A wave of sukuk defaults has called into question the integrity of an asset class that many had assumed was gold-plated. But despite at-times hysterical media coverage, the asset class is in the midst of a very normal maturing phase, and once legal precedents have been established, it will again flourish – at least in those jurisdictions where legal rights are enforced. Solomon Teague reports.
With their underdeveloped and shaky legal systems, investing in corporates in Middle Eastern countries is always a riskier proposition than investing in the US or Western Europe. This is not confined to sukuk. Conventional debt financings of Middle Eastern corporates tend to be expensive, relative to the size of the company. In July, Kuwait Projects Company, despite its strong sovereign links, paid 99.20 for 10-year bonds. More recently, in October, Qatar Telecom priced a six-year deal at 99.24, and a 10-year at 99.16.
Investors in the Middle East require compensation for the weak legal structures in these countries, which can make any default a potential minefield. But the uncertainty associated with sukuk is even greater. Although there have been three high-profile defaults from the Gulf Co-operation Council in recent months, none has yet been successfully restructured. There is no precedent of a legally enforced sukuk restructuring in the region to help facilitate such an agreement.
Sukuk workouts will be determined by the decisions taken in their home jurisdictions, regardless of whether they are officially subject to UK or any other country’s laws. Even if a London court gave the green light to investors to seize the assets of, for example, a Kuwaiti or Saudi company, the courts of those countries would be unlikely to enforce those judgements, rendering them meaningless.
The uncertainty surrounding sukuk is likely to encourage investors to push for a higher premium to buy them. With different countries in the Middle East having different attitudes to international financial markets and investors’ rights, the affect will vary between countries. Sukuk that are in restructuring in Kuwait are likely to experience very different outcomes to those to be restructured in Saudi Arabia, said Ahmad Alanani, director of fixed income sales at Exotix in Dubai.
“There’s already a hierarchy in the perception of sukuk deals,” said Alanani. “The United Arab Emirates offers more comfort than Kuwait, and Kuwait offers more comfort than Saudi Arabia.”
Kuwait has seen a number of high-profile defaults in recent months: International Investment Group defaulted on its sukuk in April; while Investment Dar was the first company to pursue a restructuring under Kuwait’s Financial Stability Law. Kuwait is perceived to have the will to resolve the legal uncertainty surrounding sukuk, but the authority’s response has been lethargic.
IIG defaulted on its US$200m sukuk in April and then again in August. But the situation will not be clear until there is a resolution on Investment Dar, which will set the precedent for other Kuwaiti companies to follow. Investment Dar managed to reach agreement among its creditors in June and submitted its proposal to the Kuwaiti court, which is considering the proposal.
Investment Dar proposed an amortising schedule for its plan to term out restructured debt over five years, starting by September 30, with the first profit payment and first fixed amortisation payments due by March 31 2011 and September 30 2011. The plan was approved by 80% its creditors.
Saudi Arabia’s Saad Group default illustrates the significant uncertainty facing investors in that country. Since March, local sources have revealed that the company will not propose a restructuring plan until freezing orders placed on it by various jurisdictions have been lifted, according to Citicorp, the delegate of its US$650m sukuk.
Although holders of Saad’s Golden Belt 1 sukuk in October agreed an indemnity plan with Citicorp, paving the way for a future retrieval of capital, that possibility seemingly remains a long way off.
“The Saad case is nowhere near being resolved,” said Alanani. “Lawsuits have been filed in multiple jurisdictions only to be thrown out, shifting the case back to Saudi courts and putting the focus on SAMA. The situation is a black box. There is little hope for investors and the sukuk are trading at around 25 cents on the dollar, which is option value.”
Islamic finance is not well understood. A sector that has not fully matured, there has been a failure on the part of issuers to properly communicate the mechanics of Islamic structures such as sukuk. Equally, investors have bought them without taking the trouble to fully understand them, having had certain misconceptions.
Many investors in sukuk believed they had recourse to the underlying assets, in what was the most significant misunderstanding about the product. In fact, in most sukuk, investors acquired the beneficial right to the underlying, rather than the legal title itself, and therefore had no claim to the underlying itself when the sukuk came up for restructuring.
Instead, the underlying – usually property – was transferred to an SPV to hold on behalf of the investors. This misunderstanding about how a sukuk restructuring would play out was responsible for considerable resentment among many investors when it became apparent, according to a senior Islamic banker based in Dubai.
This is true of both Western and Islamic investors. Westerners assumed a sukuk was essentially just a more secure version of a bond. Islamic investors, understanding Islamic finance as always being asset-based, assumed a default would leave them in possession of the underlying. But “sukuk aren’t asset-backed, they are, in my view, asset-based. The revenues derive from the underlying asset are used to service the sukuk, but this does not imply ownership,” said Alanani.
Western and Islamic investors were therefore both wrong, but in different ways. “Both arrived at a similar set of expectations, but from different perspectives,” added the Dubai-based banker.
There are differences between typical sukuk restructurings and the more traditional variety. Sukuk deals are no more likely to require elaborate workouts than any other type of financing structure, according to Tim Buckley, managing partner in the Dubai office at law firm Walkers. The noteholders usually comprise a smaller group. Faced with a potential default, they are more often than not inclined to push out the terms of repayment, rather than push a situation into bankruptcy.
However, this inclination does not derive from the Sharia-compliance of the product they have invested in. According to Buckley, looking at sukuk products as a group rather misses the point. In fact, the deciding factor is usually the composition of the underlying asset. Many sukuk are backed by real estate assets. Sukuk backed by real estate might have more in common with traditional securities also backed by real estate than they would with another sukuk deal backed by another asset, said Buckley.
The defining characteristic is liquidity, because the illiquidity of real estate makes it an unattractive prospect for many investors to end up in possession of the asset.
“Property investing clearly presents many challenges in the current climate,” said Buckley. “Property backed finance structures are prevalent throughout the entire region, not just in sukuk but across the asset classes.”
It has been suggested that there could be a glut of sukuk defaults and restructurings coming to market. The media has responded to this with considerable alarmism, questioning the viability of the sukuk product and concluding that something that had been presented as a low risk product was, in fact, the opposite.
The Dubai-based banker dismissed the issue as a media creation, saying: “I don’t believe Sharia-compliant companies will be more prone to restructuring than traditional companies – or more sensitive to the economic cycle. People make comparisons and look for trends because there have been some high-profile cases.”
Bankers operating from the Middle East, in particular, report an intensity of coverage surrounding sukuk restructuring that is disproportionate to the coverage of equivalent sized defaults affecting conventionally structured companies or instruments. Compared with some syndications, sukuk financings are in fact very small.
“I think it is a double edged sword,” added the banker. “The sukuk instrument was seen as interesting, so when they launched there was a lot of publicity.” Conversely, traditional instruments that attracted less attention when they were launched are now benefiting from that relative anonymity, and are not attracting the media spotlight.
There have certainly been far fewer sukuk restructurings than traditional restructurings in absolute terms, mainly because there are relatively few sukuk instruments in existence, compared with traditional debt financings. Proportionately it is less clear whether sukuk instruments have performed well relative to their traditional equivalents.
It is normal for a maturing asset class to enter a phase in which it sees many restructurings. The high-profile defaults currently coming from the Middle East would serve as a major milestone in the maturing of Islamic finance, the Dubai-based banker said. The experiences of investors in recent months will educate future investors in what to expect, meaning future incidents are less likely to cause the same level of resentment.
And evidence suggests that the recent travails of the sukuk market have not scared investors away. New issues are currently in the pipeline, indicating that issuers and bankers believe support is still there for the industry. That appetite is reflected in other Sharia-compliant markets, such as ijara and murabaha. Even outside the Middle East the momentum remains strong, with a UK manufacturing entity recently raising US$20m of working capital through a sukuk issue.
Demand for sukuk will be maintained, if for no other reason than that there is a class of investor that for religious reasons has nowhere else to go. With supply limited, relative to the swathes of traditional bonds issued every month, and demand underpinned a steady, religious sector, the asset class’s future is secure. But for the market to grow it needs to broaden its appeal, said Alanani, and that can only happen when all doubts about the asset’s legal position are settled.