Saturday, 21 July 2018

Islamic finance and the M&A gap

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M&A deals in the Islamic World are down almost 50%. With conventional credit still difficult to obtain in the region, there is an expectation that Sharia-compliant acquisition financing will substitute for the shortfall. Adam Durchslag reports

The Great Financial Crisis continues, and the academic camps remain split between those who think the world will go through a "U" shaped recession and those who think it faces the infamous double-dip "W".

The Middle East has not been completely immune, leading to an assumption in some circles that Sharia-compliant funding – whether in the form of sukuk securities or loans – would somehow just magically appear from the great financial centres of Saudi Arabia and Bahrain to fill the acquisition financing gap, as conventional credit dried up in the Middle East as elsewhere in the world.

Arguably, that has not happened. The stats speak for themselves. Between 2007 and 2009 for the periods January 1 to October 5, Islamic World M&A deal flow fell by 61%, from US$127.12bn to US$49.4bn, according to Thomson Reuters data. Between 2008 and 2009 for the same periods, the drop was less steep. Activity was down 47.8% from US$94.7bn, perhaps finally pointing towards a stabilisation of the market.

Certainly, what the data reveal does not come as much of a surprise, when credit rating agency Standard & Poor's said in August that sukuk issuance was down 56% on a year-on-year basis to US$14.9bn in 2008. The sukuk market evidently had been hit just as badly as the conventional debt capital markets at the height of liquidity crisis.

Just because a company or a sovereign wealth fund made a multi-billion dollar sukuk issue for investment, balance sheet, or acquisition purposes, it did not mean that it would be just the Muslim investment community doing the purchasing but also non-Islamic international institutions – hence the downturn in the sukuk market. The latter were too worried about how to value and shore up their own balance sheets to prop up those of others.

But at the peak of the sukuk market in 2006, international institutions had indeed been keen investors. Take for example Dubai World's property arm Nakheel, which owns the QE2 and was behind the Palm Jumeirah development.


When Nakheel launched its US$3.52bn sukuk issue in 2006, BarCap and Dubai Islamic Bank underwrote the deal and listed it on the Dubai International Financial Exchange (DIFX). The Nakheel sukuk certificates then became tradable in the secondary markets across Europe, the US and Asia.

"It's an assumption that Islamic bonds are only bought by Islamic investors, which is not the case," says Dawood Ahmedji, Deloitte's European head of Islamic finance. "A large proportion of the deals in the past have been bought by predominantly non-Islamic investors . . . so deals like the Nakheel sukuk just became about 'Do I want to buy an exposure to this government or corporate at this price?'."

In other words, buying sukuk has been more an economic decision rather than purely a "faith" decision for the majority of investors. Significantly, the Nakheel sukuk issue remains to-date the world's largest, surpassing even that of DP World's US$3.5bn issue made in the same year to finance its acquisition of P&O, the ports and ferry group.

Come December 14, however, Nakheel must refinance the sukuk. Analysts believe it won't be able to do so by itself without state intervention, because of its exposure to Dubai's property crash. Because Nakheel is part of Dubai World, which is government-owned, there is an understanding that Nakheel's debt will merely morph into sovereign debt as the UAE's central bank steps into the breach with a further US$10bn rescue package for Dubai.


After the collapse of Lehman Brothers, and with the flight of international capital from the Middle East, Islamic acquisition financing has not exactly become commonplace.

Having been burnt through investments made in Advanced Micro Devices and private equity group Carlyle, Abu Dhabi sovereign wealth fund Mubadala did not, for example, use Sharia-compliant financing when it raised US$1.85bn in April. All of it was conventional – the US$1.25bn five-year bond, the US$500m 10-year and the US$100m private placement.

Comparatively few M&A transactions have employed Sharia-compliant financing so far. Even Egypt's Citadel Capital, one of the largest private equity firms in the region with US$8.3bn in assets under management, has only ever used conventional leverage. Sometimes it is just too costly for the issuer to make a financial instrument Sharia-compliant, because that would involve creating a multi-faceted structure of contracts, thus employing more Islamic financial advisers, who are few and far between.

There is also no overarching, global Sharia-compliant framework in place. That very fact acts as an additional hurdle to the growth of Islamic financial products. What may be considered Sharia-compliant in Malaysia may not be the case in Bahrain, which has a stricter interpretation of Islamic law.

However, organisations such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) are helping to establish globally accepted standards for Sharia-compliant financial products.

That issue aside, some of those deals that have actually involved the use of Islamic financing have run into trouble further down the road – not necessarily because of their structures, or lack of conforming to acceptable Islamic standards, but because of the global financial crisis.

Aston Martin

Sharia-compliant Kuwaiti company Investment Dar, which owns half of luxury car maker Aston Martin, has run into trouble, defaulting in May on a US$100m sukuk issue. That default was the first of its kind in the region. Despite reaching a standstill agreement with its creditors at the end of September, Dar may have to sell assets and that has thrown into question its future ownership of Aston Martin.

Originally, Dar was part of the consortium – which also included fellow investment company Adeem – that took over Aston Martin in 2007 from Ford for US$925m. The consortium used a £445.6m Sharia-compliant loan, arranged by WestLB and Standard Bank among others, to complete the deal.

Future growth

Still, not all Islamic institutions, including those in Saudi Arabia, always raise financing in a Sharia-compliant fashion, but that is changing as "financial correctness", in a similar vein to "political correctness", becomes the norm. That is also putting pressure on non-Islamic institutions to offer Sharia-compliant products.

Islamic financing may be in its infancy but as a tool it was never used to invest in US sub-prime mortgages. That perceived disassociation from toxic assets, and the fact that institutions want to be seen to be more conservative in their investment approach going forward, will help grow the Islamic market. Between 2000 and 2008, the sukuk market had reached US$111.9bn, according to the International Islamic Financial Market. A further US$69bn could be added to that figure between 2008 and 2009 despite the crisis.

Islamic financing has fared better than conventional financing and, as far as the future is concerned, there is certainly room for growth, believes Dan Taylor, head of banking at BDO LLP. "Is it ever going get to such a stage where it rivals conventional financing? No, but it is a very important and growing niche issue," he says.

Even the UK government had been considering making a £2bn sukuk issue to help finance its growing budget deficit, which is expected to reach £175bn for fiscal year 2009/10, thanks to falling tax receipts and the cost of rescuing the banking industry.

As economies recover, that will add momentum to the take-up of Islamic financed M&A deals. Already, it looks promising. The FTSE DIFX UAE 15 Index has recovered by 152% from a closing low on February 4 this year of 932.06 points.

Such optimism ties in with the UAE's growth projections for next year. According to the EIU, the UAE is estimated to have achieve 4.4% GDP growth for 2010. That contrasts with a contraction of 4% prediction for 2009.

"I think we will see more M&A, certainly in the Sharia-compliant space," says Campbell Steedman, head of corporate finance for the Middle East at law firm Norton Rose. Sharia-compliant acquisition financing, however, remains a small fraction of what is raised through conventional means.

in a box

Doubts over Sharia-compliance of tawaruk

Providing Islamic acquisition finance can be more hassle than it's worth as scholars question the tawaruk structure. Sarah Young reports.

The vast majority of M&A deals in the Muslim world are funded using conventional acquisition finance. The Sharia-compliant alternative – tawaruk – is plagued by questions over its Islamic authenticity. Moreover, scholar attitudes in the GCC appear to be hardening against the structure.

Tawaruk involves an individual or company buying a commodity from a financial institution. It then resells the commodity, which must not be a precious metal, generating cash. An inbuilt profit for the use of that commodity is then used to repay the bank over time.

The tawaruk structure is standard whether it comes from Malaysia, Dubai or Bahrain. What does vary, however, is whether institutions accept tawaruk as being Sharia-compliant.

Dubai Islamic Bank, for example, rejects tawaruk as a Sharia-compliant structure. Although the AAOIFI (the Accounting and Auditing Organisation for Islamic Financial Institutions) permits the use of tawaruk, certain institutions have a more rigid approach and do not subscribe to the idea of tawaruk being Sharia-compliant.

For some Islamic scholars sitting on the board of Islamic banks such as Dubai Islamic bank, tawaruk contravenes Islamic principles due to its resemblance to a loan with interest.

"The scholars who advise these institutions may have differing interpretations of Sharia and may draw differing conclusions about what is compliant or not," says Shehzaad Sacranie, a partner at DLA Piper Middle East. "Even where the scholars might agree in principle to products, they'll scrutinise the documentation closely."

Dr Hussain Hamid Hassan, chairman of the Fatwa and Sharia Supervisory Board of Dubai Islamic Bank, also sits on 17 other boards, including that of Dubai Bank, and does not believe tawaruk is a Sharia-compliant financing structure.

"There's been lots of scrutiny around tawaruk lately. Many scholars say it is not a genuine Islamic transaction, as they see the commodity trade behind it is done for the sole purpose of borrowing money," says Ehsun Zaidi, head of Islamic finance at JP Morgan.

Broadly speaking, however, the Islamic finance community accepts tawaruk as one of the only methods of providing acquisition finance within the constraints of Sharia law. But it is considered by some scholars as "a last resort", says Neil D Miller, global head of Islamic finance at Norton Rose.

"In some cases where a tawaruk structure is being used, scholars have said that once the target company has been acquired the deal must be restructured to be made Sharia-compliant and a process of debt cleansing takes place," says Miller.

Scholars with a more pragmatic outlook accept tawaruk, recognising that financing for certain transactions is extremely difficult to Islamise – in particular, deals where the acquirer is buying a less than 100% stake and there are few assets involved.

"It can be difficult to structure an Islamic finance transaction on the equity of a target company and in many cases not possible at all. Islamic finance based on shares can also be quite restrictive," says Zaidi.

In situations where assets are involved there are other options. For example, DP World's acquisition of P&O in 2006, involved raising financing based on assets owned by the acquirer. From a Sharia perspective, the financing raised was delinked from the acquisition made.

The tawaruk structure remains for many a viable option. "Lots of well-respected scholars do accept tawaruk," says Zaidi. "As long as Islamic banks feel comfortable that the market will accept tawaruk structures, they will continue to be used."

But the idea that tawaruk is a necessary evil, rather than an important pillar of the Islamic finance offering, does seem to be gaining traction. Financiers and lawyers alike believe there is a gradual movement towards raising the standards of Islamic finance.

"There is a possibility that Dr Hussain Hamid Hassan's stricter interpretation and rejection of tawaruk is something that could be adopted by more scholars in due course," says Sacranie.

The leeway that scholars historically afforded to the Islamic finance industry to help kick-start it over the past 30 years is gradually being phased out as the Islamic finance market matures.

"The industry is at a crossroads," says Zaidi. "There's a fine balance between the scholars enforcing tougher standards and the industry's need to grow and provide a meaningful alternative to conventional finance."

The fact that scholars are increasingly encouraging Islamic financial institutions to look for alternatives to the tawaruk structure suggests the stricter direction in which the industry seems to be headed.

While advisers say this is the case in the GCC region, Malaysia is singular in its more permissive approach. The lines of thought that have developed between scholars in the Malaysian region and those in the Middle East are somewhat different and transactions that are approved as Sharia-compliant in Malaysia may not be acceptable to GCC-based scholars.

As such, the debate around tawaruk is primarily a GCC phenomenon. Moreover, in Malaysia there exist a handful of other structures that can be employed to help facilitate Sharia-compliant acquisition finance.

Despite the academic probing of tawaruk, the fact is that very few deals have actually called on it, as lenders have on the whole chosen to employ conventional acquisition financing.

"There haven't been many Sharia-compliant M&A deals," says Miller. Going forward, however, he expects there will be more as the recovery gains momentum. With a shadow hanging over tawaruk, he believes there is potential for innovation.

"New structures and alternative solutions will develop," Miller says. "We've got some inquiries on our desk and we're looking at using Islamic contracts in new ways and preparing ideas."

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