Tuesday, 11 December 2018

IFR Mid East 2006 - Corporate finance blooms

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The corporate finance markets in the GCC are going through an unprecedented boom. International banks and investors are keen participants. Business and political concerns are near the surface, however. By Rod Morrison.

Data from Thomson Financial released for the first time (see tables at the end of this article) show the strength of the boom in the bank loan and bond/sukuk markets. In the first half of the year, international banks raised more than US$50bn in loans for the region. The bond/sukuk figure topped US$10bn. At a time when there are plenty of petrodollars in the region, this figure represents a big extra infusion of funds from outside the region. And after the numbers were put together, in January to June, July saw a further US$5bn in project finance and US$10bn in corporate loans raised from just from four deals – Qatargas 4, Etisalat, ADNOC and Dubai Holdings – plus more local bonds and two significant sukuk.

The US$50bn loan figure is split 50/50 between project finance and general corporate finance loans. The proportion of project finance deals to general loans is very high, even for an emerging market. The reason for this that energy and petrochemical prices are buoyant and as a result project finance in the region is undergoing an unprecedented boom. Back in 2003, GCC project finance activity was US$8bn, a record at that time, then it rose to US$18.5bn in 2004, to US$31.1bn last year and now to US$25bn in first half of 2006. Phew!

The LNG sector in Qatar was the initial driver behind this boom. But now activity has shifted to petrochemical and refinery schemes in Saudi Arabia, plus ongoing activity in the power sector. For the first time, Saudi Arabia has overtaken Qatar as the leading centre of project finance in the region. And this shift is likely to remain in place. Qatar is coming to the end of its LNG expansion programme while Saudi Arabia has just started on its project development programme, in both the public and private sectors.

With the boom, there has been one downside for lenders – margin collapse. The latest mega project financings for quasi-state companies such as Aramco, Sabic and Qatar Petroleum have 15-year tenors with pricing in the 50bp to 60bp range. Some of the private sector Saudi schemes – Sipchem VAM being the latest – still have margins of plus 150bp, but these financings carry higher risk, few if any construction guarantees and have less robust sponsors – important in the cyclical energy markets.

In the power sector, margins are getting to be sub-70bp. The recent QEWC deal, with a state guarantee, started the trend at 55bp but now a range of refinancings, plus the new Fujairah scheme, are coming in at 65bp then stepping up to above 100bp. The deals also have 20-year plus tenors.

The upshot of the lower pricing and long tenors is the fact the local and regional banks are finding the project finance market too competitive. With their own costs of funds in the 40bp range, there is no money to be made by banking these deals. So the project finance market has gone from a situation three years ago where liquidity was an important concern, and project sponsors sought any available source of local funds, to one now where the sponsors are swamped by international banks seeking to lend money. Local banks only contributed 20% to the project finance loan total in the first half of 2006 at the mandated lead arranger (MLA) level. Islamically structured deals have fallen away this year too as the wall of international money has taken over.

ABN AMRO topped the half-year project finance league table. The bank is building up its presence in the region through its Dubai office and its long established Saudi Hollandi affiliate. It has not been a market leader of late but its place at the top is due to the fact it took on all the US$3.4bn debt for Sabic's Yansab deal and then sold it down to the general market. It was an aggressive move at the time and its competitors wondered just how much it had formally underwritten and whether any other banks would join the deal. But plenty did.

Mitsubishi UFJ and SNBC came in second and third, showing the Japanese interest in the region – with Mizuho seventh. Other regional stalwarts HSBC, Calyon and SG came in third, fourth and fifth. The other main regional player, BNP Paribas, dropped out of the top 10 as it balked at some of the low margins on offer. But the French bank remains very active in the region.

GIB, Apicorp and ABC all managed to stay in the project finance MLA Top 20. It is an interesting time for these pan-GCC institutions. They were created as region-wide financing institutions, backed by GCC and Middle East governments, and over the years they have provided important sources of funds.

Now as the region grows, the role of the more localised banks is becoming more prominent as the local economies get bigger. And at the same time, the international banks are falling over themselves to lend into the region. So the regional banks could end up being squeezed. The same process is occurring at other regional institutions, such as Gulf Air which being hit by both international and local competitors.

For the regional banks, their role will come back into sharp focus once again if international liquidity dries up. But if the current situation is maintained, they will have to seek new strategies, albeit from a strong base. GIB looked at buying a retail outlet but acquisition prices for other banks are currently too high.

The main risk in the project finance arena is whether high energy and petrochemical prices will be maintained. Construction prices are going through roof but with high energy prices most projects are still economic, although a few have stalled.

The high oil price is driven by political instability, mainly relating to Israel, Iraq and Iran, not by demand/supply economics. Gas prices in the US, a big LNG import market, for instance, have been falling as local gas stocks have been rising. Demand for oil globally is dropping too. So if the political instability was removed, oil could be in for big fall.

Political instability is, therefore, both a benefit and a concern for the region. An implicit benefit in that it drives energy prices higher and this drives the Middle East economies onwards, but an explicit concern in that instability is on the doorstep. The US/Iran situation is perhaps the biggest local fear. In Dubai, for example, the small local population has very strong links to Iran. The Iranians are widely perceived to have been increasing their influence on events in the region, heightening concerns further on top of the nuclear issue and some of the new president's recent statements.

Life continues calmly in the GCC. The bombings in Saudi appear under control and there has only been one in the GCC outside Saudi, in Qatar, plus the bombings in Egyptian tourist resorts. Bahrain has seem some local demonstrations but little else. There are underlying concerns and fears, however.

Project finance is backed by a range of contracts linked to a single project. Corporate loans are simply banked on the credit of a company. Some would say the two markets are merging in the GCC, particularly in terms of margins. Certainly, corporate borrowers are benefiting as much from the margin collapse.

Margins on corporate loans for the big local names are diving to unprecedented levels. Corporate loans do have much shorter tenors than their project finance counterparts, at five or seven years, but margins for the leading quasi-state corporate names are now around 20bp or below. Indeed, there now seems to be some local 'ego' competition from borrowers to get cheaper margins than their counterpartsQatar Petroleum obtained a five-year US$550m loan at 17.5bp with fees of 5bp and 7.5bp in May. Etisalat then got a one year US$3bn loan at 22bp with fees from 7bp to 12bp in July. Then ADNOC came in with its US$4.5bn five year loan at 19bp.The ADNOC loan is interesting as the funds will back the expansion of the Borouge petrochemical plant in Abu Dhabi. ADNOC had been looking at a project finance solution, then looked at a 15-year corporate loan, which was not do-able even in the current market, then finally opted for the five-year corporate loan. The deal is still being finalised.

The UAE, Abu Dhabi and Dubai in particular, have never been keen on the structured project finance approach. The Emirates prefer to borrow on balance sheet with few conditions attached to their lending. It is no surprise, therefore, that the UAE is top of the corporate loan and bond tables and bottom of the project finance tables.

There is still plenty of margin diversity in the local loan markets for those prepared to look. Etihad Airways was recently in the market for a US$520m financing, paying 92.5bp all-in to fund six airplanes. The 15-year deal puts the planes into an SPV and is backed by a loan from Barclays Capital and 15% equity from Oasis International Leasing. There is no balloon residual value on the aircraft at the end of the deal. Presumably, Etihad could have got a shorter general loan but instead opted for a standard aircraft financing deal.

Dubai Holding has put together an US$2.25bn 18-month bridge loan with Emirates Bank International and Standard Chartered. It is priced at 70bp. This will back the company’s 35% purchase of Tunisie Telecom. And Kuwaiti investment house AREF has raised a three year US$100m deal on an Islamic basis from ABC Islamic and Standard Chartered at 150bp.

It is notable that the financial sector appears towards the top of the corporate bank and bond tables, as borrowers in their own right. International banks and investors are happy to provide substantial funding to local banks. The local banks then onlend to sectors in the local economies. The financial strength of the local banks is a point of concern. The concern is directly linked to the asset valuation bubbles in both the local stock and property markets. Local banks have lent to local investors to buy shares and to property companies, and associated property industries, to build real estate assets.

The share boom was corrected in the region back in February. The impact on local bank results is expected later in the year in terms of problem loans and lower brokerage fees. Many local banks had share portfolios and these were easy to liquidate. So perhaps of bigger concern is the property boom.

Both Moody's and Standard & Poor's have issued special reports on the subject. While both have expressed concern, they say it is difficult to precisely calculate the bank sector's exposure to the property markets. Moody's says an average of 15% of the loan book is exposed to the property market, although it adds: "We believe additional exposure is hidden in exposure to trading conglomerates that are also involved in construction." It believes this figure could be as high as 30% in Dubai and 20% to 25% in Abu Dhabi, the really hot property markets. At 15% of the loan book, that figure would compare with 100% of a bank's equity capital.

National Bank of Dubai (NBD) is a good example of a standard GCC financial institution. The institution was founded in 1963 but remained a sleepy bank until just after the turn of the century when new management was bought in. It is now full of bankers and expats from other commercial banks. Its loan book has grown quickly,from US$9bn in 2003 to US$25bn now.

Construction and real estate take up 29.3% of the book with 'others' pencilled in at 29.2%. The bank has 15% of its portfolio outside Dubai, and hopes to grow this to 25%, and has lent 27% to its top 10 corporate names.

Three recent deals of interest show its growing activity. The bank was an MLA on a US$175m 10-year loan for the Kempinnski Hotel and associated Qatari West Bay property development priced at 175bp. It provided an 11-year US$70m loan, priced at 190bp to 200bp, to Al Habtoor Construction to fund one of five hotels and a shopping arcade in the Qatari City Centre development. And it is the MLA on an 18-month US$60m deal for IPCC, the Iranian petrochemical complex. This is the Iranian company's first foray into the loan market after French banks arranged some loans in 2005. NBD was going to put in place a dollar/yen hedge to meet the client's requirements but in the end IPCC decided against this structure.

NBD is currently undergoing its Basel II accreditation process. It will be into the foundation approach this year and into the foundation basic level internal ratings based (IRB) approach in 2008. Basel II is having some fundamental effects on the GCC capital markets. The dive in loan pricing for projects and leading corporates is partly driven by Basel II. International banks, with their advanced IRBs already in place, are allowed to risk-weight loan exposures more precisely and this means more keenly.

With lower amounts of capital set aside to cover any problems with the loans, the international banks can lower their pricing. The banks run their IRB approach themselves so there is an interesting internal conflict of interest with an advanced IRB bank. But nevertheless it is the intention of the regulators that the risk capital put aside for better investment grade credits is low. Hence the high quality projects and corporates in the GCC can now attract very thin margins.

The hope among the local banks is that they too will start to attract thin pricing on their own borrowings. If this occurs, GCC banks will be able to raise funds at the rates of their international competitors and be able to compete for more business. Under Basel I, GCC banks have a flat risk weighting of 100%. This means banks and bond investors in GCC bank financings cannot price the deals cheaply, as they have to set aside a 100% risk weighting to the financing. Under Basel II, from 2008 onwards this risk weighting is expected to drop to 14.4%. Loans and bonds raised by GCC banks could therefore attract much cheaper pricing. NBD's last bond came in at 39bp, all things being equal a 2008 bond should be much cheaper.

It is not all good news though. The Basel II risk weighting change will not impact on Saudi Arabia. Banks in that market already have a 20% risk weighting under Basel I. And GCC bank exposure to the risky local property market could limit the ratings upgrades they obtain from the international agencies. Moody's points out that despite the improving financial performance of GCC banks, it has only gradually upgraded them due to systematic local market fears. And finally, local banks in Basel II will have to price precisely property loans according to risk, which could hit local property lending.

The corporate loan and bond/sukuk tables show Barclays Capital and Deutsche Bank made a big impact on the corporate finance markets with some notable deals in the first half. US investment banks, however, are starting to staff up. Nicholas Hegarty, head of investment banking at Barclays Capital, is off to a competitor, rumoured to be Lehman, while Jeffrey Culpepper has become head of Merrill Lynch's investment banking team in the region after leaving a similar job at Deutsche.

European, Japanese and local banks play the leading roles in the corporate loan tables. European and Asian investors are said to be the main buyers of corporate bonds, particularly bank bonds. The local currency bond market is still in its infancy but there are signs it is growing. Emirates Financial Services, HSBC and National Bank of Dubai have just arranged a US$500m local currency bond for Emirates Airline, priced at 65bp over the seven-year term.

The structured bond market has yet to take off. There have been no genuine securitisations to speak off yet in the region. However, investment banks are still hoping this market will develop and we are still promised some deal flow in the near future. One issue holding back securitisation in the GCC is cultural – banks and corporates like to keep hold of their assets.

There is continued interest in the Islamic form of bond issuance, the non-debt asset-backed sukuk. Deal flow has not grown as expected but there have been movements in this market this year. The Dubai Ports (DP) deal was financed by a massive US$3.5bn convertible sukuk and Aabar Petroleum followed that up with a US$460m convertible sukuk.

The DP deal was a particular success. But there was no date certain on the convertible or indeed a strike price, just a commitment to 30% of the company. So perhaps this deal shows the market was simply hot for assets. Dubai is expected to issue another massive sukuk shortly to fund various infrastructure projects such as the light rail scheme. And Saudi companies are starting to show an interest.

In July, HSBC led a US$800m corporate sukuk for Sabic, priced at 40bp. This sukuk can only be bought by local investors. It has a 20-year tenor but can be redeemed at par after five years. Half the issue was bought by funds, 15% by corporates and 35% by banks. In a further sign of diversification, Qatar Real Estate is issuing a US$270m deal through Qatar National Bank. The company is 27% government-owned and builds houses for Qatar Petroleum.

The market remains in its formative stage, however. There are ongoing attempts to address some of the structural features of sukuk that have been holding back market development. Liquidity is one. Given the limited amount of issuance thus far, sukuk investors tend to buy and hold issuance, partly due to the local culture of holding assets but partly due to lack of other issues to trade.

Liquidity Management Centre (LMC), the Bahrain based institution that is charged with developing the market, is introducing an Islamically structured repo product with the backing of the Bahrain Monetary Authority (BMA). This will help develop the secondary market and allow investors to trade sukuk more efficiency. In addition, LMC has it own US$100m one-month portfolio programme that investors can buy into and is expanding this to US$200m this year.

Another development is the issuance of a sukuk for general corporate purposes. Emirates Islamic Bank and LMC have issued a US$50m sukuk for Bukhatir Investments. The funds are currently used for corporate finance but are not backed by assets. To become a tradable sukuk, the issuer will need to put some assets into the structure.

To have a secondary sukuk market, having tradable sukuk is obviously key. The popular commodity-backed murabaha sukuk is not tradable, for example. But the istisna equipment/construction-linked and ijara lease-linked sukuks are tradable. These two types of sukuk have been combined on recent transactions. Gulf Finance House (GFH) raised US$134m towards the Bahrain Financial Harbour development in July 2005 and included a US$5m Islamic bridge facility.

The structure was used more recently on the Tabreed deal from July this year. The US$200m five-year issue was priced at 125bp. This is an istisna to ijara structure and was put together by CIMB, Dresdner and HSBC. It is the second sukuk for Tabreed, the UAE-based cooling company.

Pricing on the second deal was a lot thinner than on the first, at 125bp compared with 200bp. It benefited from an investment grade rating of BBB– and better market conditions. However, for the first six months of this sukuk's life, the structure will include US$160m of palladium, with the metal price hedged out by HSBC. This is because most of the cooling plants in the portfolio have yet to be completed. When they are complete next January, they will be admitted into the structure.

Finding a sukuk structure that takes project risk on a deal has yet to be fully achieved. Finding a tradable non asset-backed sukuk is tough too. The market has developed in Malaysia but in that market the rules are written down in the financial regulations. In the GCC, the Islamic scholars take more of a deal-by-deal role.

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