 2011, Babacan said that nine of the 71 action items had been completed and another 13 were being addressed. However, progress continues to be made, with Mehmet Ş im ş ek, minister of finance, announcing in April 2012 that new rules would make it easier to set up portfolio firms to manage international funds. For income earned from investments abroad, these funds will be exempt from any tax liabilities.

PRIVATE EQUITY: Regardless of the challenges involved in turning Istanbul into a financial centre, it is clear that foreign investor interest in Turkey continues to increase, particularly in the area of private equity. The number of private equity firms operating in Turkey has increased substantially over the last decade, according to lhami Koç, general manager of Investment. “Prior to 2000 there were only two private equity firms in the country: now there are over 50. Interest is coming from Europe and the US to Turkey’s capital markets, while Gulf and Russian investors are heavily involved in real estate,” Koç said. Şebnem Kalyoncuoğlu Ünlü, CEO of Alkhair Capital, also highlighted the importance of Gulf investment. “Gulf investors, particularly investors in sharia-compliant products, see that there is great value in income-generating assets in Turkey. Thus, Islamic funds are trying to balance their real estate development portfolios with office rental investments,” she told OBG.

Significant deals in the past few years have included BC Partners’ 2008 acquisition of local retail chain Migros; TPG Capital’s purchase of a 90% stake in Turkish spirits company Mey Içki Sanayi, which it acquired for $810m in 2006 and sold in 2011 to Diageo for $2.1bn; and Abraaj’s 2007 purchase of a 50% stake in Turkish hospital chain Acıbadem, which it sold for $1bn in January 2012 (see analysis).

As the Mey Içki and Acıbadem deals indicate, to date the most common form of exit has been selling to a corporate buyer, rather than an IPO. Mert Tarlan, a managing director in the investment banking unit and head of corporate finance at UniCredit, told OBG that this will likely be the preferred exit strategy for the next few years. “Private equity firms are keen to make sure their first forays achieve the best money multiple so that they continue deploying funds into Turkey. A trade sale of majority shares invariably achieves the highest money multiple, as witnessed in Acıbadem and Mey Içki, especially the latter. Firms have chosen to play it safe. I expect this trend to continue in the next two to three years, and then we will gradually start seeing more minority sales, IPOs and secondary public offerings (SPOs). Private equity in Turkey will see the real take-off when we start to see the good exits through IPOs and SPOs,” he said.

In terms of sectoral focus, many private equity investors are looking at consumer products and services, with retail and health care two particularly important areas. For example, Carlyle MENA, the Turkish unit of Carlyle Group, has invested in Medical Park Sağl›k Hizmetleri, which operates general hospitals and related facilities, as well as purchased a 48% stake in Bahçe ş ehir Kolejleri, a Turkish education group.

While the attention paid to consumer-driven segments is not surprising given Turkey’s demographics, these sectors have become increasingly crowded from the perspective of investors, with a large amount of capital chasing a shrinking number of deals. On the other hand, these areas of the economy continue to enjoy strong growth and consolidation could create further opportunities. In terms of alternatives, energy and infrastructure are also likely candidates to attract the interest of private equity investors.

OUTLOOK: While 2011 was not easy for the İMKB, performance improved in the first months of 2012, with the İMKB 100 closing March at 62,423.04, up 22% on year-end 2011. Market analysts have attributed this rapid increase to actions taken by the European Central Bank and the US Federal Reserve to increase global liquidity. However, it is important to note that these moves generally supported the performance of bourses across all emerging markets, and that Turkey likely does not represent a special case. The outlook for 2012 is positive, with a lira that has risen above its lows of 2011, inflation under control and the CBRT adopting a looser monetary policy stance, all of which together bode well for the country’s equities market.