Arcapita's ambitious plan to exit bankruptcy

I didn't expect to find much in the "Debtors' motion for an order..authorizing debtors to implement global settlement of senior management claims" (pdf), but it included details about how Arcapita is planning to exit bankruptcy.  The filing details what the company describes as "a long-term business plan designed to effectuate, among other things, an expeditious exit from bankruptcy" aided by a previously approved incentive plan with employees that Arcapita states has "stabilized their operations and avoided the flight of the Arcapita Group’s best employees who have most, if not all, of the institutional knowledge required to effectively manage the Debtors’ interests in Arcapita Group investments and portfolio companies."

The earlier plan allowed terminated employees (and current employees if they remained with the company through November) to settle the amounts they owed Arcapita from an incentive plan that allowed them to co-invest with Arcapita in portfolio companies. 

The incentive was provided by an affiliate of Arcapita loaning them money (through a qard loan) to invest in Arcapita's deals.  The loans were repaid in 5 equal payments of 15% of the loan amount from a portion of their annual incentive payments.  If they remained with Arcapita for 5 years, the remaining 25% of the loan was forgiven.  The earlier plan allowed employees (with the exception of senior management) to have the amount they owed forgiven in exchange for returning their share of the investments in portfolio companies corresponding to the amount they still owed Arcapita. 

The current request is to allow the senior management (6 individuals in total) to participate in the same type of plan, except to make it dependent on different conditions.  Currently these 6 people owe Arcapita $7.5 million, while the 'fair value mark' of the shares they are offering in return is just $4.0 million (although Arcapita claims that "the aggregate value of the shares which may be returned to Arcapita via the Senior Management Global Settlement would actually exceed the related aggregate [incentive plan] obligations."). 

Although Arcapita believes these shares are worth more than the debts being forgiven, the management has also offered to waive their claims against Arcapita for bonuses from 2011, although it is unclear why bonuses to management should be owed for a year when the company was in dire financial straits (and potentially insolvent according to KPMG's mid-level valuations of its assets).  The motion argues that litigation over these claims would be difficult since they would occur in foreign jurisdictions, and would be challenged by the senior management would not be enforceable since the funds are owed to a subsidiary of Arcapita that is not involved in the bankruptcy proceedings. 

The motion further argues:

In addition, the historical treatment of the [incentive plan] also undercuts any argument that the obligations thereunder should be enforced now.  The Arcapita Group historically did not pursue departing or terminated Employees in respect of their [incentive plan] exposure.  Employees may argue that the Arcapita Group’s failure historically to enforce these obligations supports their treatment as an incentive plan, not an obligation which needs to be satisfied.

More important for those who are interested in how Arcapita could exit bankruptcy, the condition for senior management's proposed plan to become effective is: 1) the case is forced into liquidation of the company before December 15, 2012 in either the US (under Chapter 7) or in the Cayman Islands; or, 2) the filing of a reorganization plan by December 15, 2012.  A reorganization plan that would qualify would:

either (1) a standalone chapter 11 plan whereby the current entities emerge from chapter 11 in a substantially similar organization (the “Standalone Plan”) or (2) a chapter 11 plan (the “Toggle Plan”) that provides for both (a) a restructuring plan premised on the Debtors’ raising new equity capital from investors (the “New Money Plan”) and (b) a Standalone Plan.  If a Toggle Plan is filed, it will “toggle” from a New Money Plan to a Standalone Plan if a minimum of $500 million of new equity is not in escrow prior to plan confirmation.  If at least $500 million of new equity is raised and in escrow by December 15, 2012, a New Money Plan can be filed as an Eligible Plan, satisfying the Plan Milestone.

From this, it appears that Arcapita believes it can either liquidate sufficient assets to meet their obligations (or convince those creditors to take a haircut), or raise $500 million in new equity (and presumably also get creditors to agree to extend their debt or otherwise restructure it. 

Arcapita says that the incentive plans are about 46% underwater (the valuation of the shares are about 54% of the debts incurred--the book value of those assets).  It would seem likely that senior management holds either a representative slice of Arcapita's portfolio (at the worst).  The latest values of Arcapita's investments was September 30, 2011, so the figures are a bit dated, but the reported value of the company's investments was $2.35 billion (total assets of $3.57 billion). 

Through the last annual report from June 30, 2011, the $2.46 billion in investments had been marked down (through cumulative fair value changes) by just $90 million (3.7%).  The vast majority (>99%) of the investments are accounted for as Level 3 assets, which are based not on market prices but on unobservable inputs "e.g., valuation methodology using EV/EBITDA multiples or discounted cash flows."  There was an additional $17.2 million in fair value adjustments in the three months to September 30th (4.3% cumulative loss recognized on the balance sheet). 

This is probably a reasonable way to value investments in private equity because they tend to be held for many years and are not liquid (the 'private' part of 'private equity').  But using the 46% fair value-to-original value discount that a mid-point valuation established for the senior management's coinvestments through the investment program values the firm's investments at $1.326 billion (compared to the value from 9/30/2011 of $2.365 billion). 

Adjusting the equity reported on 9/30/2011 by the difference ($1.039 billion) left Arcapita technically insolvent at today's investment valuations, with negative net equity of ($6.5 million).  For Arcapita to attract new equity capital, it will need to find new investors who view the mid-point valuation from KPMG as undervaluing the assets Arcapita holds and, likely, also be willing to assume that Arcapita's creditors will agree to 'extend-and-pretend' while it monetizes its assets. 

Management clearly believes it can convince investors that both will hold true, and can convince them in the next 3 months.  Only time will tell. 

Arcapita's district cooling investment in jeopardy

Arcapita, the Bahrain-based Islamic investment bank currently in Chapter 11 bankrupcty, filed a motion (pdf) that would allow a $1.9 million murabaha financing, with a profit rate of 15%, into District Cooling.  District Cooling is a joint venture with Dalkia Utilities Company that provides district cooling and other services to three developments in Bahrain and Abu Dhabi. 

The financing would be bridge financing while Arcapita and District Cooling renegotiate a concession agreement with Abu Dhabi’s Tourism Development & Investment Company (TDIC) to reduce capital needs by lowering the number of cooling plants at Saadiyat Island from three to two, as well as to pay for diesel fuel and rent for the temporary plants currently in operation on Saadiyat Island, as well as to continue construction required under the concession agreement. 

Arcapita stated in a filing with the Bankruptcy Court that it believes it is in the “ordinary course of business” to fund District Cooling and that it can do so without Court approval, but in response to objections from creditors it is asking for court approval to “support candor” in its disclosure of the transfer of capital to entities not included in the bankruptcy process.

Without the additional bridge financing, Arcapita believes it could lose its entire investment in District Cooling, a minority interest they estimate is valued at $20 million, which includes a guarantee made by Arcapita of a $10 million performance bond from Standard Chartered Bank, Arcapita’s secured creditor. 

Arcapita foresees a “public relations nightmare” that could inhibit its ability to conclude a reorganization plan if it is not allowed to support District Cooling.  It estimates that absent additional funding, Paragon ABD Cooling, the entity providing cooling and other services to Saadiyat Island, will run out of money in late September. 

District Cooling is currently negotiating with Dalkia and TDIC to modify the concession agreement, as well as negotiating with third-party and present investors and Dalkia to provide an exit for ABD that would preserve the value other two subsidiaries of District Cooling, one of which is currently operating at the Bahrain Bay development and another at Al Areen, both in Bahrain.  Arcapita has requested a court hearing on the motion to allow for the murabaha, but the date has not yet been scheduled.

Look forward for the future of Islamic finance, not to the past

Gulf News' financial correspondent Andrew Shouler wrote an article that contains some valuable insights, but much more folly.  The basic idea of his argument is that Islamic finance is different substantially enough from conventional finance that it allowed the industry to avoid most of the impacts of the financial crisis, although he tries to hedge that idea with the idea that Islamic banks were "There are both cyclical and structural distinctions, he suggests. Many Islamic banks were set up in the past decade, and were victims of timing. Yet, holding greater cash reserves is prudent and will bode well, and the potential for liability gathering in terms of deposits is another clear advantage."

He is right that timing has played a big part in the success of Islamic finance, but I would argue that rather than being a 'victim' of timing, Islamic finance benefited from having its growth period recently.  Had Islamic finance developed earlier, it would have had the opportunity to make similar foolish bets as the conventional financial industry.  It would have also developed ways to get exposure to the real estate boom in the US and parts of Europe and given the penchant before the crisis to develop ever more complicated structures (to be the 'first' this or that), there might have even been Islamic CDOs (although probably not Islamic synthetic CDOs). 

And even without the use of CDOs there were plenty of examples of Islamic investment banks that blew themselves up using leveraged bets on real estate (e.g. Gulf Investment House or Arcapita, not to mention many smaller Kuwaiti Islamic investment banks).  And Shouler does give room to this argument by saying: "In the Gulf, while the tenets of Islamic finance helped spare its institutions from certain exposures, they were still, like others, especially vulnerable to real estate."

Where his argument gets things right is on the current prospects for Islamic finance and sukuk refinancings in particular quoting Dr. Massoud Janekeh, head of Capital Markets at BLME: " 'Markets expected a wall of maturities in 2012,' he said, but the refinancing that has actually occurred is 'a huge endorsement' of confidence in the sector and region."

I would not go so far as to say it has been a 'huge endorsement' because of companies like Arcapita which sits in bankruptcy and Dana Gas, which still faces a tricky maturity date coming up for its $1 billion sukuk. 

Where there may be some room for progress in the future is mentioned in a passage where Shouler quotes Faisal Aqil, Deputy CEO, Consumer Wealth Management, Emirates Islamic Bank and Dubai Bank, "Partnerships between banks and their customers that include the essential concept of profit/loss sharing have been “one of the main factors that helped Islamic banks withstand the widespread effects” of the crisis, he says, so that Islamic finance is perceived increasingly as a “credible substitute” for conventional banking business."

There are possibilities in the future to create debt alternatives that have partnership features and shared profit connected to shared risk which I described in my latest newsletter.  However, looking backwards, it is factually incorrect to say that profit and loss sharing have impacted Islamic banks' ability to survive the crisis because for the most part, they do not use profit-and-loss sharing products (murabaha and ijara, which replicate conventional debt structures in their economic outcome are much, much more common). 

Shouler concludes with something that I wish would be true, but is unfortunately not the world we live in within Islamic finance: 

Ultimately, Janekeh draws a parallel between the lessons of the crisis generally and the specific characteristics that Islamic finance brings. Though it is still a niche sector, IF “will contribute with its simplified structures and ethical dimension” to the aftermath, he argues. “If you look at the global initiatives, you will see many of these features.”

There are many things that I can say about Islamic finance that give hope for its future as an alternative for conventional finance, but 'simplicity' is not one of them.  There are places where there could be more simplicity (e.g. post-AAOIFI ruling mudaraba sukuk) where assets with stable distributions could be pooled to create a product that offered an alternative to conventional bonds.  However, this is not the direction the industry is going.  Instead the product mix (and sukuk in particular) are becoming increasingly complex instruments, although thankfully not as complex as some of the pre-financial crisis issuance like the Nakheel Pre-IPO convertible sukuk. 

The Islamic finance industry should aspire to greater simplicity and find areas like SME financing or agriculture financing where it can make a positive impact, or trade finance where it can offer an alternative to conventional finance that makes use of the classical contracts more in line with their classical uses (rather than using them as building blocks in complex structured finance transactions).  Trying to rewrite the history of the financial crisis and the way that Islamic banks operate is the wrong way to promote Islamic finance as a viable alternative to conventional finance.  Fortunately, there are better ways that Islamic finance can contribute to the market especially now that public opinion of conventional financial services are near their low point.  That should be the focus. 

Arcapita seeking $150MM - $200MM in Shari'ah-compliant DIP financing

For those readers who do not follow me on Twitter, here are a few tweets relating to the motion (PDF) filed by Arcapita requesting permission to pay $500,000 in expenses to an as-yet unnamed financing partner for $150MM - $200MM in Shari'ah-compliant debt financing, which Arcapita says is the first such debt (Shari'ah-compliant within a Chapter 11 bankruptcy). 

The vulnerability of sukuk markets

The resurgence in sukuk issuance since the twin shock of the global financial crisis and the Dubai debt crisis has been nothing short of remarkable.  One of the most surprising indicators of how much demand for sukuk has rebounded is that the Dubai sovereign sukuk--issued by the very sovereign that was at the center of a storm in December 2009--has seen its yield drop from 6.396% when it was issued to just 3.2% yesterday.  There have been a few hiccups in the 'year of the refinance' (notably with Arcapita's $1.1 billion syndicated murabaha), but many new sukuk have been issued, including the largest sukuk in history, the $4 billion Qatari sovereign sukuk which priced to yield 2.1% which reportedly left enough buyers out that they flooded the secondary markets, bidding prices up.

The development of the Islamic repo market (as nascent as it may be) has likely also encouraged a few extra buyers for sukuk, since they can realize some liquidity from their sukuk holdings through Islamic repo that allows them to hold onto that sukuk.  This is true in particular for investment-grade sukuk like Qatar's sovereign sukuk.  At the same time, reports suggest Western investors are becoming interested again with sukuk, through both primary and secondary markets.

This is a good thing.  More demand and better secondary market liquidity will help bring new issuers into the market to provide more supply to meet the demand, which is clearly growing.  However, the rapidity with which the market has boomed should be a cause for some concern.  There will undoubtedly be a break in trading activity once Ramadan begins, but after the Eid, will there continue to be the same confluence of financial market conditions to support the prices for sukuk?

Will Western investors return to Europe if there is a pathway to a solution of the Eurozone debt crisis?  Will there be geopolitical tensions in the GCC that affect local investment demand in sukuk versus 'safe' assets like US Treasuries (since not all investments from that region are dedicated entirely to Shari'ah-compliant investment strategies)?  These are always concerns for the market, but when it has risen as quickly as it has recently, the risk of something happening that spooks an already relatively illiquid market rise. 

In the long-run, sukuk markets are likely to continue to grow as Islamic finance increases its share of the financial markets in the GCC, but that does not mean the growth will occur along a straight line.  There will be rough patches (hopefully not as challenging as the last five years), but the demand for sukuk is robust and the more mature that market becomes, the more it is likely to attract new potential investors and issuers. 

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). 

Arcapita's portfolio company profine sold to private equity firm Hidden Peak Capital

Arcapita's subsidiary profine GmbH, a German-based plastics window frame manufacturer was sold to Hidden Peak Capital, a special situations private equity group based in Germany.  The terms of the transactions were not disclosed, but it likely includes the repayment of the murabaha loan from Commerzbank for up to €125 million that is guaranteed by Arcapita (total borrowing amount is not disclosed in the court filings). 

The murabaha facility entered the court documents when Commerzbank requested permission from the bankruptcy court to serve notice on Arcapita that the facility was in default to perfect their claim on Arcapita, which they contended should be exempted from the automatic stay. 

While the sale, which may need approval from the bankruptcy court, resolves one issue in front of the court, it will likely heighten the challenges by creditors on Arcapita's ability to continue to make inter-company transfers.  Not all of Arcapita's subsidiaries were covered by the bankruptcy, so there is a possibility that proceeds from the sale could be moved into non-debtor subsidiaries, away from the reaches of creditors. 

Arcapita bankruptcy update

In the latest week's newsletter (sign up for the newsletter on the right side of the blog; an archive is available on my website), I included a summary of some of the latest developments in the Arcapita bankruptcy case[1].

Arcapita’s bankruptcy case is ongoing and a recent objection by Standard Chartered, which provided $100 million of murabaha financing to Arcapita in 2011, presumably to finance the company through its anticipated debt restructuring of the $1.1 billion murabaha whose imminent maturity led the company into bankruptcy. 

The objection by Standard Chartered is based on the potential, according to Standard Chartered, for Arcapita to make inter-company transfers of dividends that should be held for Standard Chartered due to its mortgage on the equity of a number of Arcapita subsidiaries.  Standard Chartered, in a court filing, described that “if the value of the Subsidiary Guarantors, which is at best uncertain, is transferred to AIHL [Arcapita’s Cayman Islands holding company] or Arcapita Bank, Standard Chartered’s security interests could be rendered worthless and the Subsidiary Guarantors could impermissibly be rendered insolvent to the detriment of Standard Chartered”. 

Standard Chartered is asking the court to make the approval of any budgets the court is presented with by Arcapita require approval by Standard Chartered as well.  More concerning for the unsecured murabaha holders, the senior position of Standard Chartered means Arcapita will have to come up with more money before lower priority murabaha creditors get paid. 

In another document filed with the bankruptcy court, Barclays Bank, which is on the committee of unsecured creditors, has asked the court permission for its affiliates to trade claims on Arcapita’s debt, as long as it separates those trading activities from its position as a committee member to avoid potential conflicts of interest. 

As I mentioned in an earlier blog post, is the fact that the murabaha financing is being traded (and the trading is unlikely to occur at par).  Yet, there has been much less controversy about this than about the potential for the Goldman sukuk to be traded since it was listed on the Irish Stock Exchange (even though it was never likely to trade).  

There are a few filings so far this week including two (pdf 1, pdf 2) requesting an extension of the time Arcapita has to file its financial statements to June 21, 2012, from the previously extended deadline of May 3, 2012.  In their filings, Arcapita cite a need to consider "nuanced legal issues[...], in particular, payments and distributions to and from insiders and other affiliates".  They also cite as a source of delay, "the Shari’ah-compliant nature of the Debtors’ investments requires a thorough analysis of some of the characterizations required by the Schedules and Statements"

Another filing, this one from Commerzbank (pdf), asks the court to grant a relief from the automatic stay to allow Commerzbank to serve a notice of default on profine GmbH, a portfolio company of Arcapita that manufactures PVC window frames, on a Euro125 million murabaha line of credit (guaranteed by Arcapita), which profine defaulted on a week before Arcapita filed for bankruptcy.  Under the murabaha (the total amount outstanding is not specified in the filing, but is described as "principal plus unpaid profit"), Commerzbank could only exercise the guarantee once 14 days passed after the default.  Commerzbank argues that delivering a claim notice to Arcapita is only a ministerial act designed to perfect and crystallize Commerzbank's claim, and therefore it would fall outside of the automatic stay.  It is unclear whether the default was related to funding problems at Arcapita, but profine announced a management change on February 24, weeks before defaulting on the murabaha (followed of course by Arcapita's bankruptcy filing). 

[1] Note: I am not a lawyer, so this post represents my opinion from reading the court filings.

Arcapita bankruptcy - The benefits of the bankruptcy process

Arcapita is working through the bankruptcy filing and with their public statements to portray the hedge funds who bought the debt in the secondary markets as the bad guys who forced the company into a hastily prepared bankruptcy to 'protect' the company's other creditors.  Arcapita's preferred method was to 'extend-and-pretend' the $1.1 billion syndicated murabaha facility for three years.

However, as Bloomberg notes, the hedge funds had their own concerns that Arcapita was paying unidentified consultants ($96.3 million so far this year) and had sold an asset to Qatar Islamic Bank,  two weeks before the bankruptcy, which Bloomberg reported "has a relationship with Arcapita".  For any creditor, the prospect that Arcapita could move funds around freely if it remained outside of bankruptcy (perhaps distributing it to other investors or moving it to countries where it would be harder to recover) is a legitimate concern. 

I have seen arguments made that paint the hedge funds as the 'vultures' who bought the murabaha at a discount, pushing an otherwise healthy company into bankruptcy.  However, it is impossible to know whether Arcapita is a healthy company because of the lack of transparency into their financials (the most recent statements available are for the quarter ending September 30, 2011), and they provide little transparency on the operating companies' financial situation.

As I mentioned in a post earlier this week, Arcapita reports on their own website that they have only one portfolio company that they bought after the financial crisis.  That is J. Jill which they bought less than a year ago in a leveraged buyout.  As I reported in the past year for The Islamic Globe, J. Jill's debt has been downgraded twice to Caa by Moody's (and CCC by Standard & Poor's) on concerns about high debt levels and that prospects for J. Jill to breach debt covenants.  While J. Jill is one of the only company where there is some vision about the leverage levels of portfolio companies, it led investors to be concerned that Arcapita's investments (as reported on their balance sheet) might not be accurately valued. 

If the assets were more significantly impaired than Arcapita has assumed in its financial statement, the equity Arcapita holds in the portfolio companies might be written down (e.g. if a company like J. Jill were taken over by its creditors, which could wipe out equityholders).  Holders of the murabaha including the hedge funds might want to force greater disclosure of the true financial position of the portfolio companies, as well as Arcapita itself, and a more transparent outcome.  This is where bankruptcy can work well, because it tries to find the most equitable solution for creditors, as well as providing a way for the business (if possible) to continue as a going concern.

At this point, it would be easy to jump to the conclusion about the financial state of Arcapita or the motives of the hedge funds who bought the debt at a discount.  However, it makes more sense to wait until a fuller picture of the case emerges as Arcapita works through the bankruptcy process.

Arcapita bankruptcy

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 happens). 

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. 

Leverage 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. 

The 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.

Trading murabaha (Arcapita and Goldman Sachs)

There are a lot of areas where criticism has been directed at Goldman Sachs' murabaha sukuk, but one area can probably be dismissed: the listing of the sukuk on the Irish Stock Exchange.  The concern is that the sukuk will be traded at values other than par, which is not allowed in most cases (outside of Malaysia where bay' al-dayn or debt trading is permitted). 

The argument from Goldman Sachs is that the listing on the Irish Stock Exchange is for "tax mechanism purposes", not for trading according to a Shari'ah scholar quoted by EuroWeek.  The prospectus states that the sukuk is not tradable except at par, but this is just a statement from the scholars, not a legally binding part of the prospectus.  A spokesperson for the Irish Stock Exchange has also said it "would not be appropriate for an exchange to determine price in the market" (also from the EuroWeek article). 

This makes sense, and while not desirable from a Shari'ah perspective, will inevitably be a concern whether or not the sukuk is listed.  Arcapita's $1.1 billion murabaha (which the company was not able to roll-over leading the firm to file for Chapter 11 bankruptcy protection) would have contained a similar requirement around trading for Shari'ah-compliant investors, yet it traded a year ago at 76 cents on the dollar and other market data suggests it was trading between 50 and 60 cents a few months ago. 

I am not making an argument on Shari'ah grounds here (I am utterly unqualified to make a judgement on such an issue), but on the mechanics of how Islamic finance interacts with the conventional financial system.  There is no requirement that Islamic debt be subscribed only by Shari'ah-compliant investors, nor would that make sense.  The issuer buys a commodity (or other tangible asset) from the investors at the cost plus a markup and agrees to make deferred payment for the asset.  The Shari'ah board reviews the transaction to ensure it complies fully. 

An Islamic financial institution which subscribes to the murabaha would hold the debt and could--if it chooses--sell it to another institution, but only at par (something its own Shari'ah board would oversee and sign off on).  However, the other investors who are not required to be Shari'ah-compliant are freely able to trade that receivable to other conventional investors at whatever price they decide is fair (if they were to sell to an Islamic financial institution, the buyer's Shari'ah board would likely determine that the purchase must take place at par). 

The murabaha issued to conventional investors is subject only to the law chosen that governs it (e.g. English or New York law is most common) and the post-sale transactions with non-Islamic investors would be governed by whatever securities laws apply to the buyers and sellers.  It would be inappropriate and impossible to have Shari'ah scholars ruling on the transactions between two parties who do not subject themselves to remaining Shari'ah-compliant.  Nor would transactions at prices besides par make the rest of the issued murabaha not Shari'ah-compliant. 

Returning to the Goldman Sachs sukuk, there are other more pressing issues for potential Islamic investors than the tradability of the sukuk.  For example, the use of proceeds and the ability of a non-Shari'ah-compliant institution to fund its non-compliant businesses using Islamic financial products.