Tuesday, June 12, 2012

Lessons from Arcapita

When I was writing for The Islamic Globe, I covered Arcapita and in particular the financial difficulties around its J. Jill portfolio company as that company saw the debt used for the acquisition downgraded several times.  It led me to look more deeply into the financial statements of Arcapita and recognize a problem with the upcoming maturity of a $1.1 billion murabaha due in March 2012.

J. Jill was instructive because it was, I believe, the only new investment made by Arcapita after the financial crisis and the speed at which it soured (in terms of credit downgrades) was surprising.  At the time, I thought that it might have been a problem of Arcapita not realizing the "new normal" where lenders were much tighter in offering debt financing (the downgrades were due to J. Jill running up against debt covenants, which were likely to be breached since they became more constrictive in future years). 

Unfortunately, the Islamic Globe suspended publication and Arcapita filed for bankruptcy (meaning the most current financial statements were from September 2011) before I could finish an article about the firm's problems.  Since the bankruptcy, I have followed intensely the filings with the bankruptcy court and have been puzzled that the company did not request permission from the court to sell profine GmbH, which it sold to a German private equity company in late April 2012, more than a month after the bankruptcy filing.  The lack of court filings was hard to understand since the profine press release announcing the sale said: "profine GmbH, one of the world’s leading manufacturers of PVC-U profiles for windows and doors, has a new owner. The Frankfurt company Hidden Peak Capital has bought up the shares of the former owner, Arcapita Bank BSC of Bahrain."

There was a good deal of activity in the bankruptcy court concerning a debt guarantee provided by Arcapita to Commerzbank, who provided the financing for the acquisition, but nothing about the sale of the company.  I went back then to the original 'first day' filings, and found the story laid out clearly, but must have glossed over on first reading.  They detail troubles at profine much earlier, as early as May 2008 (seven months after Arcapita acquired the company). 

To be fair, this was months after the failure of Bear Stearns and the credit crisis was just in its early stage, but it matches up quite well with the few details I have about J. Jill, which was acquired after the credit crisis, but with the same leveraged buy-out mentality of Arcapita.  In May 2008, Arcapita sunk an additional 25 million euro in equity into profine, and provided Commerzbank with a 125 million euro guarantee, tied to profine's financial performance, which worsened in the financial crisis. 

Beginning in 2009, Arcapita and Commerzbank worked on a subsequent financial restructuring of profine, which they finally closed in November 2010 requiring an additional 45 million euro in equity capital by the end of 2011.  When that date neared, Arcapita was in dire straights trying to raise the capital to repay the murabaha (the failure to do so earlier was ascribed by Arcapita to the European debt crisis in 2011).  They negotiated a one month extension to put up the remaining 13 million euro in equity, but at the end of January, they decided to withhold the funds (whether due to the financial situation of profine or due to their own lack of cash I don't know). 

As a result of their decision, their board members were sacked and Commerzbank accelerated the debt due by profine to Commerzbank.  As a result of Arcapita's bankruptcy, which was attributed to distressed debt buyers of their $1.1 billion murabaha taking a hard line, Commerzbank now has to wait for the bankruptcy court to approve a restructuring plan in order for them to make good on Arcapita's guarantee of profine's debt.  An educated guess suggests that Arcapita's financial guarantee was secured by Arcapita's equity interest in profine, which was likely taken before the bankruptcy filing, and thus Arcapita did not need to request bankruptcy court approval for the sale of profine to Hidden Peak Capital. 

At the end of the day, both the J. Jill and profine acquisitions suggest that Arcapita was aggressive with the amount of leveraged used in taking over these companies, and whether that type of leverage is appropriate for an Islamic financial institution should be a topic for discussion in the industry.  There will always be some degree of leverage in financial institutions.  Islamic banks that issue sukuk are leveraging their equity investors' money also, but with fewer casualties during the financial crisis (Islamic investment banks have taken the brunt of the pain from forced deleveraging and a sharp drop in deal flow and therefore income throughout the financial crisis and its aftermath). 

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