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. 

Highly leveraged Islamic private equity will not perform differently than conventional private equity!

I saw an article about the 'promise' of Islamic private equity, which included a few claims about the differences between Islamic PE and conventional PE that I thought were not quite accurate in most cases, and important in deciding whether Islamic private equity is a worthwhile avenue for the amount of growth being forecast. 

Prior to the global financial crisis of 2008, the conventional private equity (PE) industry flourished on excessive cheap debt and this came back to haunt it when the markets collapsed.
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Islamic PE avoided that trap due to the restrictions it imposed on taking conventional forms of leverage.

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Such PE funds will use sukuk or Shariah-compliant leverage to finance their acquisitions.  

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Most of the Islamic PE funds are domiciled in Mena and the GCC region and focus on real estate. They have suffered from the property market bust in the region.

First off, I think that including real estate transactions in private equity give the impression that Islamic PE is much bigger than it actually is, because the main similarity between real estate-based private equity and what is traditionally thought of as 'private equity' is the high leverage used in the transactions.

Let's go back and reconsider the definition of private equity.  A National Bureau of Economic Research (NBER) working paper published by Steven Kaplan and Per Stromberg (pdf) describes private equity in the context of their research, which I think provides a good description of what is generally included in the 'private equity' label and what is generally not.

In a leveraged buyout, a company is acquired by a specialized investment firm using a relatively small portion of equity and a relatively large portion of outside debt financing.  The leveraged buyout investment firms today refer to themselves (and are generally referred to) as private equity firms.  In a typical leveraged buyout transaction, the private equity firm buys majority control of an existing or mature firm.  This is distinct from venture capital (VC) firms that typically invest in young or emerging companies, and typically do not obtain majority control.  In this paper, we focus specifically on private equity firms and the leveraged buyouts in which they invest.

As this paper explains, private equity as it is commonly used, is just a euphemism for leveraged buy-outs; acquisitions of public companies by private investors where the buyers rely heavily upon debt to pay the purchase price.  To take one specific example of an Islamic private equity transaction, look at Arcapita's acquisition of J. Jill (notable because its debt was rated by Moody's and the rating described some of the factors that led Moody's to its final rating).  Moody's wrote: "J Jill's B2 Corporate Family Rating reflects the company's relatively small size in terms of revenue and profits and narrow product focus in the women's specialty retail apparel sector. The ratings also reflect the company's high leverage. Pro forma debt/EBITDA is about 5.7 times (incorporating Moody's standard analytical adjustments for operating leases). "

It excludes venture capital, and is not necessarily focused on the real estate sector (real-estate private equity is a different asset class).  But regardless, what defines private equity (traditional or real-estate) is that it enhances the return with debt.  It is perfectly possible to enhance returns with Shari'ah-compliant forms of debt but it is another thing entirely to support the growth of this type of asset class, done with Shari'ah-compliant tools, and then to suggest that somehow it will inherently be better than traditional private equity executed with conventional debt.  

Debt is debt, and whether or not it is structured to include or strictly avoid interest, it will bring the same type of feast-or-famine returns that conventional private equity does.  The key point is not whether the debt is interest-based or Shari'ah-compliant, but whether the debt level is high or low.  The reason is that higher debt levels can enhance returns when things go well, but have an equal connection with 'enhancing' the downside as well.  The higher the debt goes, the more upside it can provide, but the faster it can self-destruct if the value of what is bought declines. 

Consider two identical firms, both bought by a private equity firm, with different levels of debt.  

Firm 1: Acquired for $100 million, $10 million in equity and $90 million in debt
Firm 2: Acquired for $100 million, $25 million in equity and $75 million in debt

Assume for a moment that there was a fixed measurement of the value of the company, for example, 2.5 times revenue, so the revenue at the point of acquisition was $40 million per year.  

Now, assume the valuation of the firm (the 2.5 times revenue multiple) stays the same and the revenue fluctuates with the economy and the company's execution of its business strategy.  The lenders providing the debt financing want to keep some margin of safety and are going to step in before they start to take losses (through debt covenants concerning revenue, profitability, cash flow, for example).  

If the economy slows down and the company's revenue drops to $35 million (a 12% decline), then the value of the company will decline to $87.5 million.  How will it affect each company?  Firm 2 will be valued at $87.5 million with $75 million in debt, so the private equity firm will have lost some money, but will still probably be afloat.  Firm 1 on the other hand, will be in a bad situation since the company will be worth less than the debt used to buy it.  Even if it is sold without a fire sale (which would further lower the amount it would sell for), the private equity investors would have a total loss and the creditors who funded the acquisition would face a loss as well.  

It does not matter whether the $90 million in debt was taken out using an ijara sale-and-leaseback or secured bank debt.  The high degree of leverage has wiped out the private equity investors' equity, and forced the creditors to take a loss. 

The final point is, so what?  So what if Islamic private equity functions the same as conventional private equity, but just avoids interest-based debt and companies engaged in haram business activities.  Well, I don't necessarily have an issue with an Islamic version of private equity, but it has to be described accurately, and that means explaining that it has the potential to go just as badly as private equity has in the conventional space over the past few years as debt has tightened, economies have slowed and valuations from before the financial crisis no longer look reasonable.  The only thing that can make Islamic private equity different is if it does not succumb to the rosy assumptions that make private equity funds think they can succeed with highly leveraged investments often enough to offset the times when it goes badly.  

If Islamic private equity were different, it would use much less leverage than conventional private equity, and accept the lower returns that come from using less leverage.  But, it would also be a more stable, sustainable version of private equity focused on adding value to companies, rather than just slashing costs to keep the companies able to service their high levels of debt. 

Financing food and agriculture through Islamic finance

The Islamic Development Bank's (IDB) Islamic Corporation for the Development of the Private Sector (ICD) announced that it is partnering with fund manger Robeco to launch a $600 million agriculture private equity fund, $350 million of which will be raised by the end of the year.  The fund's investment focus is to "invest in projects that promote steady food supply [by making] private equity investments in food and agriculture projects as well as companies across various target countries in a Shariah-compliant way".  The CEO of the ICD, Khalid Al-Aboodi, said that the fund would "address the inefficiencies and wastage facing the food and agricultural sector throughout our member countries".  

The fund idea sounds to me like a great way to encourage Islamic financial institutions to finance projects which benefit a much larger number of people than building luxury resorts.  Food security is one of the most important issues facing many countries with high levels of poverty, so dealing with the issue using Islamic finance would be a way to demonstrate that Islamic finance does "get it" that financing activities that benefit people at all income levels is part of its ethical mandate. 

It is important, however, to clearly define the areas where the fund will focus, and identify investments at weak points in the food growing/distribution network so that it will accrue benefits to the investors as well as the people living in countries where financing is directed.  In particular, the fund should put a focus on not funding 'white elephant' projects that create a profitable cash flow for investors (e.g. from contracts with local governments to pay for services, but which are unable to provide a benefit to the population because other complementary infrastructure is absent). 

Addressing 'food and agriculture' sounds like a simple, narrow area, but it is easy to define investments in other areas that can be instrumental in reducing wastage, for example, in the food distribution process that could lead to significant 'mission creep' for the fund which would dilute its effectiveness.  For example, ensuring a reliable supply of electricity in rural areas where food is grown allows for refrigeration and freezing of food, which allows it to be distributed more widely, opening up markets for farmers.  From another direction, without a reliable supply of electricity, efforts to increase agricultural productivity in rural areas will accomplish little if most of the expanded productivity is lost to waste since it cannot be refrigerated or frozen and transported to the markets where it will be consumed.  

It is good to see the IDB's ICD put a focus on directing investors towards the Shari'ah-compliant financing of an area that can be hugely beneficial for the poor, while also having potential to deliver return to investors if it is done correctly. 

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). 

What will replace the property bubble in the GCC?

One of the trends in Islamic finance outside of the GCC (and excluding Malaysia, which has a thriving local Islamic finance industry) is that countries, fund managers and companies are eager to tap the financial resources of the GCC countries, particularly when oil prices are high and funds are entering the GCC seemingly faster than they can be deployed. Another factor in the flow of funds from the GCC to the rest of the world is the need to diversify (both geographically, but also the relative scarcity of investment opportunities locally. There is also some movement of funds internationally to take advantage of non-real estate based private equity and venture capital (look for an article in this coming week's Islamic Globe on a development in the U.S.).

This theme of funds flowing out from the GCC and being sought out by countries, companies and fund managers internationally is not solely the domain for Shari'ah-compliant investments; it is probably larger on the conventional side. On the Islamic side, two recent countries vying for a piece of the GCC investment pie were Indonesia, which is trying to attract both money and expertise in Islamic finance, and Russia, whose region Tatarstan is considering issuing a sukuk focused on attracting foreign capital from the GCC.

With the sheer amount of capital flowing into the GCC (and mostly into the hands of a few wealthy individuals and sovereign wealth funds), there are probably good reasons why international investments are likely to be able to attract this capital (and benefits for the GCC from this occuring). However, the more that international investment opportunities are able to attract GCC capital, the slower the region will be to developing a domestic financial sector as well as capturing the spillover in other areas from regionally-focused investment firms.

The main impediment to the deployment of capital in the region is that there is still too much dependence on oil for a big chunk of the GDP in many of the GCC countries. Because of the large oil wealth (and relatively under-developed public goods like a proven legal system), there has not been as much progress on creating a private sector outside of the energy sector. Even within the energy industry, there has been a significant reliance on expatriate workers, which is fine on its own, but when combined with the underdeveloped private sector outside of energy, you see the levels of unemployment (particularly youth unemployment) which hurts future prospects for non-energy-related sectors.

Some countries have found industries in which they can grow; Bahrain (at least until the recent protests and martial law) had developed a large financial sector while Dubai developed itself as a real estate/tourism capital with a significant role in international trade through ifs port. However, each has its own limitations and does not on its own create a sustainable, diverse economy that would generate a diverse enough set of investment opportunities to keep more of the money generated from natural resources locally.

Then there is the financial sector locally, which does not have a stellar track record post-crisis (not alone in that regard in the financial industry). Too much of the money invested locally went into real estate, which created a bubble at least as significant as the subprime-fuelled bubble in the US (all real estate is local, so there were some exceptions). The key point for Islamic finance with this is that the real estate bubble did not have nearly the same conventional focus as it did in the U.S. The blow up in real estate (e.g. in Dubai) was due much more to sky high prices than it was to derivative products magnifying the extent of the growth in prices.
For this reason, Islamic banks--particularly investment banks--had a much greater exposure to this real estate bubble than they did to the U.S. bubble. Like conventional banks, they had extended credit to real estate developments (either directly or through "private equity" transactions) with the expectation that prices could keep risisng. When they stopped rising and began their precipitous fall, the investment banks shrivelled. With the real estate bubble gone, many of these investment banks and particularly the ones with a focus mostly on real-estate driven "private equity" have struggled to find a way to generate revenue.

Now, without a property bubble to generate investment activity locally and with the spigots opening anew with rising oil and natural gas prices, the capital is accumulating and it needs a home. The Islamic financial institutions (like conventional banks) are returning to growth slower than the flow of funds, so there is a greater and greater share that will need to be invested internationally. Thus, the countries, companies and fund managers internationally have returned to make a 'pitch' to the GCC to invest the funds in banks in Indonesia, regional governments in Russia and private equity funds in the United States (among others).

The downside to the GCC if this persists and nothing more sustainable is developed post-real estate bubble is that the funds will not benefit the local economies as much as they could if found a home developing non-energy-related industries locally. So, while much of the capital from the energy resources is being invested internationally, there should be a continued focus on greating local industries--particularly new small businesses--that will be able to absorb some of the capital and create a relatively larger impact in terms of employment than large, capital-intensive businesses like downstream energy business or financial services.

Sukuk issuance from Europe, Amlak & Tamweel merger 'unlikely'

The Bank of London & the Middle East (BLME), a UK-based Islamic wholesale bank launched a division to advise on sukuk to attract investors from the GCC and Asia to UK and European companies. They expect to close their first deal within a year. The move comes shortly after the first UK corporate sukuk was launched. I have not had a chance to view the prospectus for that sukuk, but it was a 5-year convertible musharaka sukuk (with 10% coupon) issued to one investor, Millenium Private Equity. The conversion from debt into equity will occur on the meeting of pre-determined performance milestones, according to an article in Khaleej Times. The structure is likely to be complicated to incorporate both the convertible nature of the sukuk with a fixed coupon and remain in compliance with the new AAOIFI rules on musharaka sukuk. However, from the perspective of a private equity investor, the structure of a sukuk rather than an equity contribution makes sense. It gives the investor a higher priority claim on the business' assets than equity and also a coupon, although that will be unlikely to benefit the investor if the sukuk sours. The coupon on the sukuk (if both principal and coupon are convertible) provides the company with the incentive to meet the milestones for conversion earlier because the accrued coupon payments will translate into more dilution for the company's other owners the longer it takes to reach those milestones. One of the features of a musharaka is that both partners are permitted to be engaged in the management of the business (akin to private equity investors taking board seats of companies they finance). At the risk of generalizing without having read the prospectus myself, this structure sounds like a good way for Shari'ah-sensitive private equity investors to both provide themselves with greater security (or equivalent security to conventional private equity) but also use a structure that some scholars describe as "more genuine".

The Amlak and Tamweel merger is now 'unlikely' according to the chairman of Tamweel following Dubai Islamic Bank's acquisition of a majority stake in the Islamic mortgage company in Dubai. The lender still has a significant way to go before it can resume operations as normal and will likely need a capital injection. Tamweel is working on a plan to resume lending in the market and expects to release a plan in 'the next few months'. Another article citing the chairman of Tamweel says that they expect Q3 results to resemble the first two quarters of the year. They took significant provisions in 2009 and expect to "translate our revenues into some profits". In many ways the issue facing Tamweel is similar to what is facing other mortgage lenders in countries that have experienced a real estate boom and bust. The pain may be over (or nearly over) but a resumption of 'business as normal' will not happen overnight. The economic recovery globally has remained slow and the appetite for new debt is likely to be significantly constrained (the 'new normal'). The recovery for mortgage lenders like Tamweel will most likely be slow both because borrowers are more hesitant to take on new debt but also because the standards on which Tamweel will lend are likely to be far more stringent than before the property bubble collapsed.

There is a fantastic article in The Asset magazine about an interview with CIMB Islamic CEO Badlisyah Abdul Ghani that covers a broad variety of topics including the impact (and potential impact) of the credit crisis on Islamic finance and the need for better regulation of Islamic finance. It is a good, brief read. A few exerpts:

"One reason why Islamic banks were not as affected as conventional Western banks, argues Badlisyah, is that they were not sophisticated enough to participate in derivatives and other leveraged transactions. "The situation could have been much worse if the Islamic banks had been as sophisticated in employing leverage as their conventional banks’ counterparts were in the previous years."

"As in conventional finance, he says, Islamic finance relies on the creditworthiness of an issuer or a client to decide where liquidity is channelled and directed. "Whatever structure is in place – whether it is Islamic or conventional – credit is still credit and it needs to be paid."

"Badlisyah argues that everything that exists in Western capital markets that is of genuine value to banks and corporates has already been incorporated in Malaysia under the Islamic derivatives regime. This, he argues, is the reason why Malaysian Islamic banks have been successful in managing the volatility and fluctuations that have buffeted the industry in recent years. The ban on credit default swaps is completely justified, he feels, and will likely be for keeps."

"From Badlisyah’s point of view, that Malaysian Islamic banks emerged from the global financial crisis relatively stable and unscathed is due to the regulatory framework that was put in place. "Malaysian banks found themselves totally isolated from the crisis because they had not been allowed to invest as much overseas after the Asian financial crisis."

• AAOIFI is expected to provide rules governing the entry into and exit from contracts that are Shari'ah-compliant. However, it is unclear at this time what this will mean.
  
• Central Bank of Bahrain Governor Rasheed Al Maraj is quoted from a dinner honoring Professor Simon Archer: "Many remain comparatively small and focused on niche markets. The result is that we have an industry that comprises many small-scale firms engaged in very similar activities and with comparatively high concentrations of risk. As I have said several times in the past, for the long-term health of the industry it is important to generate greater scale and diversity. [...] the events of the past few years should have given the industry a clear signal that it must reduce its reliance on real estate as an asset class [and] The industry should look instead at the scope for increasing the finance it provides for productive assets such as factories, ports, mines and oil processing facilities. Financing these activities may appear less profitable in the short-term, but may be a better proposition on a risk-adjusted basis." I agree.
  
• Islamic Finance Asia has a good article on the challenges to developing secondary market liquidity in sukuk.
  
• The IMF study on Islamic vs. conventional banks in the crisis has been released.
  
• A look back at the post-crisis (and especially post-Dubai debt crisis) dominance within the primary market for sukuk from Asia. A Bloomberg looks forward towards the potential issuance that could result from the 10-year, $444 billion Malaysian development plan.
  

Islamic finance lagging in private equity; sukuk for the Saudi mortgage market

An article cites Hussein Hassan, the head of Middle east structuring at Deutsche Bank pointing out that Islamic banks avoid private equity despite its similarity with the partnership approach in Islamic finance contracts like mudaraba. This is attributed to the use of high levels of debt in private equity, the financing of haram industries and the asset-liability mismatch in Islamic banks which limits their ability to invest in longer-term projects. Lahem Al-Nasser covers a similar topic when he chides Islamic banks for financing more "traditional" projects over projects which are new and untested. He says this bias is based on the management having experience in conventional banking who believe that "Islamic banking is nothing more than a marketing instrument to make profit" and they "lack the incentive to push for creativity and innovation".

The VP and MENA business manager for corporate trust at BNY Mellon Corporate Trust in Dubai suggests that "sukuk would be the best way to mortgage homes in a Shari'ah-compliant fashion" using an asset-backed structure. I would tend to agree because so long as most of the mortgages are tradable (i.e. not based on murabaha), they could be securitized in a way similar to the Islamic Development Bank's sukuk al-istithmar. In the istithmar sukuk, the underlying assets are other financing contracts (in the case of the IDB sukuk, they are murabaha, istisna'a and ijara). The sukuk is tradable so long as the proportion of ijara contracts (by value) is more than one-half of the total assets. The reason for this is that murabaha and istisna'a contracts create a debt obligation (the financier holds a receivable for future payment), whereas an ijara contract provides the financier with ownership of an asset.

Kazakhstan is planning to issue $500 million in sovereign sukuk, in part to try and make the country the "Islamic finance hub" for the former Soviet Union. The government of Abu Dhabi-owned Al Hilal Bank opened the first Islamic bank in the country earlier this year. The CEO of the Kazakhstan branch of Al Hilal Bank, Prasad Abraham, tempers the expectation saying that issuance could start at just $200 million this year but rising to as much as $3 billion per year by 2015. The sukuk is replacing a cancelled $750 million Eurobond, which Bruce Gaston, the CEO of Skybridge Finance, says will cost the government up to 150 basis points m more compared to the Eurobond.

Other News

• Kuwait Finance House Research estimates that global sukuk issuance in 2010 will reach $30 billion. The first half issuance was $16.5 billion.
  
• Al Baraka Banking Group plans to raise $200 million through its first sukuk issuance by the end of 2010. Al Baraka also signed a non-exclusive memorandum of understanding with the Islamic Corporation for the Development of the Private Sector (ICD). ICD is part of the Islamic Development Bank group.
  
• Gulf Finance House is planning to increase its capital by $300 million but did not specify how it plans to raise that capital.
  
• Dubai may issue debt in 2010, but it is "not under pressure to do anything".
  
• Bahrain Financial Harbour raised $240 million through a 7-year ijara facility to repay debt.
  
• The Al Rajhi Bank-Cagamas cooperation may only be the first effort to bridge the divide--particularly in Shari'ah standards--between the GCC and Malaysia. While much of the news concerns the Shari'ah standards, there are other areas where harmonization of standards becomes difficult. Megat Hizaini Hassan, the head of Islamic banking & finance at Zaid Ibrahim, is quoted saying: "In the Middle East, in certain jurisdictions [Islamic finance] is not even regulated so how can you harmonise?".
  

Islamic wealth management, avoiding future crises, Moody's says Islamic finance could reach $5 trillion

The Islamic wealth management report from Bank Sarasin raises one point which I believe is true across the Islamic finance industry: the diversification of assets is not nearly as expansive as in conventional finance and in many cases leaves investors with too much exposure to real estate. It also is too focused on transaction-based compensation for Islamic bankers. The emphasis is placed on deals and there is too little focus (and compensation based on) the long term needs of Muslim investors. As an asset manager myself, I have watched the Islamic finance industry expand, particularly in the issuance of sukuk, with much of the focus on new financial products that expand the financial structures used in conventional finance. That is not necessarily problematic because good diversification relies on different asset classes from which investors can choose. However, when the focus is on creating a diverse set of structures and not on the types of investments, there will be an unmet need. For example, the equity asset class has been the easy part with Islamic indexes being around for over 10 years now. However, there remains a shortage of fixed income-like products that is only partially filled by sukuk (for example, there is still no fixed income-substitute within the United States). A lot of the other structures being created have still focused on property finance. There can be many different ways created to provide investors with exposure to real estate markets, but that still only addresses one asset class. It may create diversification (e.g. geographical) within that asset class, but a focus on real estate markets as a predominant investment area leaves asset managers struggling to create a diversified portfolio for Muslim clients (whether or not they are exclusively focused on Muslim clients). Perhaps the (nearly) global property bust will will make other areas more attractive, but it may just create a new area where activity is concentrated. That would be a shame and would harm the investors that are the source for the Islamic finance business.

The CEO of Fajr Capital, Iqbal Khan, said that Malaysia can provide an example for reform within the Islamic finance industry, particularly to separate the utilitarian and financial intermediation roles to prevent the problems that arose during the credit crisis. Mr. Khan said that there should be a separation to prevent the need in a future crisis for Islamic investment banks to be bailed out the government to preserve the basic payment systems within the banking system. Those payment systems could then be backstopped if necessary but ""Everything else - Mudharabah-based, asset-based, unit trust and investment fund - goes into separate business. These two, never the twain shall meet, they have to be kept separate". I believe he is absolutely correct. The flaw with the universal banking model and allowing the investment banks and commercial banks to merge (in the U.S., this was through the Gramm-Leach-Bliley Act) forced the government to bail out all or none of the banks and the combination of the two into large financial holding companies meant that in order to keep the payment systems intact, the investment banks had to be bailed out lest their losses endanger the institutions as a whole, which led to the crisis within the 'boring' areas of the credit markets unrelated to the investment banks' operations.

Moody's says that Islamic finance assets could grow to $5 trillion without providing a date by which this could be reached. They said assets were $950 billion in 2009, which is higher than previous estimates from other groups which were in the range of $800-$850 billion. Moody's says that Shari'ah-compliant derivatives, if 'employed with care', could provide a useful purpose for hedging purposes. The recent IIFM master agreement on Islamic derivatives includes a requirement that they only be used for hedging, not speculation. Moody's VP and Senior Credit Officer Anwar Hassoune cautioned that "IFIs aim to utilize derivative instruments to hedge against risk and to improve risk monitoring practices. However they are keen to do so in a Sharia-compliant manner, rather than imitating conventional derivative instruments, in order to avoid losing their special status as Sharia-compliant banks, which makes them very attractive to a large population of Muslims." Moody's warns that IFIs have weak asset-liability, investment, and liquidity risk management. An article published by the Wharton School at the University of Pennsylvania discusses the role of ratings agencies within the Islamic finance industry, specifically within the sukuk market.

Other News

• An article in the Financial Post (Canada) discusses the recent UFANA conference in Toronto (at which I was a speaker).
  
• $4.67 billion in sukuk were issued in the first quarter of 2010 according to Zawya, compared with $0.63 billion in the same period in 2009. Malaysian issuers accounted for 53% of all new issues, Indonesia for 33.5% and Saudi Arabia with 9.6% from the Dar Al Arkan sukuk of $450 million. Malaysia is planning a US dollar-denominated sukuk.
  
• An opinion column in the Kuwait Times asks whether Islamic banking has enough focus on providing a competitive and quality product to ordinary people.
  
• A GCC-based VP at iShares offers an interesting view of the current state of Islamic indices.
  
• Just as private equity has faced significant headwinds over the past 2 years, so has the Islamic private equity industry and things are just starting to get back to doing deals.
  
• The New York City Bar is planning a seminar on Islamic law including a portion of the seminar covering Islamic finance.
  
• Indonesia's efforts to expand the share of its banking system made up by Islamic banks is described in an article from the Oxford Business Group. The government is planning a 5 trillion rupiah sukuk (555 million) issue on April 13.
  
• Standard Chartered's Islamic finance window has avoided Islamic hedge funds based on a concern that the arbun structure used to create short-selling-equivalent has not been widely accepted among Shari'ah scholars.
  
• An article describes what AAOIFI does and what it is working on now.
  
• Sudan, which has been largely cut off from capital markets since US economic sanctions were imposed in 2007 because of the genocide in Darfur, is issuing $300 million in sukuk.
  

Reuters Islamic finance summit

Reuters Islamic Finance Summit

There are a number of articles about sukuk from the Reuters Islamic finance summit. This is not terribly surprising because of the place of sukuk as the 'face' of Islamic finance, especially among Western investors. There are a few issues raised in these articles.

One article describes how the development of sukuk by French issuers, in particular, an $1.37 billion (1 billion euro) sukuk from an unnamed corporate issuer, has been delayed by the uncertainty about legal rules about sukuk in France. The French parliament passed a law recently clarifying the legal and regulatory treatment of sukuk, but it was thrown out by the courts on procedural grounds. France has said it wants to be a European hub for Islamic finance, but in the absence of a resolution of these issues, it is unlikely that it will be able to catch the U.K. quickly where regulatory and tax changes have already been made to put Islamic finance on a level playing field.

There are a few somewhat conflicting articles about Islamic finance in the Gulf that, despite the seeming contradictions, describe the situation facing Gulf issuers in the wake of Dubai World's request for a debt standstill (which investors were reminded of by recent news as well as other sovereign debt issues in Greece). The capital markets for new sukuk are relatively frozen right now, especially in the UAE and there have been few non-sovereign issues in the past year. However, there is significant latent demand by money market funds for high-grade corporate and sovereign issues.

An advisor to Morgan Stanley, Yavar Moini, does provide some background for what is needed to unlock this latent demand and bring new sukuk to market: domestic capital market development. However, in order for this development to occur, there needs to be greater legal certainty about how sukuk behave in different situations and for different structures. The advantage that many sovereign issuers have over corporate issuers in this environment is that many Gulf states (Dubai excepted) have signficant oil reserves that finance the government budgets and with oil prices having recovered, the revenue to repay debts on time is less uncertain than with corporate issuers whose ability to pay is less certain and more dependent on local economic conditions. This is, of course, accentuated for issuers looking to issue sukuk backed by real estate projects like Dar Al Arkan, which issued a smaller than expected high-yield sukuk (10.75% coupon) to raise $450 million compared to expectations of between $500 million and $750 million.

Worldwide, Mohd Daud Bakar, a Shari'ah scholar, expects that the leading country for new issues (ex-Malaysia) will be Saudi Arabia, based on its need for infrastructure projects and economic growth fueled by the rebound in oil prices. He expects 10 to 15 sukuk issues from Saudi issuers during the year. Bakar is also working for the South Korean Korea Investment & Security Company, which is structuring a sukuk for issue after the country passes a proposed bill to create a tax exemption for sukuk.

Apart from these new issues, there could be additional sukuk activity in the secondary markets with several Gulf-based banks launching sukuk funds. There have been a few sukuk funds launched since the onset of the financial crisis beginning with one launched by Algebra Capital in August of 2008. These funds will probably try to tap the desire for investors to invest in sukuk while taking advantage of depressed prices in some sukuk in the secondary markets. The growth in secondary markets will be aided by these funds who will provide a bid for distressed and other sales of sukuk holdings. The test for the markets will be whether these funds will then warehouse these sukuk until maturity or whether secondary markets will become liquid enough for them to sell holdings before maturity. If these funds become active players in the sukuk secondary markets, they could lower pricing for new sukuk by increasing the liquidity of sukuk (which would lower the liquidity premium attached to new sukuk issues).

An article with quotes from a lawyer in Islamic finance, Farmida Bi, and Toby Birch, the founder of Birch Assets Ltd., provides some interesting comments on the difference between sukuk and conventional bonds. Ms. Bi is quoted: "Investors have realized after Dubai World that what they are buying is not typically something that (gives) recourse to an asset". Mr. Birch described that "If bonds were properly Islamic there would be no guaranteed rate of return: the idea of a sukuk is you share the income flow because you are a co-owner of the real assets". This is, I think, the correct assessment of the situation of the sukuk market, but I am concerned that the selling of Islamic finance as asset-backed, while selling asset-based sukuk may reflect a flaw in how the industry markets itself and in particular, the difference between substance and rhetoric. If Islamic finance promotes itself as different because it is asset-backed, it should offer product that are secured by assets. In other cases, it should use investment structures that share risk between issuer and investors (like the Saudi Hollandi Bank sukuk). What is creating confusion is where structured of a sukuk based on an asset leaves investors without recourse to that asset. Islamic finance is not always asset-backed, but in the structures where an asset is involved, investors should have recourse to that asset.

In a related article, Mohd Daud Bakar, describes that the industry was developed to allow Muslims to buy houses and cars and has not yet moved beyond this area to involvement in the real economy. He is right to some degree; the Islamic finance industry is largely contained to offering products to others within the financial services industry with the exception of retail institutions which....offer financing for houses and cars for consumers. Another article describes the prospects for private equity in Islamic finance and real estate is now again in vogue in Islamic finance. The debate on the connection between the Islamic finance industry and the real economy is somewhat constant in the background, but the questioning of this connection (and the same discussion in conventional finance) somewhat loses the point that finance is by its nature somewhat disconnected from the real economy except that it is engaged in providing financing for everything else. If there were a concern about financial industry people becoming involved directly in the economy to directly benefit others, I think the best outlet would be Islamic microfinance. It is still relatively underdeveloped and could use the (volunteer) efforts of the top minds in Islamic finance.

Despite the growth touted for Indonesia in an article I linked to yesterday, there are a number of hurdles for Islamic finance in Indonesia, despite its large Muslim population. The primary obstacle is tax and regulatory difficulties for Islamic financial products (and I have seen other articles which cited endemic corruption as another obstacle. However, if the information in this article is correct, there may be a simple lack of demand from consumers, either through lack of understanding of Islamic finance or a belief that Islamic finance is not authentic or necessary in its current for, which replicates (or 'camouflaflaged' as it was described by the cheif economist at Bank Danamon, Anton Gunawan) conventional finance.

A company, Halal Industries, plans to establish a halal park in Wales.

Other News

While many Islamic investment banks are selling assets, Unicorn Investment Bank is considering raising between $250 million and $500 million in equity for acquisitions and distressed asset sales.

Islamic Investment Banking 2009 report

The Yasaar Media report, Islamic Investment Banking 2009 (available free from Yasaar Media as a PDF), provides a thorough review of the history and current state of Islamic investment banking. Below, I provide a basic summary of a few areas that I found the most interesting. It is not a comprehensive summary of the report and the areas that I highlight are very limited by what I took from them. I would strongly suggest a read through this interesting, detailed and timely report.

The premise from which the report begins is that although Islamic finance has experienced a rapid burst of growth during the past decade, not all areas of Islamic finance are experiencing the same pace of growth, particularly following the credit crisis which caused a global economic crisis. In the specific area covered by the Yasaar Media report—Islamic investment banking—there has been a significant reduction in the growth rate in 2008 and thus far into 2009. The areas in which this has been most pronounced is in private equity and sukuk issuance. One reason for this shrinkage is that on the whole, Islamic financial institutions, particularly investment banks, were too concentrated, both by industry (primarily real estate) and geographically (significant focus on the GCC region). The real estate sector in the GCC provided Islamic investment banks with a high rate of return relative to other areas and also provided an asset on which the financing could be based. This gravy train of high and stable returns ended when the global economic downturn led to the bursting of what had become a large bubble in parts of the GCC.

One of the first areas tackled by the report is the significant overlap between private equity and the Islamic concept of mudaraba. While this is familiar to one who thinks on the subject, the Yasaar Media report takes the comparison one step further in light of the financial situation of the day. In conventional private equity, there is significant reliance on high levels of debt that would not be possible in an Islamic private equity transaction. In the wake of the financial crisis, ‘deleveraging’ is the word of the day and therefore the more equity-based Islamic private equity transaction could be viewed by investors as well as the recipients of the investment as a preferable means of raising private capital.

The next area where the report focuses is probably one of the smallest parts of the Islamic financial industry—venture capital. Because the Islamic venture capital industry is not developed in any size, the report provides a broad focus on what it will take for an Islamic venture capital industry to emerge and highlights the role the Malaysian government is playing to develop the industry. In the course of describing the similarities between venture capital and Islamic principles that support profit-and-loss sharing, the Yasaar Media report raises the interesting dimension of how the profit-and-loss sharing ratio should be determined to remain Shari’ah-compliant. For a sector that has been largely overlooked, this leads one to recognize how even areas that seem quite natural for Islamic finance have more complex issues of Shari’ah-compliance that have yet to be resolved.

Mergers and acquisitions, another area covered, is on with particular relevance in the current financial environment where smaller institutions may be squeezed in ways that larger rivals are not. It has been the conventional wisdom that the UAE and other parts of the GCC are ‘over-banked’ for years. However, there are difficulties caused by several factors that may limit the actual merger and acquisition activity within the Islamic financial industry. As the report states, many of the M&A activity that is possible because of depressed valuations would be desirable from an industry-wide perspective may run into regulatory hurdles or simply the problem that the banks are not ‘for sale’.

Unlike many of the areas of Islamic investment banking that have been severely hit by the financial and economic crisis of the last year, Islamic syndicated lending has been one of the first to recover and although it is on pace to fall year-on-year, its supply has recovered quite a bit more substantially than, say, the sukuk market. As mentioned above, the counterpoint to the relatively quick recovery is the rethinking that has to occur about the desirability of using real estate as a large part of an investment bank’s investment portfolio.

The section on capital markets was one that provided thorough cover of the issues facing, in particular, sukuk following questions from Sheikh Taqi Usmani about the Shari’ah-compliance of the mudaraba and musharaka sukuk which was followed by a steep drop in issuance due to the credit crisis. These problems were complicated by the default or bankruptcies of several issuers which leaves the market for new sukuk somewhat in limbo. Although a reduction of the stress facing capital markets has led Indonesia and several GCC countries to resume sovereign issues, the supply of new corporate sukuk issues remains constricted by pricing and uncertainty about default resolution.

Following on a discussion of capital markets is a detailed overview of the situation Islamic banks face in terms of liquidity management as well as the avenues that are currently being used. More than most areas of Islamic finance, the types of liquidity management tools are incredibly varied. This reflects the rather underdeveloped state of this area of Islamic finance despite its premier importance to Islamic financial institutions. This will be a continued area of stress for Islamic bankers until there is something more uniform that is able to meet the demand in a way that is both comparable in ease to conventional inter-bank lending as well as broadly accepted as Shari’ah-compliant.

The report finishes with a summary of Islamic trade finance, a quietly important area of Islamic finance that, despite the lack of attention it receives compared to sukuk and liquidity management, provides significant value to the non-financial businesses that use it. It seems a relatively good area to conclude the report since it is the area that is most important for non-financial businesses and, unlike many areas of conventional finance, this is the ultimate raison d’etre of Islamic finance.

I have written a forthcoming report for Yasaar Media on Islamic finance in North America, which will also be available on the Yasaar Media website. To receive reports as they are released, you can email media@yasaar.org with the subject line ‘Please send me your research reports immediately on publication’.