I am not too surprised by the Arcapita bankruptcy (the NY Times has a copy of the bankruptcy filing on their Deal Book blog, their other filings are available here). Their portfolio of investments was mainly from pre-financial crisis, with the lone exception being J. Jill. They had $1.1 billion in a syndicated murabaha financing coming due at the end of the month, and reported only $19 million in cash as of September 30, 2011 despite many asset sales earlier in 2011.
I have written quite a bit about the troubles with J. Jill (which saw its debt ratings downgraded repeatedly) for The Islamic Globe, including in late February 2012.
However, the problems with Arcapita were far deeper than just the
troubles of J. Jill (the debt of the two is separate and one does not
directly affect the others, apart from the potential cash infusion that
would be required from Arcapita to stave off default by J. Jill if that
The biggest problem for Arcapita is that it
was unable to continue its business model (leveraged buy-outs and sales
of its holdings at a profit) after the credit crisis hit. In the
immediate wake of the credit crisis, potential buyers of its portfolio
were likely unable to get their own debt financing. As the crisis
dragged on, the holdings remaining on the Arcapita balance sheet (most
of the holdings were in part sold off to their investors when deals were
completed) were worth far less than they were purchased for.
works both ways. Arcapita (and other private equity companies) relied
upon their holdings appreciating so that they could be sold off for more
than they paid to buy, with the returns amplified by the leverage they
employed, both on a portfolio company level and the holding company
level (the more debt they had to support their balance sheet, the higher
the returns to their equity holders. However, their business model
imploded along with the business model of many private equity
companies. It is impossible to speculate about whether they were
disproportionately hurt compared to their rivals. Their headquarters
building sitting alone on the location of a development at Bahrain Bay
they began in 2005 which has still not been completed says more than any analysis of their balance sheet can.
real question for creditors is whether the extend-and-pretend will
succeed. If they extend the murabaha they are hoping that Arcapita's
holdings can be sold for prices high enough to repay the company-level
debt and return enough cash to Arcapita's coffers to repay the murabaha,
so long as it is not turned into a fire sale. The situation is
complicated by distressed debt funds owning between 15% and 25% of the
murabaha by my best estimates (with the remainder split between around
60% original syndicate members and 20% who likely invested directly in
the syndicated murabaha in 2007).
Arcapita blamed this
minority as precipitating the bankruptcy filing, but perhaps these
investors put a fair value on Arcapita's holdings, and they would not be
able to repay the murabaha and continue on as a going concern
afterwards, even if they were given additional time. The concept of
bankruptcy and Islamic finance is not well established and one of the
few relatively successful bankruptcies of an Islamic debt instrument was
East Cameron. It was solved through a relatively ad hoc solution in a
US bankruptcy court that saw some conventional funds work with Islamic
investors to create a solution that allowed for the Islamic investors to
potentially recover some of their investment, while remaining within
their Shari'ah mandate.
From what I could see in the
East Cameron filings and a post mortem from people I spoke with, the
solution wasn't pretty (i.e. it wasn't solved along the exact lines
drawn up in the contracts), but instead relied upon the focus of US
bankruptcy courts of finding an equitable solution. Perhaps a similar
resolution of the Arcapita bankruptcy through US courts could make the
US a more recognized jurisdiction for Islamic finance. That, more than
anything, would encourage more Islamic finance in the US.
A post script: I wasn't able to fit into the blog post the
connection between current discussion of presidential candidate Mitt
Romney's involvement in private equity with Bain Capital and the
Arcapita bankruptcy, but they do have a strange overlap. Bain Capital
has been heavily criticized for leading American Pad & Paper into bankruptcy in 2000. Three years later, the firm was bought by Arcapita.