Dar Al-Arkan sukuk

The Dar Al-Arkan sukuk was one of the first, if not the first, sub-investment-grade sukuk to be issued following the credit crisis and the sharp decline in sukuk issuance that followed. I have not had a chance to fully review the structure until now, but there are a few areas where the sukuk deserves its sub-investment-grade rating, in my opinion, apart from any credit rating of the issuer.

Dar Al-Arkan is a Saudi Arabian real estate company that invest primarily in undeveloped land, although it is expanding its property management business, which is generally a less volatile source of cash flow because it does not depend on the prospects for new developments as much. The sukuk uses two SPVs, one domiciled in the Cayman Islands which issues the sukuk and acts as trustee for the investors. The funds from the sukuk are then placed with another Saudi-domiciled SPV that manages the investments for the investors. The latter SPV is owned entirely by Dar Al-Arkan.

The first issue this creates is that it makes any investors' claims dependent upon the Saudi legal system, which does have a track record based on the numerous foreign oil companies operating within the country, but which is an emerging market and those concerns are also present within the Kingdom as well, in my estimation. The fallout from the Nakheel sukuk (before it was repaid with assistance from Abu Dhabi) focused attention on whether investors could enforce claims within a Gulf emerging market legal system as easily as they could within a developed market legal system, which generally has a more predictable legal system. There was a dual legal system structure in the Nakheel sukuk with the sukuk governed by English law and the mortgage provided to investors enforceable under Emirati law. In the Dar Al-Arkan sukuk, however, there is not the additional complication of a quasi-state-owned company as there was with Dubai World.

Once the funds are transferred into the Saudi SPV, the SPV acts as wakil under a wakala agreement to provide murabaha and ijara financing to subsidiaries of Dar Al-Arkan with returns greater than the periodic distribution amount of 10.75%. The first issue is one of a perceived conflict of interest with the owner of the wakil being the owner of the subsidiaries who will receive financing through the ijara and murabaha agreements. The sukuk is certainly an unsecured offering with a guarantee by Dar Al-Arkan only applicable as I read the offering memorandum if the investment manager is negligent. The portfolio of assets has to be managed in a way that ijara make up at least 51% to ensure the sukuk are tradable under commonly accepted Shari'ah standards (e.g. the most recent Islamic Development Bank sukuk).

My main point of concern with how the structure is created is that it relies on the investment manager (owned by Dar Al-Arkan) making arms-length transactions with other Dar Al-Arkan subsidiaries. This is possible, but with a fixed return on the sukuk and the excess amounts being retained by the investment manager, there is a strong incentive that is not necessarily in the investors' favor. If the investment manager is not negligent, any excess return above the 10.75% is retained by the investment manager (essentially by Dar Al-Arkan), while any losses based on non-payment of the murabaha or a deterioration of the value of the ijara assets are borne by the investors.

If I were an investor (I am not), I would much prefer to have the investment manager be independent of the issuer of the sukuk (Dar Al-Arkan) to ensure that incentives are aligned with the interests of investors instead of being conflicted with both sides to each ijara or murabaha agreement being owned by a common owner (Dar Al-Arkan). In reality, the sukuk is a debt of Dar Al-Arkan, but there are enough different entities involved that if the projects didn't materialize in the way anticipated by Dar Al-Arkan, it could create a significant tangle for lawyers and various courts to unravel the investors' claims.

Note: Because this post is about a specific investment, I would like to emphasize that (with all of my posts) it is not investment or legal advice, nor is it an offer or solicitation to buy or sell any security.