This year is expected to see M&A activity pick up in the Middle East as the economic climate recovers. DINA ELSHURAFA explores how Islamic finance can play a part in helping firms to enhance operational efficiencies and diversify their portfolios through M&A transactions.
Despite the bleak outlook for mergers and acquisitions (M&A) transactions globally and in the Middle East, the value of M&A activity in the Middle East rose in 2012 for the first time in three years, reaching the highest level since 2008. The total value of M&A transactions announced in 2012 hit US$25 billion, a 76% increase on the value of deals completed in 2011 and a reversal of the declining activity since the onset of the financial crisis.
In the region, Qatar is becoming one of the most active countries and in 2012 there were US$6.7 billion of M&A transactions involving Qatari firms. Qatar witnessed the largest regional M&A transaction in 2012, the acquisition of a 19% stake in Industries Qatar by local General Retirement and Social Insurance Authority, valued at almost US$4 billion.
Similarly, Saudi Arabia and the UAE continue to be active in the M&A sector as the pace picks up in the region. Saudi Telecom Company is reported to be continuing to aim at expansion through M&A as it did in Indonesia and Malaysia.
The start of 2013 witnessed the merger of the first ever three-way Islamic bank merger in Bahrain between Elaf Bank, Capital Management House and Capivest, creating a strengthened financial institutional with a total equity of approximately US$340 million. Another significant merger was Qatar National Bank’s US$2.6 billion acquisition of Egypt’s National Societe Generale Bank, previously owned by France’s Societé Générale.
The use of conventional debt to finance public and private sector transactions has fluctuated over recent years due to a period of economic uncertainty and limited access to credit. During the onset of the global financial crisis, there was an expectation that Islamic acquisition finance would fill the gap left by the lack of availability of conventional debt in the M&A sector. This expectation did not materialize, primarily due to the decline in activity in the M&A sector between 2009-11. With the recent increase in the levels of activity in the M&A sector and the continued uncertainty regarding the availability of conventional debt, there is a renewed focus on the role of Islamic acquisition finance in M&A transactions.
Islamic M&A?
Islamic acquisition finance has not been as commonplace as other types of Islamic finance. The reason perhaps being that it is more challenging to satisfy the rules of Shariah in an acquisition financing. The business of the target is of particular relevance as the use of proceeds for any acquisition will be closely scrutinized in light of Shariah restrictions.
In order to qualify as a Shariah compliant investment, at least 95% of a company’s gross revenues must be generated from business activities not prohibited under the Shariah principles. Any haram business activity involving alcohol, tobacco, pork-related products or pornography will not be permitted. In complex M&A transactions, involving targets that have a diverse global business, such activities might not seem relevant at first glance, but on a closer examination, the target’s business activities may contravene Shariah principles.
Certain financial criteria, as drafted by AAOIFI, recognize that business activity in the modern world cannot be isolated entirely from practices that are prohibited under Shariah. AAOIFI’s Standard No.21 establishes arbitrary thresholds that can be adopted when screening for acceptable investment targets.
These include (for example) that the target company’s conventional (interest bearing) debt should be less than 30% of its equity (market capitalization)and income from prohibited components should not exceed 5% of the total income. Islamic M&A therefore requires strict criteria to be met. Some scholars are prepared to take a pragmatic approach and giving the purchaser a period during which it must ‘clean-up’ the target business so that it ensures that the target is compliant with Shariah principles.
Tawarruq—Shariah compliant M&A?
Although the vast majority of M&A transactions in the Middle East are funded using conventional debt finance, the Tawarruq structure offers a Shariah compliant alternative. However, this structure continues to be subject to critical commentary as to its Islamic permissibility. Tawarruq, or a commodity Murabahah, involves a transaction where a financial institution sells a commodity to a customer on deferred payment at cost plus profit, and the customer then sells the commodity on a spot basis to a third party for cash. It is easily applied to acquisition finance where the proceeds of the Tawarruq are restricted to the acquisition of the target.
The Tawarruq structure is standard in Malaysia and is commonly used in the UAE and Saudi Arabia.The International Islamic Fiqh Academy ruled against the use of organized Tawarruq, whereas AAOIFI has published Shariah standards with respect to Tawarruq transactions providing for certain conditions on the permissibility of the structure.
Most recently and setting itself apart from its GCC neighbors, the Omani Central Bank, in its latest regulatory framework on Islamic banking, has prohibited the use of Tawarruq in the sultanate. Whilst Tawarruq may not be ideal, the question of its Islamic permissibility is not absolute. It has been suggested that for there to be a viable Islamic acquisition finance structure, Tawarruq should be allowed to develop subject to some form of policy parameters.
The future
Whilst sovereign wealth funds and large industrials may continue to seek growth by investing outside of the region, growth in M&A activity in the region will be driven by SMEs operating in sectors that are ripe for consolidation.
In addition, the Middle East has a significant number of loosely organized family conglomerates that are beginning to seek the benefits of corporatization and looking for strategic partners to expand and enhance operational efficiencies and to diversify their portfolios through M&A transactions.
The current expectation is that 2013 will witness continued growth in M&A activity involving Middle Eastern firms, where Islamic acquisition finance can play a significant role.
Dina Elshurafa is an associate in the Energy, Infrastructure Project and Asset Finance Group at White & Case. She can be contacted at
[email protected]
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