Sukuk finance case studies
For Emirates airline, the use of sukuk finance has been a huge success. The
company issued its first sukuk (Islamic Bond), with a seven-year term, in 2005,
which was listed on the Luxembourg Stock Exchange. The $550m was repaid
in full in June 2012.
‘The repayment of our first ever sukuk bond is part of Emirates’ varied
financing strategy and reflects our robust financial position,’ said Sheikh
Ahmed bin Saeed Al Maktoum, chairman of the Emirates Group and chief
executive of Emirates airline.
Emirates’ initial injection of equity finance at the time of its creation 24 years
ago has been supplemented by a variety of financing options, including
operating leases, EU/US export credits, commercial asset-backed debt,
Islamic financing, conventional bonds, as well as sukuk.
Tim Clark, Emirates’ president, recently stated that the airline had traditionally
used European debt to finance purchase of its fast-growing Boeing and Airbus
fleet. The French banks were particularly forthcoming with finance solutions.
However, since the global debt crisis in 2008, the traditional debt markets
have taken a risk averse position – even with a business like Emirates, which
has an unbroken profit-making record.
Clark outlined that obtaining funding for new planes using sukuk could be
tricky because Islamic finance, in addition to forbidding payment of interest,
prohibits pure monetary speculation and requires deals to involve concrete
assets. It would be harder to win a seal of approval from Islamic finance
scholars for a sukuk that was based on assets, which the airline did not yet
own.
For new aircraft, it is not impossible but it is much more complicated as the
cash would have to go from investors through a special purpose vehicle to the
manufacturer before a lease-back arrangement is put in place. Hence, using
existing assets to obtain sukuk finance is far easier.
Emirates currently has two aircraft-based sukuk instruments that have been
issued globally, and is backed by existing aircraft: a $500m issue from GE
Capital in November 2009, and a $100m deal for Nomura in July 2010.
Emirates is not the only success story when it comes to the use of sukuk
finance. Dubai shopping mall developer Majid Al Futtaim decided against
issuing a conventional bond because of pricing concerns. It mandated its
banks to set up a separate sukuk programme. Turkish Airlines has followed
suit and will finance the purchase of its expanding fleet with Islamic bonds.
The sukuk market has been relatively resilient during the instability in global
financial markets, which has made it more difficult for even highly rated
companies around the world to issue conventional bonds. That is partly
because Islamic investors in the Gulf remain cash-rich, partly due to the
limited supply of sukuk, and partly since sukuk investors tend to hold the
bonds until maturity. If these bonds are not being sold on to other investors,
there is little or no chance of the bond value fluctuating.
Recent events have shown the same is not true for conventional bonds. The
influence of the credit rating agencies with their regular reassessment of
government and corporate credit ratings has caused downward movement in
prices. As one commentator recently stated: ‘Equities are the only game in
town – bonds carry more risk.’
However, the story of Dubai World, the sovereign investment fund of the Dubai
royal family, gives the other side of the story when it comes to the use of
Islamic finance. On 25 November 2009, the financial world was shocked when
Dubai World requested a restructuring of $26bn in debts. The main concern
was the delay in the repayment of the $4bn sukuk, or Islamic bond, of Dubai
World’s developer Nakheel, which was especially known for construction of the
Dubai Palm Islands.
The Nakheel sukuk was quite a complicated instrument. It was broadly based
on the aforementioned Ijarah structure. In theory, the SPV has legal ownership
over the asset in this sale and leaseback arrangement. However, in this case
the SPV only had a long leasehold interest for a period of 50 years. The issue is that leasehold right is not seen as a real right or property right under UAE law as applicable in Dubai. What may have seemed secure was not.
Nevertheless, the Nakheel sukuk was backed by a few additional guarantees
that should have provided sukuk investors with some recourse. As such, these
guarantees gave investors the confidence to invest in the sukuk. A guarantee
from the state-owned parent company, which implicitly provides a government
guarantee for the sukuk (despite the fact that the prospectus clearly stated
otherwise), had reassured investors. This misplaced assumption misled
investors in their risk–return decision on the investment.
The issue, however, did not end there; the complications worsened when the
parent company that acted as guarantor found itself in a situation that made it
no better placed than Nakheel to repay the sukuk. Dubai World is also just a
holding company for a number of other companies beside Nakheel. However,
all of Dubai World’s subsidiaries have their own creditors and their own debts
to service, and the important thing for Nakheel sukuk-holders is that the
creditors of Dubai World, through the guarantee, are subordinated to the
creditors of the subsidiaries of Dubai World.
A public statement on 30 November 2009 by the Dubai Finance Department
director-general, that the Dubai World debts are ‘not guaranteed by the
government’, appears to correctly reflect the legal position, as the Dubai
government was not required by the lenders, and nor did it provide, any
contractual guarantees in respect of the Dubai World debt.
As history tells us, Nakheel did not default on its Islamic bond. The well
reported $10bn bailout, including providing $4.1bn to assist Nakheel directly
from Dubai’s rich neighbours Abu Dhabi, calmed the markets. But this was
only part of the solution. Nakheel also issued new sukuk bonds to some of its
creditors in lieu of amounts due to them. This was a key part of the company's
restructuring.
In a prospectus attached to the new sukuk, Nakheel revealed that it wrote
down the value of its property and project portfolio by almost Dh74bn
(US$20.14bn) in 2009 as its fortunes flagged. The company also said it
changed tactics in response to the financial crisis, forging ahead with a
selection of its projects and putting others on hold.
Conclusion
The global debt crisis sent shockwaves through the financial markets and, at
the time of writing this article, the western banks remain reluctant to loan cash
to the business community. Islamic finance, and in particular sukuk, has to
some extent filled the gap left by the traditional debt markets.
The Sharia principle on which it is based is fundamentally important and
should ensure it is a safe and sensible finance option for both the company
needing the finance as well as the sukuk holder. Clearly, companies like
Emirates have shown the way on how to make sukuk one part of their finance
portfolio.
However, the Nakheel story paints a different picture. A complicated Ijarah
structure and a lack of legal clarity as to ownership of the underlying asset
have clouded the water. If the Abu Dhabi bailout failed to materialize, then the
story may have been significantly different.
Sunil Bhandari is a freelance Paper P4 tutor and a member of the Paper P4 marking team (www.SunilBhandari.com)
APPENDIX – THE BASIC PRINCIPLES OF ISLAMIC FINANCE
The Islamic economic model has developed over time based on the rulings of
Sharia on commercial and financial transactions. The Islamic finance
framework is based on:
· equity, such that all parties involved in a transaction can make informed
decisions without being misled or cheated
· pursuing personal economic gain but without entering into those
transactions that are forbidden (for example, transactions involving
alcohol, pork-related products, armaments, gambling and other socially
detrimental activities). Also, speculation is also prohibited (so options
and futures are ruled out)
· the strict prohibition of interest (riba = excess).
As stated above, earning interest (riba) is not allowed.
In an Islamic bank, the money provided in the form of deposits is not loaned,
but is instead channeled into an underlying investment activity, which will earn
profit. The depositor is rewarded by a share in that profit, after a management
fee is deducted by the bank.
A typical illustration would be how an Islamic bank may purchase a property
from a seller and resell it to a buyer at a profit. The buyer will be allowed to
pay in instalments. Compare this to a typical mortgage where the bank lends
money to the buyer and charges interest.
Hence, returns are made from cash returns from a productive source – for
example, profits from selling assets or allowing the use of an asset (rent).
In Islamic banking there are broadly two categories of financing techniques:
· ‘fixed Income’ modes of finance – murabaha, ijara, sukuk
· equity modes of finance – mudaraba, musharaka.
·
FIXED INCOME MODES
(a) Murabaha
Murabaha is a form of trade credit or loan. The key distinction between a
murabaha and a loan is that, with a murabaha, the bank will take actual
constructive or physical ownership of the asset. The asset is then sold to the
‘borrower’ or ‘buyer’ for a profit but they are allowed to pay the bank over a set
number of instalments.
The period of the repayments could be extended, but no penalities or
additional mark-up may be added by the bank. Early payment discounts are
not within the contract.
(b) Ijara
Ijara is the equivalent of lease finance. It is defined as when the use of the
underlying asset or service is transferred for consideration. Under this concept,
the bank makes available to the customer the use of assets or equipment such
as plant or motor vehicles for a fixed period and price. Some of the
specifications of an Ijara contact include:
· the use of the leased asset must be specified in the contract
· the lessor (the bank) is responsible for the major maintenance of the
underlying assets (ownership costs)
· the lessee is held for maintaining the asset in proper order.
An Islamic lease is more like an operating lease, but the redemption features
may be structured to make it similar to a finance lease.
(c) Sukuk
Companies often issue bonds to enable them to raise debt finance. The bond
holder receives interest and this is paid before dividends.
This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are
linked to an underlying asset, such that a sukuk holder is a partial owner in the
underlying assets and profit is linked to the performance of the underlying
asset. So, for example, a sukuk holder will participate in the ownership of the
company issuing the sukuk and has a right to profits (but will equally bear
their share of any losses).
EQUITY MODES
(a) Mudaraba
Mudaraba is a special kind of partnership where one partner gives money to
another for investing it in a commercial enterprise. The investment comes from
the first partner (who is called ‘rab ul mal’), while the management and work is
an exclusive responsibility of the other (who is called ‘mudarib’).
The Mudaraba (profit sharing) is a contract, with one party providing 100% of
the capital and the other party providing its specialist knowledge to invest the
capital and manage the investment project. Profits generated are shared
between the parties according to a pre-agreed ratio. In a Mudaraba only the
lender of the money has to take losses.
This arrangement is therefore most closely aligned with equity finance.
(b) Musharaka
Musharaka is a relationship between two or more parties that contribute
capital to a business, and divide the net profit and loss pro rata. It is most
closely aligned with the concept of venture capital. All providers of capital are
entitled to participate in management, but are not required to do so. The profit
is distributed among the partners in pre-agreed ratios, while the loss is borne
by each partner strictly in proportion to their respective capital.
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