Alongside the record growth and exceptional investor demand of the booming Sukuk market lies a parallel story: the ongoing development and increasing complexity of Sukuk structures. Yet is this a blessing or a curse for the industry — are we moving in the right direction, or is our appetite for sophistication hampering the true course of Shariah compliant instruments? This week we explore the innovations taking place at the cutting edge of the Sukuk sector, and what this means for the industry.
Sukuk is undeniably the most popular investment instrument in the Islamic capital market, bringing a unique value proposition to both investors and issuers and promoting a diverse and flexible means of harnessing the liquidity and strength of the industry. For investors, Sukuk offer the advantage of portfolio diversification in the form of new asset classes, while issuers benefit from increased liquidity along with compliant and accessible fundraising through tapping into the growing demand for Shariah compliant investment products.
According to Bank Negara Malaysia in its recent report on the ‘Development of the Financial Sector’: “The strength of Sukuk lies in its distinct structure. The flexibility of Sukuk structures is a key factor that has led to its growing acceptance. Over the years, Sukuk structures have evolved from debt-based structures which are premised on cost-plus sale agreements (Murabahah), to lease-based (Ijarah), profit-sharing (Musharakah) and manufacturing contracts-based (Istisnah) Sukuk, as well as hybrid structures based on combinations of Shariah contracts that appeal to a wider range of investors.”
Islamic versus economic
This evolution can be broadly separated into two categories. Nick Stadtmiller, the head of fixed income research at Emirates NBD, explains that: “When you refer to a complicated structure, there are two things you could mean. One is the structuring of the cash flows — is it a Murabahah, a Wakalah, an Ijarah — the Islamic side. The other is the actual economic aspect of the transaction: in other words, what are the risks and what are the pay-offs.”
Islamic structures for Sukuk remain the fundamental building blocks, but the industry is seeing a growing number of innovative transactions that develop and expand these structures in order to create new transactions based on the needs of the company. As demand continues to far outpace supply, issuers are able to leverage this in order to create structures that meet their own specific requirements.
Anzal Mohammed, a partner and the head of the Sukuk practice at Allen & Overy in Dubai, comments that: “Given the different type of issuers that are accessing the Sukuk market, we are seeing the development of innovative structures such as the use of airtime (Etisalat and Axiata) and the combination of structures (the same issuers and the likes of Majid Al Futtaim Properties who used self-use assets as part of an Ijarah-based structure).”
Anzal also notes that: “As 100% tangible asset-based structures are difficult for corporate and financial institution issuers in particular, we have seen combined Mudarabah and Murabahah-based structures becoming the norm for subordinated Sukuk issuance by banks in Saudi Arabia. We will continue to see this development as well as further project Sukuk transactions coming to market following the very successful issuance last year as part of the Jubail project financing in Saudi Arabia.”
Craig Nethercott, a partner at Latham & Watkins, explains that: “Traditionally, the most common Islamic financing structures require the use of an underlying tangible asset as the basis of the financing which has restricted the ability of some companies to access the increasingly liquid Islamic markets (specifically in the context of the Sukuk capital markets).”
However, this is now changing and one of the most exciting features of the new sophistication in Sukuk structures is the growing use of intangible assets as the underlying basis.
Prime examples of this are the recent Sukuk issuances from mobile operators, based on airtime assets. In March 2012 Saudi Arabian mobile service provider Etihad Etisalat Company (Mobily), completed a SAR10 billion (US$2.7 billion) refinancing using an innovative airtime facility structure along with a more conventional Murabahah-Tawarruq structure.The airtime structure was first introduced by Mobily in 2007, and allowed the operator to sell minutes of airtime to investors and use the revenues generated as the basis for the Sukuk, in the absence of tangible assets. The success of the structure led to its subsequent use by Mobily’s principal shareholder, Emirates Telecommunications Corporation (Etisalat), for its own Sukuk program in 2010.
One step further
The 2012 facility took the structure a step further by introducing multiple term tranches, which according to Nethercott: “Granted greater flexibility to Mobily and more closely aligned the terms of the financing with its corporate needs.” The facility was supplemented by two Murabahah-Tawarruq facilities: one providing a revolving working capital facility while the other replicated the same commercial terms as the airtime facility. Nethercott notes that: “Whilst the introduction of multiple tranches initially led to some complex drafting issues (and interesting discussions with the Shariah boards of the financiers), the structure will now no doubt serve as a template for other companies seeking to raise multi-tranche Islamic finance.”
The popularity and success of the airtime structure clearly shows that the use of intangible assets as a basis for Islamic finance is growing more popular, as well as demonstrating the growing sophistication of the Sukuk market in Saudi Arabia and the wider Middle East.
In February 2012 the Saudi Arabian General Authority of Civil Aviation issued its debut SAR15 billion (US$4 billion) Sukuk, based on a sale of its rights to charge and collect fees from airlines. In November 2011 the Saudi International Petrochemical Company (Sipchem) issued a SAR1.8 billion (US$480 million) Sukuk using its right to receive distributions and other payments from its subsidiaries as the underlying revenue-generating assets for the Sukuk.
The innovation in the Sipchem deal lies in its asset basis. A Sukuk normally requires that the issuer has unencumbered tangible assets available, which in the case of Sipchem was a problem as the firm was a holding company with relatively few assets of its own and encumbrances at the operating level. The challenge was therefore to broaden the asset base of the holding company to accommodate a Shariah compliant structure based on real assets.
The Sipchem deal therefore involved an innovative Mudarabah Sukuk structure centered around the intangible rights between a holding company and its subsidiaries. This made the right of the holding company to receive distributions and payments from its subsidiaries the key underlying revenue-generating asset of the Sukuk — basically stripping out equity and using it as a asset basis for a Mudarabah structure. At the launch of the deal Dipti Thakar, a counsel at Latham & Watkins in Dubai, commented that: “This Sipchem Sukuk structure further reflects the increasing sophistication of the available products in the Saudi Arabian market. This product is a great addition to the toolkit available to corporate treasurers in the market.”
Sophistication through simplicity
Along with the growing use of intangible assets and new structures lies another trend: the development of hybrid structures using simple Islamic building blocks in order to create instruments that suit the specific needs of issuers.
Stadtmiller explains that: “Essentially a standard Sukuk is just an Islamic bond and the simple structure has a coupon payment with a profit rate and repayments until the end. But you can make Islamic structures with other features. For example the Dana Gas Sukuk; which has a structure which combines standard bond-like features such as fixed payments and repayment of principle with an option to convert into shares.”
Another recent example is the US$500 million First Gulf Bank (FGB) Sukuk in January 2012, which comprised a hybrid Wakalah and Mudarabah structure.
Hybrid Sukuk are garnering increasing attention and perpetual bonds are one of the most attractive new forms; brought into the spotlight by the Malaysia Airlines System (MAS) RM2.5 billion (US$816 million) perpetual junior Sukuk program. Launched in June 2012, the first tranche of RM1 billion (US$326.4 million) was fully subscribed by Malaysian retirement fund Kumpulan Wang Persaraan (KWAP) with MAS claiming to have received firm commitments for the rest of the program.
Unlike normal bonds, perpetual bonds do not have a redemption date; and the holders receive a coupon only when the company issues dividends, rather than receiving a periodic fixed coupon. The perpetual Sukuk has the advantage of being recognized as equity capital under Malaysian accounting standards, while still giving a long-term funding rate of 6.9%. It therefore provides equity at a relatively lower cost of capital compared to common equity, whilst offering an attractive yield to investors. Rafe Haneef, CEO of HSBC Amanah Malaysia, noted at the launch of the transaction that the hybrid Sukuk was an attractive option for companies which have reached a certain debt-to-equity ratio level. “It is just emerging as a concept and hopfully you will see the market trend move towards that. It will gain popularity here among companies which do not want to dilute their shareholding and at the same time are constrained by debt levels.”
Tier 1 trend
This new trend towards equity-style Sukuk is growing increasingly popular as issuers figure out how to structure their Sukuk to meet their balance sheet requirements. Most recently, Abu Dhabi Islamic Bank (ADIB) announced the launch of an innovative new Shariah compliant hybrid Tier 1 non-call perpetual notes issue, which is expected to be benchmark sized at around US$500 million and will be the first international perpetual Sukuk. The key feature of the Reg S deal is its simplicity, however, with one banker commenting that: “It was specifically designed to avoid being over-engineered.”
Stadtmiller explains that: “A Tier 1 capital issue is more like a fixed income investment in terms of the economics of the transaction, but it is actually recorded as equity on the bank balance sheet.” The transaction has been compared to the preferred shares hybrid Tier 1 deals done by US banks, as because the notes will be accounted for as equity instead of liability, they will not be required by Basel III to include loss-absorption provisions. The ADIB Sukuk is designed to comply with the Basel committee’s criteria for additional Tier 1 capital in anticipation of possible Basel III implementation in the UAE, yet despite its hybrid nature will be based on a very simple Mudarabah structure. “This is very straightforward,” said another banker. “The most challenging part of the structuring was converging Islamic rules with Basel rules.”
Sabana’s convertible first
Over in Singapore, the country is making its own contribution towards pushing back the boundaries with the issuance in October of the first convertible Sukuk since 2009, Sabana REIT’s SGD80 million (US$65.3 million) 4.5% convertible Sukuk due in 2017. The structure was specifically tailored to the REIT’s needs; combining the concepts of Murabahah, Ijarah and Wakalah to allow the Sukuk to acquire property assets which then formed the basis for the underlying revenue-generation for the Sukukholders.
Gregory Man, a senior associate with Clifford Chance representing Morgan Stanley as sole lead manager and bookrunner, explained that: “We needed to execute the transaction in two stages because Sabana REIT required the funding from this issue to acquire the real estate asset that would ultimately underlie the Sukuk. We entered into a Murabahah transaction to provide Sabana with its acquisition funding, and then the asset was injected into the structure so that the transaction going forward was part-Murabahah and Ijarah.”
The deal represents one of the most sophisticated Sukuk structures ever seen on the market, with Man commenting that the most difficult aspect was in creating the complex structural flexibility for convertibility features that investors required. However, the team that worked on the transaction have high hopes for the future with the Sabana REIT structure acting as a template for new issuances. Matt Fairclough, a partner at Clifford Chance, commented on the launch that: “Islamic finance is becoming more sophisticated and we have seen the development of both hybrid Sukuk as well as more sophisticated convertible Sukuk such as this. We will continue to see these sorts of developments as the Islamic finance industry continues to grow.”
However, a vital issue holding back the complexity of Sukuk transactions is the lack of standardization regarding Shariah compliance. While in Malaysia the market benefits from a single Shariah board which decides whether a structure is permissible, in the Middle East there is no common board which can cause considerable problems. “They have to get more stakeholders on board; and sometimes a complex structure will be approved by some Shariah boards and not by others, and that limits the potential investor base,” explains Stadtmiller. “So having a more complex structure means getting more Shariah boards in the region on board with the idea and getting them comfortable with the underlying structure as Shariah compliant.”
A key example of this was the Goldman Sachs deal, which proposed a structure that used commodity contracts which had the potential to be traded away from par on the Irish exchange. This led to vehement controversy between Shariah scholars as to the Shariah compliance of the deal and eventually halted the process entirely.
“As the transactions get more complex in terms of Islamic structure it does open up the possibility of different opinions, and it will take more time and more effort to get a more complex structure that a wide range of parties will agree to,” warns Stadtmiller.
Market players have also expressed concern at whether Islamic investors will buy into the new hybrid structures. Sukukholders are traditionally conservative, with little appetite for innovation and a preference for short-term vanilla Sukuk of five years or less. So while issuers may be excited about the new opportunities offered by more complex Sukuk structures, there is no guarantee that the market will respond.
Stadtmiller explains that: “As institutions that are dedicated to using Islamic finance grow, inevitably they will want to try different structures. But in terms of what can actually be done in the marketplace, I would say that one of the major limiting factors is investor appetite. Particularly in the Middle East, people have historically been very content with plain vanilla Sukuk, with a fixed coupon and secure return. So the challenge is to engage with the Islamic investor community and see whether they are prepared to take new risks with slightly more complex products.”
Perhaps this should stand as a warning for the industry. Innovation is vital, but not for its own sake. Sophistication of Sukuk should develop in the cause of advancement and improvement; offering real benefits to investors and enhancing rather than impeding compliance with Shariah — which is of course the highest goal of all. — LM