April 2012

April 29, 2012 (PDF) – NEW LOOK

Dana Gas Sukuk Restructuring

Dana Gas, the Emirati-based oil & gas company, hired Blackstone to help it restructure its sukuk which has dropped significantly in value on fears the company will not be able to convert its growing receivables from Egypt into cash to repay investors.  The yield has also risen along with the receivables growth from the company’s operations in the Iraqi region of Kurdistan, where oil companies with contracts with the regional government are under pressure from the Iraqi central government, which says the contracts are invalid.

In March, oil giant ExxonMobil announced it was freezing its contract with the regional government of Kurdistan, after pressure on it because it also operates in southern Iraq.  Dana Gas has not announced any changes to its own contract with the regional government, but fears of legal changes that affect it will likely to remain just behind the Egyptian receivables in investors’ minds.

However, the restructuring environment could be markedly different for sukuk issuers now that Arcapita has been pushed into bankruptcy by funds that held its murabaha debt.  The entry of these investors into the distressed market limit the ability of issuers to force hidden write-downs on their creditors

through ‘extend-and-pretend’ debt deals.  While these deals promise full repayment later in the future, in reality, they are forcing investors to take a net present value write-down.

Investment banking firm Exotix is quoted by Bloomberg saying that the principal write-down on the Dana Gas sukuk, which when paired with a 2-3 year maturity extension, would reduce the yield-to-maturity down to zero from current prices, suggesting that if the principal reduction is in the cards, it has yet to be fully priced into the current market price. [Ed: Exotix was quoted suggesting a principal write-down was in the works, the analysis of YTM which follows was mine, not Exotix's]

What is significant with the prospects for a restructuring of sukuk that includes an explicit principal write-down is that it should make it easier for investors to reference market prices in determining the likely principal write-down for distressed sukuk.  One of the largest risks in many countries in the GCC for sukuk investors is that insolvency laws are underdeveloped and untested and the sovereign is present in many of the distressed debt negotiations.  Dana Gas is a private company, so the outcome of the restructuring, if it proceeds in a way that treats investors fairly, could help to clarify the expectations for investors in non-sovereign sukuk.

April 22, 2012 (PDF)

Sukuk shortage is a problem for takaful too

Reuters is reporting that takaful growth is slowing despite a large market potential with takaful representing only 17% of the total insurance markets in the Gulf and Malaysia.  The article does not address the issue of cost, but it is likely that takaful is more expensive than conventional insurance because most takaful providers are smaller, they have fewer investment options to ensure that the fund will be sufficient to meet claims, and there is limited retakaful cover forcing takaful providers to keep more risk themselves.

In the context of last week’s newsletter, which focused on the shortage of sukuk for pension funds, there are many overlapping problems for takaful providers.  The conventional industry manages its risk in part by investing most of the premiums in fixed income to provide more predictability about the funds they will have available to meet claims in the future.  Takaful providers cannot invest in the same allocation as conventional insurers because they have to look to sukuk to replace conventional bonds, and sukuk are in short supply, even in the well developed market of Malaysia.

This shortage has led takaful funds to have greater exposure to equities, real estate and alternative assets, which have greater volatility than most investment-grade bonds (or sukuk).  The greater volatility likely leads takaful providers to charge higher premiums to ensure that there will be sufficient funds available well into the future to meet claims.

To some degree, this problem could be offset if takaful providers were larger and could get more diversification in the pool of clients contributing to the takaful fund, but this would not help the problem of managing the assets in the takaful fund.

Instead, most takaful providers, according to the Reuters article, are looking to find more growth in other markets, like North Africa, where takaful is less available, but these markets are likely to provide additional challenges to takaful providers in managing the takaful fund.  They are either going to look to established markets for sukuk to put in their allocation, or are going to increase their exposure to equities.  Both come with additional risk.  The latter is clear, but the former adds a new risk: the risk of investing in sukuk denominated in foreign currencies adding foreign exchange risk which is difficult to manage in a Shari’ah-compliance way.

There are growing pains in any new industry, but as the takaful industry grows it will be constrained more and more by the problems of the Islamic finance industry generally, where they will have to find solutions that are not like those used by conventional insurance.  It will likely become a continuing story until the underlying problem of too few sukuk is addressed.

Updates from the Americas

Arcapita’s bankruptcy case is ongoing and a recent objection by Standard Chartered, which provided $100 million of murabaha financing to Arcapita in 2011, presumably to finance the company through its anticipated debt restructuring of the $1.1 billion murabaha whose imminent maturity led the company into bankruptcy.

The objection by Standard Chartered is based on the potential, according to Standard Chartered, for Arcapita to make inter-company transfers of dividends that should be held for Standard Chartered due to its mortgage on the equity of a number of Arcapita subsidiaries.  Standard Chartered, in a court filing, described that “if the value of the Subsidiary Guarantors, which is at best uncertain, is transferred to AIHL [Arcapita’s Cayman Islands holding company] or Arcapita Bank, Standard Chartered’s security interests could be rendered worthless and the Subsidiary Guarantors could impermissibly be rendered insolvent to the detriment of Standard Chartered”.

Standard Chartered is asking the court to make the approval of any budgets the court is presented with by Arcapita require approval by Standard Chartered as well.  More concerning for the unsecured murabaha holders, the senior position of Standard Chartered means Arcapita will have to come up with more money before lower priority murabaha creditors get paid.

In another document filed with the bankruptcy court, Barclays Bank, which is on the committee of unsecured creditors, has asked the court permission for its affiliates to trade claims on Arcapita’s debt, as long as it separates those trading activities from its position as a committee member to avoid potential conflicts of interest.

As I mentioned in an earlier blog post, is the fact that the murabaha financing is being traded (and the trading is unlikely to occur at par).  Yet, there has been much less controversy about this than about the potential for the Goldman sukuk to be traded since it was listed on the Irish Stock Exchange (even though it was never likely to trade).

April 15, 2012 (PDF)

A shortage of sukuk…in Malaysia of all places

Even in the face of record issuance, pension funds in Malaysia are reporting that they are being held back from expanding their sukuk holdings by a shortage of investment-grade sukuk.  This Bloomberg article is particularly surprising since the largest of the pension funds (Malaysia’s Employees Provident fund holding $153 billion of the total $192 billion managed by the pension funds commenting for the article) is located in Malaysia, which has the largest and deepest sukuk market in the world (in terms of total issued sukuk and secondary market liquidity).  Total sukuk outstanding that are domiciled in Malaysia as of July 29, 2011 was $112.3 billion, nearly 63% of the total outstanding sukuk globally.

The funds mentioned in the article are:

  • Employees Provident Fund (Malaysia, AUM: $153bn)
  • Kumpulan Wang Persaraan (Diperbadankan) (Malaysia, AUM: $27bn)
  • Jaminan Sosial Tenaga Kerja (JAMSOS) (Indonesia, AUM: $11.5bn)

In addition to pension funds, takaful providers (of which Malaysia has several), are likely to have the highest demand for long-term investment-grade sukuk to meet their longer-term investment mandates, while banks and other financial institutions are likely to demand domestic sovereign debt, in order to minimize the capital they are required to hold (generally risk weightings for domestic sovereign debt is lower than for domestic investment grade corporate bonds or sukuk, meaning the banks must hold less additional capital against their sovereign bond or sukuk holdings than if they invested in similarly-rated corporate sukuk.

If the institutions (pension funds and takaful firms) who typically have long-term (if not hold-to-maturity) holding periods are finding too little supply of sukuk than they are also likely to hold onto whatever sukuk they are able to buy, which will effectively remove it from the secondary market.  This will most likely constrain the development of secondary market liquidity because other holders of sukuk are less likely to sell it into (less liquid) secondary markets fearing that they will either not be able to find a replacement sukuk or will have to pay up to get it.

The story of low supply exacerbating illiquidity in secondary markets does happen (most notably in the lack of secondary market liquidity for sukuk in the GCC before the financial crisis).  It is more surprising that pension funds in Malaysia are finding limited supply and therefore limiting their holdings of domestic sukuk while looking outside of the country for sukuk (Bloomberg reported that they were planning to increase their holdings of non-Malaysian sukuk from $1.7 billion to $3 billion by 2013).

If the largest market for sukuk is experiencing a lack of supply, then there is likely a much larger market potential for sukuk.  If the market can expand to provide sufficient or near-sufficient supply for long-term buy-and-hold investors, than there will be more supply available for shorter-term investors (including sukuk funds).  The Ernst & Young Islamic Funds & Investment Report 2011 (pdf) broke down the AUM in Islamic funds by asset class (data as of 2010), which showed that fixed income funds are a much smaller part of the Islamic funds market than the conventional fund market.  The E&Y report showed sukuk funds representing 7.8% of the total assets under management in the Islamic funds industry.  For comparison, the trade group for US mutual funds, the Investment Company Institute showed that 20.4% of all mutual fund assets were in just taxable bond funds (excluding assets held in municipal bond funds, or in money market funds, which make up 4.2% and 21.4% of all mutual fund assets in the US, respectively, compared to just 1.1% of Islamic funds’ assets).

These funds will be drawn into the market by liquid secondary markets because they are much more likely to trade than the banks, pension funds and takaful providers.  However, if there are shortfalls in supply even in the largest markets, then the sukuk funds will develop slower than they could with greater liquidity.  This demonstrates again the need for the Islamic financial industry to continue to attract more investment grade issuers (both sovereign and corporates) to the market.

April 8, 2012 (PDF)

Green sukuk and infrastructure development in the Middle East

Recently, an article on the Knowledge@Wharton (Wharton is the business school at the University of Pennsylvania) discussed the infrastructure challenges facing the Middle East and suggested that it was more important to the region than oil and gas.  While the article had only passing mention to Islamic finance (a final paragraph mentioned the development of the industry over the past 30-40 years), it should receive a higher priority.


The article included a quote from Hesham Tashkandi, senior operations leader at GE Energy in Saudi Arabia: “The UAE does not have as much oil as other countries, so it may find that it would be better to burn the gas and oil itself, rather than continue to trade on the global market”.  This is in contrast to the perspective that I described with reference to the prospects for a green sukuk.  My comments were based on the sentiment expressed by Indraj Mangat, a partner at Eversheds LLP: “Building a renewables industry allows more crude to be exported”.

The basis for my blog post was that the GCC would be well served by developing more renewable energy generating capacity (financed through a green sukuk) because the countries in the region are quite energy and carbon intensive, when measured by carbon emissions per unit of GDP.  The six countries in the GCC are among the top 15 in carbon emissions per capita (they are ranked slightly lower in the emissions per unit of GDP).  If they shift their own use away from oil and gas, and instead export the gas to more efficient users of energy, then the aggregate carbon emissions should decline.

However, a green sukuk could be used to finance more than just renewable energy: the Wharton article describes the need for more technology to deliver clean water (50% of the population in the Middle East do not have access to clean water).  Either (or preferably both) renewable energy generation and water treatment and distribution facilities could be developed with financing raised through a green sukuk (which is being promoted by the Climate Bonds Initiative).

A sukuk for a solar farm or water treatment plant would be a good fit: a large amount of capital is needed up front and the project would have a tangible asset to back the sukuk, which would make periodic payments based on the sales of either water or electricity it generates.

The one potential difficulty in getting new projects financed with sukuk is that they would most likely have to be istisna’a-ijara sukuk.  During the istisna’a phase, the sukuk would not likely be tradable.  However, once the project is constructed, it would be an ijara sukuk and most likely tradable.  A solution to this potential problem would be for the sukuk to be issued by a company that has already operating facilities looking to build new capacity.  The sukuk could then be an ijara sukuk on the existing solar farm or water treatment facility with the proceeds used to construct additional capacity.

With sukuk markets surging, it seems like now is a good time to expand into new areas for Islamic finance.  The renewable energy and infrastructure to provide clean water are areas that would have a positive social impact, in addition to being financially viable.  Much more useful in my opinion than the pre-crisis focus on over-building bigger and more lavish luxury homes to meet highly uncertain demand (as the post-crisis crash in real estate in some areas has demonstrated).

Updates from the Americas

TCW to manage NCB Capital’s Shari’ah-compliant international equity funds

Trust Company of the West (TCW), Amundi and NCB Capital, the Saudi asset manager formed an alliance to manage NCB Capital’s international Islamic equity funds.  Perhaps the entry of a large US-based asset manager into the Islamic funds market can make Islamic finance more familiar to Wall Street, which has lagged other Western financial centers in Islamic finance.

UM Financial sale process hits a roadblock

The UM Financial bankruptcy process hit a snag when the 9 offers from 7 bidders came in under the amount UM Financial owes to Central One Credit Union.  As a result the receiver rejected the offers and is reviewing the process of the sale of the portfolio.  Filings with the bankruptcy court say that the bidders and Grant Thornton engaged in weeks of negotiations, but could not find an acceptable price to all parties.

It is a bit surprising that the receiver expected to receive full value for the portfolio, a snag that derailed previous negotiations for the sale of the portfolio before the receivership.  Grant Thornton continues to administer the portfolio and

April 1, 2012 (PDF)

The lesson from Arcapita

There is an often repeated expression that when a bank has to try and convince the market of its solvency, it has already lost the battle.  When banks lose the confidence of the market, its fate has already been written in stone.  Finance runs on confidence and when that is lost, it is only a matter of time before the bank itself is lost.


When I began covering Arcapita for The Islamic Globe, my first article was about the potential for the company to restart its deal business with the acquisition of J. Jill, a women’s apparel company in the U.S., which it acquired from a conventional private equity firm in a leveraged buyout (in April 2011).  At the time, I gave Arcapita the benefit of the doubt and assumed that, while it was facing a murabaha coming due in a year, it had been just sidetracked from its primary business of buying and selling companies by the financial crisis.

Last fall, Arcapita saw the debt on J. Jill downgraded, which I also wrote about with a bit more urgency on the murabaha coming due the next spring (i.e. now).  The debt deal was structured so that the debt covenants became more restrictive over time, but could be cured with equity injections from Arcapita and its investors.  With several exits from its portfolio, Arcapita seemed to be taking advantage of the improving deal environment in the financial markets.

When J. Jill was downgraded again, it was February 2012 and the murabaha was coming due in months, I expected to see a cash build in the company in the September 2011 as a result of the portfolio company sales the previous year.  However, the financial statements revealed a troubling lack of cash on hand as of September 30.  As a result, I dug into the financial statements and portfolio holdings and, when The Islamic Globe suspended publication, I was hard at work determining why the murabaha was trading at around 60 cents on the dollar.

Since the September 2011 statements are the most recently filed financial statements and no information will be available through the bankruptcy filing until early May, I still have no more information of the company’s cash position, but the bankruptcy filing revealed that the murabaha cannot be paid when due (it matured on Wednesday).

Arcapita requested the bankruptcy court approve continued payments for its employees and some creditors, and one of the funds that owns $88 million of the $1.1. billion murabaha objected on the grounds that Arcapita has “provided absolutely no visibility into the operations of these non-Debtors [their subsidiaries not included in the bankruptcy, including Arcapita, Inc., it’s US operations], and to this date have refused to offer any assurances that the portfolio companies or their non-Debtor managers will not engage in transactions outside the ordinary course of business without the approval of this Court”.

That creditor, Euroville S.ar.l (the hedge fund Fortelus) argued in an objection that Arcapita was asking to finance expenses more than what was “minimally necessary to “keep the lights on” including what it describes as “enormous operating expenses, lavish employee benefits and exorbitant rent obligations to an insider landlord”.

These issues will be handled by the bankruptcy court (and one should not rely too heavily on statements from parties involved in the bankruptcy who may have their own motives), but the issue remains: when should an Islamic finance company announce defeat, rather than saying “Retreat, hell! We’re not retreating, we’re just advancing in a different direction.“

One of the primary objections by Fortelus is that Arcapita is retaining all of its employees, even though the company has made but one deal since the financial crisis (J. Jill) and is certainly not making any now (it has 191 employees it wishes to continue to pay, including executives (and their discretionary bonuses), down from 275 on June 30, 2011).

Despite the steadfastness shown by Arcapita’s management, it is clear that it (if not its business model) has failed.  It acquired companies in leveraged buyouts just like conventional private equity firms.  It also leveraged itself up with the murabaha, and also the unrestricted investment accounts it invested on behalf of investors into the companies it owned.  It accelerated these activities in the years before the financial crisis when debt was cheap and companies were expensive (the murabaha was issued in 2007).

When credit becomes expensive and the investments made on margin drop in value, a firm exposed to both should recognize that it cannot fix the situation, not continue on the same path (Arcapita blamed the European financial crisis in late 2011 for its failure to roll over the murabaha).  However, Arcapita became defensive, both to creditors and to reporters covering the company.

Islamic finance is not immune to failure and failure is a natural part of finance.  The problem comes when institutions whose business model cannot accept this fact and try to either continue on as normal or deny there is a problem and attack those who raise questions.  A failure to evolve and abandon failed businesses will only hamper the development of Islamic finance.

Updates from the Americas

The Toronto Financial Services Alliance proposed regulatory changes (pdf) for the Ontario government to attract Islamic finance.  The proposed changes relate to regulatory and tax changes to put Islamic finance on a level footing.  Interestingly, one of the proposed changes is to “repurchase of public lands in the future”.  If the change were adopted, it would open the way for the government of Ontario to issue a sukuk.  In 2010, there was a Bloomberg article which suggested that three government agencies in “one Canadian province” were looking at sukuk totaling $1.5 billion.  However, whether that had proposed beyond discussion phase are unclear since Omar Kalair, CEO of now-bankrupt UM Financial was the source for that information.