Middle East corporates and issuers are becoming more inclined to issue Islamic tranches within their conventional financing facilities in a bid to attract a wider investor base and to tap the more liquid Islamic banks to meet their financing requirements. NAZNEEN HALIM looks at whether this trend is here to stay.
The recent issuance of the Satorp Sukuk, a joint venture between state-run Saudi Aramco and French oil conglomerate Total worth SAR3.75 billion (US$1 billion), marked the first project financing Sukuk for Saudi Arabia, according to Saad Rahman, an executive director at Credit Agricole S.A. in Bahrain. “The deal worked because of Aramco Total’s credibility and standing in the market — to the deal’s investors, it was almost like taking up a quasi-government deal. However, the deal itself took a while to structure due to its complexity and a relatively more complicated process,” he explained.
The issuance was part of a larger financing facility worth US$14 billion, and attracted much attention from the Islamic finance arena and, more importantly, Saudi Arabian investors; who prior to this were more inclined to invest in the conventional debt market due to its fixed-income returns and higher yield.
The 14-year Shariah compliant offering achieved keen pricing of 95 basis points (bps) over six-month SAIBOR, meeting the tight guidance of 95bps–105bps over the benchmark, mainly due to the financial and reputational support of its sponsors.“The sponsors are guaranteeing this, so the risk factor is very low; it’s a good investment and there’s a lot of cash in the kingdom,” revealed Fawaz Nawwab, the chief executive of Satorp. The greenfield development will process 400,000bpd of Saudi heavy crude when fully operational in December 2013.
Perhaps the credit crunch is to some extent a blessing in disguise for the world of Islamic finance: with corporates, financial institutions and international issuers seeking a wider investor base and looking to tap into the more liquid Islamic banks for financing. According to a recent report by Kuwait Finance House, Sukuk issuances in the GCC – previously a relatively muted market for Islamic bond issuances – are looking up in the next few years due to growing demand from institutional investors, a longer-term appeal and increased infrastructure spending plans throughout the region.
It is a well-known fact that Middle East investors are more inclined towards investing in paper, which provides high returns, and with global bond yields at an all-time low, Islamic paper is becoming a more attractive option for investors previously heavily involved in the conventional bond market. Mohammed Paracha, an Islamic finance partner at Norton Rose, explains that the issuance of Islamic paper alongside conventional financing facilities, as exhibited by Satorp and a growing number of Middle Eastern corporates, is no longer a matter of choice but a corollary of market conditions following the 2008 financial downturn. “As you know, the conventional banking sector was substantially affected by the financial crisis in 2008 and had to write off huge losses. This caused severe balance sheet problems and stricter credit approvals, and resulted in credit crunch in the market. In order to find liquidity, corporates in the Middle East¬ turned to Islamic banks to meet their financing requirements.
“As Islamic banks have been affected less than the conventional banks by the financial crisis, they have been able to, to a certain extent, increase their market share by filling the gap left by their conventional counterparts.”
Chris Utting (caricature), a partner at law firm White & Case, reveals a more socially responsible spin to the reason behind the growing number of Middle East corporates choosing to issue dual tranche papers. “The local banking market in certain Middle Eastern countries, Saudi Arabia for example, is only willing to provide funds through Shariah compliant structures. Companies hoping to have the greatest liquidity and sources of capital will therefore ensure that investors in such markets have an acceptable Islamic structure. Often this is not enough, so it needs to be combined with conventional facilities to raise the required capital. In addition, many Middle Eastern corporates based in predominantly Muslim countries consider the use, to the greatest extent possible, of Shariah compliant structures in their financing as part of being good corporate citizens.”
Another reason behind the use of Islamic financing facilities within conventional issuances is due to the unforgiving market conditions in the Middle East and Europe at present, making the issuance of straight Sukuk more expensive for corporates. Islamic facilities enable these institutions to gain a better pricing from banks as opposed to issuing Sukuk in the market. However, in terms of pricing between conventional bonds and Sukuk, Saad from Credit Agricole S.A. reveals that there is currently not much discrepancy between the two.
Both Islamic and conventional bank treasuries in the GCC are becoming more keen on buying Islamic paper. However, the dearth of Shariah compliant assets has been hindering Islamic institutions from receiving a larger portion of the pie, and because Islamic institutions tend to keep Islamic paper on their books rather than taking advantage of the tradable nature of the certificates, conventional investors have previously shied away from tapping into the more liquid Islamic market. However, the rise of Islamic project financing facilities is expected to change this perception and create a more active secondary trading environment. “Project and infrastructure financing involve the construction and operation of large assets, have some element of public utility, and a correlation between the amount of the financing and the value of the assets, all of which fit well within the principles of Islamic finance and appeal to Islamic investors,” said Utting.
Structural challenges
A lack of standardized documentation continues to pose a challenge to the structuring capabilities of dual tranche issuances for issuers and those involved, and the relative reluctance of Islamic investors to be part of sharing and inter-creditor arrangements with conventional lenders could also hamper the popularity of such issuances. However, increased education amongst Islamic and conventional investors alike could potentially alter such perceptions for the better, industry experts believe.
Paracha also agrees that the issue of the sharing of security between conventional and Islamic banks acts as one of the greatest challenges to the proliferation of dual tranche issuances. “As Islamic structures usually require transfer of ownership of property, assets or a project which is being financed, Islamic banks have direct rights to the secured assets and this would place the Islamic banks in a senior position over the conventional banks. In order to achieve pro-rata sharing of the security, Islamic and conventional banks have to enter into security sharing arrangements in order to overcome this issue posed by Islamic structures,” he explained.
The way forward
Project financing is expected to lead the dual tranche issuance arena in the Middle East, with the demand for infrastructure financing seeing consistent growth in the region over the past few years. Having already established a healthy track record with issuances by the Kuwait Paraxylene Production Company, which included a US$347 million Islamic tranche within its US$1.4 billion financing facility, and Umm Al-Nar’s (an Abu Dhabi government water and electricity plant) US$250 million Islamic tranche – part of a US$2 billion issuance – among others, the recent political upheavals in the Middle East are also expected to pave the way for new government-led infrastructure projects. “The project financing arena needs a lot of cash and multi-financing sources, most definitely,” Saad revealed.
Paracha (caricature) is also bullish on the prospects for Islamic financing to be part of the mega demand for infrastructure financing in the Middle East. “Islamic finance is well suited to project financing of infrastructure assets. There is not only a desire on the part of Islamic banks to participate in the development of infrastructure that will benefit society, but also the compatibility of long-term funding of assets sits very closely with Islamic finance principles. That being said, we are generally seeing more Islamic finance in the general banking and structured finance market than in project finance, which is a reflection on the slow-down of projects in the region at the current time.”
He also added: “In the past, the Islamic banks’ participations in facilities with conventional tranches used to constitute only a small portion of the whole facility. Now, we are seeing sizeable transactions financed only by Islamic banks. In that regard, the share of Islamic banks in facilities with conventional tranches is increasing and this trend will definitely continue. Don’t forget that conventional banks with Islamic windows also participate in the Islamic tranche, which allows even larger ticket sizes.”
Utting is also confident that dual tranche issuances will continue to be a regular feature in the financing arena; and its popularity is expected to grow not only in the Middle East, but also in emerging markets due to its diversity and ability to appeal to a much broader investor base. “Financings of corporates or projects based in the Middle East are likely to continue using at least one tranche of Shariah compliant financing. The interesting development to follow will be the increasing use of Islamic structures by investors who are investing in countries outside the Middle East, such as in Europe or some of the predominantly Muslim former Soviet republics. Clearly the more Islamic debt there is, the greater will be the potential for secondary market trading,” he concluded.