In November 2012 FWU Group issued the first Sukuk ever backed by intellectual property rights; an innovative new structure which won the Islamic Finance news Ijarah Deal of the Year 2012. We speak to the people behind the issuance to discover what one of the most significant launches of the year was all about.
The FWU Group is a Germany-based insurance provider which specializes in white label Family Takaful unit-linked investments, offered through its bank distribution partners and including savings, education and marriage plans. Coming to market as the first European corporate to tap the Shariah compliant sector since 2004, the media noise around its recent US$55 million Sukuk has been considerable. Yet unsurprisingly, most of the attention has been due to its structure and its asset backing rather than its size. FWU Group has hit a number of firsts, but as a structure the issuance was unremarkable. What makes the grade is the fascinating intangible asset-backing utilized by the Sukuk Ijarah. In this week’s issue, we take a look at how the ground-breaking intellectual property asset class opens up new avenues for exploration in the Islamic capital markets.
A first for Europe
Although the European market has not yet seen any significant sovereign Sukuk issuance, a few corporates have quietly moved towards the market. UK-based International Innovative Technologies, a maker of milling machines in northeast England, privately placed a Sukuk Musharakah with one investor in Dubai; while in France in summer 2012 a EUR500,000 (US$643,441) Sukuk was issued by French Halal food specialist Bibars to finance the opening of its new restaurant in Paris. A second Sukuk was in the area of solar panels and finances, lanched as an ecological, economically responsible investment by Legendre Patrimoine, and the first French Islamic certificates open to private individuals as well as institutional investors.
However, until the FWU Group Sukuk this was the extent of the Shariah compliant capital market activity in Europe. In November 2012 however, FWU Group announced what was considered to be the first issuance by a German corporate and the largest of its kind in Europe. The US$55 million Sukuk was based on the Islamic principle of Ijarah, or sale and lease-back. The underlying assets were a proprietary computer software system and associated intellectual property rights developed in-house by the FWU Group and used by its bank distribution partners in connection with their combined Takaful operations. The FWU Group has the full proprietary rights to this system.
The Sukuk were issued through a Luxembourg SPV incorporated using a Dutch Stichting (foundation) structure — first used in connection with the quasi-sovereign sukuk issuance by Saxony-Anhalt in 2004.
According to Sohail Jaffer, deputy CEO of FWU Global Takaful Solutions: “We have been looking to refinance the Shariah compliant factoring business globally, given the rationing of bank credit across the board since the global crisis.”
Complex basis
Factoring itself is a relatively simple concept, which is operated both in Malaysia and the GCC, as well as the UK and western nations. Sohail explains that: “It is basically a business model to factor receivables and arrange a payment upfront to the distributor”. For most insurance firms globally, the banks receive their commission upfront on long term regular savings and pension plans, of up to 20 years. As an example, if a customer is contributing US$300 per month, the bank is therefore entitled to a commission every month for the next 20 years. For a bank, obviously it does not want to wait this long to collect the commission: it wants the full amount of commission on day one calculated on US$300 multiplied by 12 months multiplied by 20 years, or roughly US$72,000. “In order to finance the commission on this total amount,” explains Sohail, “you either need bank lines of credit — which are drying up — or you go directly to the Capital Markets and one of the instruments of choice is a Sukuk issue. A sukuk enables the issuer to tap directly into the investor market in order to collect the funds needed and hence alleviate the balance sheet strain of the insurance provider paying commission upfront.”
Barry Cosgrave, a senior associate at Vinson & Elkins which structured the deal, explains that: “The biggest issue for us was to understand how to identify the asset. How do you identify with certainty down what an intellectual property (IP) asset is? The question of ownership is also an issue as software programs are subject both to update by the owner (who needs to update it on a periodic basis to make sure it still functions correctly) and to certain customizations by the individual end-users to fit that software program to their specific requirements.” This raises a question of ownership: how do you acknowledge what actually constitutes your leased assets, and what constitutes the assets that are in fact owned by the lessee as opposed to by the lessor?
A simple structure
“Another of the challenges one faces with intellectual property,” says Cosgrave, “is that you can’t actually see or touch it which makes it hard to identify. So one of the things we had to do was find a way to identify the assets with sufficient certainty to satisfy what is an important requirement for Shariah scholars. The key identifier for the IP in a software program is what is known as the source code. This is a unique code which is retained on a locked disc in a secure location. The possession of that code is the key to identifying that software program (and associated IP) and to transferring the ownership.”
Following the transfer of ownership of the asset under contract, delivery is made by way of the delivery of this source code. “So in the event of a default or restructuring,” explains Cosgrave: “The Sukukholders have recourse against the source code itself in the same way as other Sukuk which involve the transfer of moveable assets. Of course the Sukukholders have their rights under the purchase undertaking to claim for unpaid amounts against FWU, giving them the desired recourse to cash repayment, but ultimately they have the right to take possession of the source code.”
“The irony is in this transaction,” explains Cosgrave, “is that the asset was complex but in truth the structure involved a relatively straightforward Ijarah. Once we had identified the asset a well-tested structured was already in place so the complexity rested with the asset more than with the more straightforward structure.”
Scholarly credit
Another feature of the FWU Sukuk which suggests a positive future for this new asset class is the almost universal approval it has received from scholars in all regions. Cosgrave explains that this is due to the broad base of scholars that the firm used to work on the Sukuk. “I think the key with most Sukuk, even the ones deemed to be very complex, is really being clear with the scholars and working very closely with them from an early stage of the transaction. One of the things we did right at the very beginning was to define the asset and sit down with the scholars and explain to them in detail what the asset did, and what its functionality was.”
Although some standard structuring issues arose, including questions such as ensuring the asset was a purely functional one and not one that was used to facilitate interest-bearing transactions, Cosgrave emphasizes that “those issues regularly come up and as such are not new to this issuance. The key is to get the scholars involved from an early stage so they understand what you are trying to do, and what you are trying to achieve with the transaction.”
What is it worth?
One of the notable aspects of the FWU Sukuk, which broke new ground in terms of creating a new asset class for backing these structures, was a valuation report produced by Ernst & Young which ascribed a value to the software system. A formal auditor’s report, this both valued the software and effectively collateralized the FWU transaction, by establishing that the intellectual property rights were worth more than the value of the Sukuk.
Yet the very complexity of the FWU Sukuk made it in fact very simple to sell. According to Sohail: “Certain insurance companies, the more enlightened ones, are using what we call digital applications to do the sales fulfillment.
“We are not using an external device, we are using a proprietary web portal, or software, which is internet based. This means that we have a proprietary system which the bank sales person in the branch of the bank can log into and then on opening the system, can see the application form, the policy illustration, the policy certificate and all the administration that the sales person needs to help the customer with – for example if he wants to increase or decrease his premium over time, he might want to nominate new beneficiaries, etc. All this can be done by the system. This system gives us a competitive edge because it reduces the paper chase in the middle office of the bank, because everything is now computerized.”
Sohail explains that: “If this was a manual, paper-based system then you would have to employ an army of people to work it out in the back office to analyze the information on an excel spreadsheet. This is not just a source code, it is the system that is currently used in Malaysia by major bank distribution partners — we have actually licensed this system to them, our local takaful partner in Malaysia is Takaful Ikhlas.”
Private v. public?
Given the size of the transaction, FWU Group realized that it was not going to get a major investment bank like Standard Chartered or HSBC, who are chasing big ticket items in the market like over US$1 billion, to be the underwriter for an issue of this size. “Being a mid-sized corporate,” said Sohail, “we felt that as we had friendly investors identified in the UAE market, it made more sense to go the private placement route for the first deal, to establish our track record. We already knew the investors, we had explained the transaction to them, so it made more sense for us to go that route on the first transaction.”
A new world
Public or private, however, there is no doubt that the Sukuk has broken new grand and opened a path for other SMEs to follow. “As a German corporate this is the first Sukuk we have seen from a corporate in the German market. I am very surprised, frankly, given what is happening in Europe and given what has happened to bank lending, which has effectively dried up for the SME sector, that [the European SME sector] haven’t really thought about tapping into the pool of liquidity that exists in the MENA region and Malaysia, by accessing the Sukuk market.
“Sukuk are simply an alternative way of tapping into the capital markets and if bank lending is drying up it represents a very real option for the large and under-funded SME sector in Europe. Liquidity exists in the MENA region, so why are they not tapping this asset?” Cosgrave suggests that: “With this new asset class, more established businesses can now look at a lot more options to raise capital.
“I think it is hard to judge for the future but I don’t see why we would not see more of this type of Sukuk. One of the problems we have had in the past few years in the Sukuk market is that the Ijarah has been the most commonly used form of Sukuk, for obvious reasons. However, one of the problems many companies face is that they don’t have an inventory of land, or buildings, or cars etc. to use for an ijara Sukuk. By looking at alternative asset classes such as intellectual property or other income-generating intangible assets such as airtime vouchers more opportunities should open up for Sukuk. And this is relevant both for companies looking to raise finance in a Shari’a-compliant manner and also potentially for innovative technology or similar companies that might not necessarily have thought about Shariah-compliant funding in the past.”
Sohail agrees. “As the traditional sources of funding (banks, financial institutions) cut back their lending to SMEs and as the new Basel capital adequacy requirements come into play, banks are becoming more and more risk averse and reducing their lending to corporates. Corporates who are not multinational names are going to have to think seriously about how they are going to tap the capital markets in future. And Sukuk represents a very viable alternate source of funding.” — LM