IFR Mid East 2006 - Preaching to the convertible
The burgeoning sukuk market has seen the most pronounced innovation in the Islamic finance sector in recent years. By Rahail Ali, Global Head of Islamic Finance, and Imran Mufti, senior solicitor, Denton Wilde Sapte, legal advisers on the PCFC and Aabar sukuks.
This growth has been primarily demand-driven. That demand has been greatly assisted by the perennial difficulty for Islamic financial institutions to transform their short-term liabilities, ie, deposits, into long-term assets. The difficulty arises because Islamic banks are unable to leverage their balance sheets through trading in debt. Accordingly, one of the significant factors for the development of the sukuk market is the creation of an Islamic money market, rather than temporarily housing excess liquidity into short-term commodity murabaha treasury liquidity management products and programmes.
With oil revenues in the Gulf Co-operation Council (GCC) set to exceed US$300bn for 2006, rising liquidity in the region is an obvious catalyst for the increasing levels of activity in the region's capital markets. Debt capital markets are not the only ones that have gained from this surge. Many big ticket IPOs have closed during this period and with local governments slowly deregulating and taking steps to reform listing requirements in accordance with international practices, this trend is set to continue for the foreseeable future. The Islamic debt and equity capital markets are ripe for growth and innovation, particularly through harnessing the returns on offer with hybrid instruments.
The predominant use of sukuk al-ijara to date in the sukuk market is explained, and justified, by the need to present investors with familiar structures: a sale and lease-back structure is easily understood even by those unfamiliar with Islamic financing. There is an appreciation that even the most attractive of credit stories can be distracted from overly complex structuring. While there is no such thing as a 'cookie-cutter' sukuk, repeat structures are symptomatic of a market seeking to create benchmark structures and yield curves.
Standardisation is a good thing, because a deal which, as is the case with sukuk, has return on assets as its core needs to be highly structured.
A conventional bond, put simply, is an IOU. Renting money and trading in debt is forbidden according to Sharia law. To make a Sharia-compliant return, assets need to be sold, leased or invested in. This is the essence of a sukuk. A sukuk is a certificate entitling the holder to the return generated by an income-generating underlying asset.
Interposing asset ownership into any financing requires full due diligence for deal viability. Considerations that need to be addressed include: Are any security interests on other third party rights over assets to be sold? What regulatory consents, approvals, etc, are required for the sale? Third party consents may be relevant because the corporate may be contractually restricted from disposing of assets by virtue of, for example, disposal, negative pledge or financial covenants.
Are the assets 'haram', ie, prohibited, for example alcohol-selling outlets? If so, can they be effectively excluded from the sale? Do documents need to be registered, recorded or filed at any public office or registry? Are any notarial or other fees payable? Registration fees will be payable in most jurisdictions when the assets being conveyed is land. What taxes could in principle be charged on the sale? Are there any capital gain, VAT/sales or other local taxes such as stamp or other documentary taxes that could be charged by a sale of the assets or even a disposal of the sukuk?
The structuring issues involved provides the backdrop to the unprecedented level of innovation in the PCFC and Aabar sukuks. Before turning to those sukuks, the musharaka sukuk structure merits separate consideration.
What happens if the sukuk obligor does not own sufficient assets or their value is not sufficient to justify the sukuk (based on an ijara structure) issue amount, because the value of the assets are less than the target sukuk issue amount, or there is a need for the assets to be created for a sale and lease-back to occur? Enter the sukuk al-Musharaka.
Standard 17, 3/6 of AAOIFI (Accounting and Auditing Organisation for Islamic Financial Institutions) provides that: "These are certificates of equal value issued with the aim of using the mobilised funds for establishing a new project, developing an existing project or financing a business activity on the basis of any partnership contracts so that the certificate-holders become the owners of the project or the assets of the activity as per their respective shares, with the musharaka certificates being managed on the basis of participation or mudaraba or an investment agency."
The first international musharaka sukuk structure was the 2005 US$200m Dubai Multi-Commodities Centre (DMCC) sukuk. A sale and lease-back was not viable as the land available for the sukuk was undeveloped and, consequently, did not have a value to justify the targeted issue amount. That sukuk received widespread acclaim for a number of reasons: as mentioned, the first international sukuk based on a musharaka structure; the first rated sukuk coming out of Dubai and the first sukuk to offer investors an option for settlement in commodities (here gold) rather than cash.
The DMCC sukuk is also distinguishable for the fact that its proceeds were to finance construction. The DMCC sukuk, with its unprecedented level of creativity, showed that it is possible to fund a construction using a musharaka sukuk structure, rather than the usual istisna/ijara or forward lease route with the complexity that entails in terms of trying to generate acceptable periodic returns during construction. In fact, the DMCC sukuk was rated Single A by S&P.
The PCFC sukuk is noteworthy for a number of reasons. The PCFC convertible sukuk al-musharaka was the world's largest sukuk closed to date, the first convertible sukuk, coupled with a number of innovations that received less attention than they deserved – understandably, the issue amount of US$3.5bn and the fact that the sukuk was linked to DP World's acquisition of P&O grabbed more headlines.
Convertible bonds are quite common, but this was the first of its kind in the sukuk market and one of the largest offerings of any kind. Its main innovative features are the convertibility of the sukuk and the 'look-back' option for the sukuk-holders. The look-back option gives holders an opportunity to participate in a qualifying public offering up to 12 months after the sukuk is redeemed, should no qualifying public offering occur within the two-year tenor of the sukuk. The look-back option gave rise to complicated, but surmounted, issues resulting from the need to identify sukuk-holders so that they repay their higher yield return.
Unlike the DMCC and PCFC sukuks, the Aabar sukuk was based on a sukuk-al mudaraba structure. A mudaraba is a partnership in profit (akin to a non-discretionary investment management arrangement) between a capital provider and a person who applies its skill and expertise in investing that capital – put differently, one partner, the rab al-maal or the investor, contributes money and the other, the mudarib or investment trustee, invests its time and skill.
The sukuk was issued through an SPV (acting as rab al-maal) with the proceeds being applied as capital of the mudaraba. The mudaraba agreement provides that those proceeds will be invested by Aabar Petroleum Investments Company PJSC (as mudarib) in its business activities in accordance with a predetermined investment plan prepared by Aabar. Returns to the sukuk holders are generated through profit payments to the Issuer, distributed by Aabar on quarterly periodic distribution dates.
The PCFC and Aabar sukuks are considered by some to be the peak of sukuk structuring. Certainly, they were landmark transactions and should be viewed as such given their innovation. Perhaps their most notable legacies will be that they caught the gaze of a plethora of banks and investors. In that sense they were truly preaching to many of the prospective players in the sukuk market.