By David Testa, Gatehouse Capital plc
Islamic fi nance is one of the most exciting areas of the capital markets at the beginning of the 21st century, and the Sukuk is very much a product of the new millennium.
The petrodollars boosting the Gulf countries together with the vibrant economies of Southeast Asia have combined to bring Islamic fi nance to the forefront of the international fi nancial community. As a result, the Islamic capital markets are growing at an exponential rate.
In both the leading Islamic centers of the Gulf and Southeast Asia, issuers are seeking to tap the capital markets in a Shariah compliant manner. The rest of the world is catching on as well — from the UK to Japan and back across the Pacifi c Ocean to the US, issuers are
looking to take advantage of investors' increasing demand for Shariah compliant investment products. Oft-quoted fi gures from the World Bank cite some 300 Islamic fi nancial
institutions and funds with more than US$250 billion of assets, growing at approximately 10% to 15% per annum, with a further US$200 billion of assets located in Islamic "windows" or divisions of conventional banks.
Growth of Sukuk market
Sukuk issues are a 21st century product, although they draw on centuries of Islamic fi nancial practice. While the 1990s saw a handful of structured-fi nance corporate deals tailor-made for a carefully delineated audience, the fi rst sovereign issue came in September 2001, with the US$100 million Sukuk issue by the Bahrain Monetary Authority although this was essentially for liquidity management purposes.
Other sovereigns soon followed suit, fi rst with the US$600 million Malaysia Global Sukuk Ijarah in June 2002 — the fi rst truly global offering — while Qatar maintained the momentum in September 2003 with its debut US$700 million Sukuk Ijarah issue.
The Sukuk market has continued to gain pace since those early years and has, more importantly, widened its range of issuers.
In the GCC, 2005 saw 11 issues raising US$2.3 billion, while 2006 saw 17 issues raising almost fi ve times the previous year's volume, with just over US$11.5 billion being raised. Last year was another record year, with global issuance to the end of September reaching almost US$39 billion, from approximately 150 issues.
It is clear from these levels that the Islamic fi nance market in general, and Sukuk issues in particular, are nevertheless still a "niche within a niche" when compared with the international capital markets as a whole. The industry is in the early stages of its life cycle and, as at the beginning of 2007, new ground is being broken with every issue, whether in terms of structure, volume or country of issuer.
In the Gulf Cooperation Council (or GCC, comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates), the growth of Islamic fi nance has several major drivers. First and foremost is retailOne leading player in Islamic fi nance has described the business as "R2B" (retail to bank), and there is little doubt that it is the retail
customer (whether the eponymous "Muslim in the street" or the increasing legions of "high net worth individuals" and "ultra-high net worth individuals") who is seeking to invest and deposit money for utilization in accordance with Shariah.
As is well known, the amounts available from this sector have grown steadily in this new century, with the repatriation of funds to the Gulf region spurred on by events such as 9/11 and the fall of Saddam Hussein, the continued high oil and gas prices and the continual development of new Shariah compliant products.
The banking network in the whole of the GCC has been impacted by this new liquidity and is reacting to it in a variety of ways. Existing banks are establishing Islamic retail, commercial and investment banking platforms. For example, in Qatar, Al Safa Islamic Bank has appeared via Commercial Bank of Qatar and QNB Al Islami via Qatar National Bank, while in the UAE MashreqBank has started Shariah compliant operations via Al Badr Al Islami.
Other banks have gone a step further and undertaken conversion to be fully Shariah-compliant, such as Kuwait Real Estate Bank, Dubai Bank and Saudi Investment Bank.
Completely new banks are also being established at a heady pace. Notable recent examples have included Al Rayan Bank in Qatar, Bank Al Bilad in Saudi Arabia, as well as Al Salam Bank and United International Bank in Bahrain.
The latter captured the headlines in the fi nancial pages in the GCC due to the initial authorized capital of US$3 billion, as well as the public involvement of the family of Prince Al Waleed bin Talal in the establishment of the bank.
Investors in the GCC are spreading their wings outside the immediate region as well. Signifi cant investment is being made by several leading players in Southeast Asia, with banks such as Kuwait Finance House and Al Rajhi Bank establishing operations in Malaysia, including signifi cant retail branch networks.
'Double-dip' opportunities
Activity has also been seen in Western Europe, in particular in the UK where fully Shariah compliant institutions such as the Islamic Bank of Britain and the European Islamic investment Bank have been established, with further institutions continuing to start up. Last year saw the authorization of the Bank of London and the Middle East, with
at least two further institutions seeking the necessary authorizations from the Financial Services Authority to start their Islamic banking businesses.
From an issuer's perspective, Malaysian corporations have for several years benefi ted from government-led initiatives designed to stimulate Shariah compliant transactions. Companies in the GCC are taking greater strides in the Sukuk market to broaden their appeal to fixed income investors, while at the same time ensuring the issuer's Shariah acceptability" to its shareholders.
Sukuk issuance is also spreading beyond the GCC and Southeast Asia and it is worth examining why issuers outside these two main Islamic hubs should be interested in Shariah compliant fi nancing. The growing numbers of potential issuers investigating the advantages of Islamic issuance are primarily focusing on diversifying sources of funding.
Potential issuers are in particular attracted by the "double-dip" opportunities afforded by a fi nancing product capable of appealing to "conventional" fi xed-income investors, as well as enticing the participation of the vast wall of liquidity latent in the Islamic fi nancial community.
The ball started to roll in August 2004, when the German state of Saxony-Anhalt issued its €100 million (US$148.3 million) Sukuk al-Ijarah. The US broke its duck in 2006, when the US$165 million Sukuk al-Musharakah was closed for East Cameron Partners, while the Sultanate of Brunei also saw its fi rst issue with the US$150 million Sukuk al-Ijarah from the government (issued concurrently with two local-currency issues).
As at the time of writing, debut Sukuk issues for Japan and China had also been announced (although not yet closed), namely a benchmark issue for JBIC and a US$250 million power project respectively.
Perhaps most notably, the UK government announced in April 2007 its intention to study the feasibility of a debut Sukuk issue, with a further discussion paper to be issued by end-2007.
Development and innovation of structures A notable feature of the Islamic Sukuk market to date has not only been the degree of innovation and creativity involved, but also the
pace at which those skills have been, and are increasingly, deployed. Each new issue brings a new structure or a signifi cant refi nement of a previously utilized mechanism.
This is, of course, to be expected given the youth of the modern-day Islamic fi nance market, but there is also little doubt that the overall trend is one of positive and constructive development, with structures tending to be simplifi ed as the underlying Shariah principles become better understood in the context of today's fi nancial environment.
The simpler the structures, the more capable they become of wider application and, therefore, of greater appeal to issuers across the globe.
Perhaps one of the most noteworthy recent developments in the GCC Sukuk market was the issue of convertible or equity-linked Sukuk, fi rst by PCFC in January 2006 with its US$3.5 billion Sukuk al-Musharakahissue due 2008, followed in December 2006 by the US$3.52 billion
Sukuk al-Ijarah due 2009 by the Nakheel Group (this latter issue is a novel pre-IPO Sukuk, as well as being the largest Sukuk issue to Both issues combined structural innovation with a successful appeal to investors for support, both within and outside the GCC, raising
signifi cant volumes of fi nancing (even by international standards) and successfully tapping into strong demand for equity-linked products.
For the Nakheel issue, for example, Sukuk holders were given the right to subscribe for any future equity offered as part of an initial (or qualifying) public offering (QPO) by any member of the Nakheel group, such rights subsisting during the lifetime of the Sukuk issue. In addition, "look-back" rights were also given to Sukuk holders, in this case subsisting for a period of 12 months after the maturity date of the Sukuk issue.
In the event of there not being a QPO during the relevant period, the return to Sukuk holders will be enhanced by an additional 2% per annum. Whilet the ground-breaking nature of both of these equitylinked issues cannot be questioned, there is equally no doubt that
both transactions benefi ted by the issuers being seen as integral parts of "Dubai Inc", namely corporate entities closely linked to the ruling parties in the Emirate of Dubai.
Another equity-linked product was the US$460 million issue by Aabar Petroleum, which was also notable for utilizing the Mudarabah structure for the fi rst time in the international capital markets. In March 2007, another exchangeable Sukuk was announced, this time by Aldar Properties in Abu Dhabi, for US$2.53 billion.
The US$225 million Sukuk issue by Sharjah Islamic Bank in October 2006 is also worth mentioning. While being on an altogether smaller scale than the "Dubai Inc" transactions described above, the issue was a capital markets debut for another Islamic structure, the ownership of assets based on the concept of Sharikat al-Melk.
Under this structure, certain rights and interests in specifi ed assets on the balance sheet of Sharjah Islamic Bank were sold to the special purpose vehicle (SPV) issuer of the Sukuk holders so that such assets became effectively "co-owned", with each of Sharjah Islamic Bank and the SPV owning indivisible interests in the Sukuk assets.
The last 12 months have also seen issues featuring put options, or including both put and call options. In Saudi Arabia, Saudi Basic Industries Corporation or SABIC issued a 20-year Sukuk Istithmar ("istithmar" meaning "investment") encapsulating put options every
fi ve years. The structure was geared to ensure that investors are almost certain to put the issue back to SABIC after the fi rst fi ve years, as subsequent redemptions will be at a discount to par.
The Investment Dar's US$150 million Sukuk Musharakah issue due in 2011 illustrated above included both a put and a call option at the end of the third year. This allows Sukuk holders to focus on a shorter maturity fi nancing for an issuer without an investment grade rating from an internationally recognized rating agency, while affording The Investment Dar the opportunity to retire the transaction after only three years should such a rating materialize and allow it to refi nance at a lower cost. Innovation continued to be seen in 2007, despite the moreApril saw the closing of the US$650 million Sukuk al-Manfaa issue
by the Sad Group in Saudi Arabia via its Golden Belt vehicle (utilizing receivables under a master lease and sublease structure), whilst National Industries Group in Kuwait has put in place a ground-breaking US$1.5 billion Sukuk program based on a Mudarabah structure. The
fi rst draw-down under the program closed in July 2007 in an initial issue amount of US$475 million.
Looking ahead
Islamic fi nance and the Sukuk market in particular are on the fast track. The geographical spread of the sector is increasing in pace, while with each successive issue it seems that new structures are being utilized and new investors being attracted to the sector. There
is also no doubt that the label of "Sukuk" in itself generates a higher profi le for any transaction.
Two distinct, but related, trends in the corporate arena will also maintain the momentum in the Sukuk market. First, the turbulence experienced in almost every GCC stock index in 2006 has led many corporations to consider the "Islamicization" of their debt to ensure their equity is able to be treated as "Shariah-acceptable", allowing Islamic equity funds (and individual investors) to invest in their shares. For example, Saudi Aramco and SABIC have each made a public announcement to this effect.
The second trend is the counterpart to this in the private sector, where many companies are family-run and managed, with the owners being Muslim. It is no surprise to understand that many such owners are now considering Islamic fi nance — and the Sukuk market — to address their fi nancing requirements. Both trends will be further reinforced by the steadily increasing variety of Shariah compliant instruments.
For corporations outside the GCC, the main attraction is the burgeoning universe of Islamic investors. The growth in the number of Islamic banks, as well as Islamic "windows" of conventional banks, has been described above and is leading to ever-greater interest by non-GCC corporates looking to tap into this expanding and increasingly liquid investor base.
At the same time, the universe of institutional investors is also growing, with the proliferation of Islamic insurance — or Takaful — companies and the increasing appetite and sophistication of GCC pension funds.
Private banking clients are also showing an increasing interest in Islamic fi xed-income products to bring a degree of compliance to their investment portfolios.
There is no doubt, however, that Islamic funds continue to be dominated by the real- estate and private equity sectors and there is an increasing need for funds focusing on the Sukuk sector to be established.
One sector where the market is still awaiting its fi rst benchmark issue, however, is in the realm of securitization. Two small transactions in Saudi Arabia have led the way for others to follow, and the Saudi market is one of the focal points for further securitization transactions during 2007, along with the UAE, where Tamweel made its debut US$220 million 25-year securitization issue in July 2007.
However, there are one or two myths and misinterpretations prevalentin the current market that need to be dispelled in order for a greater degree of clarity and understanding to prevail and to assist market development.
As for all Islamic fi nance products, the structure of a Sukuk issue must be asset-based. This has led to a certain amount of confusion of terminology, as many commentators have leapt to the assumption that every Sukuk issue is a form of asset securitization. This is a long way from reality.
To date, only a very small handful of issues can be seen as resembling the US and European securitization model (which has, as its core features, the concepts of true sale, bankruptcy remoteness, overcollateralization etc.).
Each and every other Sukuk issue has been asset-based, but in fact very few have even been capable of being described as asset-secured. The vast majority of issues revolve around an asset, or a pool of assets, but are usually structured to ensure investors have recourse to the full faith and credit of the issuer, rather than restricting their rights to the asset or assets incorporated in the structure of the issue.
This is not to say that asset-backed issues or true securitizations are not possible in a Sukuk format. Far from it — Islamic fi nance is a prime candidate for such structures (and this is discussed in greater detail below). However, in particular in the GCC, the market is still some way from seeing such issues.
Development is in many cases hampered by the lack of the necessary legislative framework in the relevant jurisdiction, although it is widely expected that further mortgage-backed securitization deals will be seen from the region in the near future.
One particularly interesting sector is the housing market in Saudi Arabia, where a long-term shortfall in the housing supply is being addressed by an expansion in residential real estate development and a corresponding need for an increase in residential mortgages.
The Saudi government has responded by announcing amendments to domestic legislation to further the home loan sector and, in parallel, to initiate the steps needed to develop securitization laws. It is foreseeable that in the relatively short-term, fi nancial institutions in Saudi Arabia will need to resort to the securitization market to meet local demands.
Elsewhere in the GCC, the massive expansion in the real-estate sector in the UAE, and Dubai in particular, has led to a different kind of pressure. Huge real-estate requirements are regularly estimated to exceed US$500 billion and credit-enhanced structures are required
to ensure the requisite support from the international fi nancial community, which to date has not fi nanced the UAE real-estate sector in the volumes required for future projects.
Again, the securitization market is one possible tool that could be used to enable the required developments. Islamic mortgage providers are leading the market and it is in all likelihood the Islamic securitization market which will provide the solution.
Issuers will, however, also have to be aware of the challenges that are facing the Islamic sector. At the top of the list of concerns is the fragmentation of Shariah interpretation across the GCC and within each jurisdiction as well. At the heart of the matter is the fact that each Islamic institution has its own Shariah supervisory board that is required to review all activities of that institution, including investments.
However, there is more than one mitigating factor at play. The lack of standardization is at the top of the agenda of almost every multinational supervisory organization operating in the Islamic fi nance sector, led by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board.
Harmonization is also one of the key considerations for the leading indices and regulatory bodies in the region, in particular the Central Bank of Bahrain. An increasingly important factor is the fact that a very small number of leading Islamic scholars are attached to an increasing number of Shariah supervisory boards.
De facto, this is leading to a greater uniformity of interpretation across the GCC (perhaps with the exception of Saudi Arabia, where it is generally acknowledged that a more conservative" school of Islamic interpretation applies).
Another prime consideration is not to leave the Islamic investors behind. The project fi nance sector has already seen the phenomenon of carefully structured Islamic tranches that nevertheless fail to attract any support from Islamic banks (e.g. the only Islamic players in the Dolphin Energy tranche illustrated above were Islamic "windows" of conventional banks).
In an era of double-digit returns for investors in the private equity and real-estate sectors, it cannot be ignored that investors in the GCC — whether Islamic or conventional — are able to pick and choose their investments, with return at the top of their list of deciding factors.
This ties in to one of the other main current criticisms of the Islamic Sukuk market, namely that there is very limited secondary market activity, which means it is diffi cult for issuers to get a clear view on how its risk is seen — and priced — in the market. The Sukuk investor base is characterized as a take and hold market and this is due mainly to the fact that the level of primary issuance has yet to achieve critical mass.
Investors are reluctant to trade the assets they have simply because there is no established pipeline of issuance. Equally, however, there can be little doubt this will change in the future, given the expected growth in issuance volumes in the short to medium term.
And last but far from least, a prospective issuer must investigate the tax consequences likely to arise from a proposed issue. This is essential, given the asset-based nature of Islamic financing and the changes of ownership entailed in the various modes of Shariah compliant fundraising .
The GCC is hardly known for its excessive taxation (although zakat and withholding tax must always be taken into account) and, in addition, the principles of Shariah are — to a greater or lesser extent — recognized by or incorporated in the local jurisprudence.
In Southeast Asia, Malaysia has led the way in introducing specific legislation designed to ensure that Shariah compliant issues are treated on an equal footing from a taxation perspective with conventional debt issues (indeed, the authorities have quite clearly enacted legislation designed to stimulate the sector, with the result that more than 80% ofMalaysian capital market issues are Shariah compliant).
Outside the GCC and Southeast Asia, tax and regulatory hurdles will have to be jumped in each jurisdiction in order to ensure issuers obtain the optimal tax treatment for a particular issue. It is crucial for a transaction be treated as a debt-raising and not a transfer of ownership in the relevant asset(s), which could otherwise trigger capital gains (or losses) or other property-related taxes and duties.
In certain jurisdictions, such as the US, is possible to seek relief from the relevant authorities on a case-by-case basis. In terms of the most advanced legislative framework, it is the UK that has most explicitly embraced Shariah compliant structures in order to facilitate fi nancial services to be offered to the signifi cant Muslim community in that country.
The then Chancellor of the Exchequer went on record in 2006 in announcing the Labour Government's "long-term ambition to make Britain the gateway to Islamic fi nance and trade". This ambition was stimulated by the recognition that "Islam is Britain's second-largest faith, and Muslims are involved in every walk of British life", evidenced by the healthy growth rate in the Islamic mortgage market in the UK and the fl exible and supportive approach adopted by the Financial Services Authority in its licensing of the Islamic Bank of Britain and the European Islamic Investment Bank.
More recently, the UK government has enacted legislation to facilitate not only Islamic retail products, but also commercial and wholesale banking products with its development of the concept of "alternative fi nancing arrangements". For example, the Finance Act 2005 permitted Ijarah structures to be extended to commercial property, while the Finance Act 2006 widened the ambit even further to Wakalah and "diminishing Musharakah".
Legislation has also been passed (in the Finance Act 2007) allowing Sukuk issues to be treated for the tax purposes of both issuers and investors in the same manner as conventional bond issues.
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