Innovation & Opportunities in Islamic Finance
By Robin Bayley & Barry Cosgrave
Posted: 25th March 2014 08:45
As the global recovery begins to take hold and confidence returns to financial markets, Islamic Finance has returned to prominence. A number of entities, often from markets and industries that had not previously considered Sharia-compliant funding structures, are exploring the opportunities that Islamic finance may present – most notably the UK government. However, there is a perception that Islamic structures are costly to implement and that without an extensive land-bank or other inventory of assets available to an issuer, Islamic finance is not a viable option. Recent developments in both the Sukuk market and more broadly within Islamic finance may prove these assumptions to be incorrect.
There continues to be a supply/demand mismatch in Sharia-compliant asset classes arising from a lack of both assets and diversification within the classes of asset that are available. This has led to problems such as a "hold-to-maturity" culture and the inevitable valuation inaccuracies that this creates. However, there are also benefits as commercial tension has put pressure on pricing and driven down yields in favour of issuers. Abu Dhabi Commercial Bank (ADCB) benefitted from this particular phenomenon in 2012 when it converted its proposed conventional bond issuance to a Sukuk in order to benefit from more attractive pricing.
Traditionally, Islamic finance has focussed on Sukuk and, owing to the need to have real assets underpinning the issuance, issuers have tended to be restricted to those with a land-bank to support such issuance. Much of this was as a result of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) pronouncement in early 2008 which criticised a number of Sukuk outstanding at that time. Criticism focussed on the valuation mechanic used to calculate the repurchase price for the assets underpinning the Sukuk and, therefore, the amount available to redeem such Sukuk. AAOIFI was of the view that where Sukuk are based on assets such as equity securities which have a fluctuating market value, it is artificial to fix the repurchase price for those assets five years prior to the date of re-purchase (in the case of a five-year tenor). This contrasts with land or moveable property which is always sold at the price agreed between buyer and seller when required. The net effect of this was to restrict issuers of Sukuk to those entities that had land or other tangible assets available to them and to focus almost exclusively on the Ijara (sale and leaseback) structure.
However, a number of recent Sukuk issuances have employed more creativity in the selection of assets to underpin the Sukuk issuance and have successfully utilised intangible (but nevertheless real) assets. Two noteworthy examples of this are the Axiata Sukuk (which used airtime vouchers as the underlying asset) and the FWU AG Sukuk (which used Intellectual Property in and to a software programme as the underlying asset). These issuances are indicative of a move away from some of the more "traditional" Sukuk asset classes and show a greater creativity by all parties involved. The effect of such issuances should be that more companies may consider ways to use the assets and/or cashflows available to them in their current business to support the issuance of Sukuk and thus find the Islamic capital markets open to them.
However, it would be wrong to focus solely on Sukuk as the only instrument available within Islamic finance. The breadth of offering within the Islamic finance sphere is growing allowing the industry to explore new, innovative structures. Sharia-compliant factoring arrangements have been successfully implemented and there is a growing interest in Islamic risk management (using the IIFM/ISDA Master Tahawwut Agreement) and structured investment products. Risk management tools in particular are assisting the Sharia-compliant market to mature and to mitigate the risk profile of issuers – something that was not previously the case. Developments have also been seen within the traditional fields of Sukuk evidenced by the growth of "Project Sukuk" (notably that issued by Sadara to fund the joint venture between Saudi Aramco and Dow Chemical) and infrastructure Sukuk (notably that issued by the MRT in Malaysia to fund expansion to the Kuala Lumpur metro) which are linked to, and intended to fund, long-term development projects.
It is perhaps worth considering why new structures and asset classes are appearing to support Islamic finance offerings. The reason for this may be quite simple: as industry professionals gain an increased understanding of the requirements of the Sharia, scholars have gained greater freedom to turn their attention to new structures and asset classes. The growing understanding of industry professionals is in turn helping to drive this process forward through the development of more sophisticated products and new asset classes to present to scholars for their consideration. This should bring greater diversity to the investment opportunities within the Islamic sphere and create opportunities for issuers and investors that have not previously considered Islamic finance as a means to raise capital.
It is important to note that Islamic financing techniques are not limited solely to Sharia-compliant companies or investors. In fact, it is estimated that two-thirds of Sukuk issued are purchased by conventional investors and there is nothing to suggest that broker/dealers treat Sukuk any differently to how they treat conventional bonds. Certain types of company – those that are involved in Haram (forbidden) activities – are naturally excluded from Islamic finance; but for most others there is no restriction. It should also be noted that there is nothing in the Sharia that says that the making of profit is forbidden; it merely restricts the means by which such profit may be made. Conventional investors have become ever-more comfortable with the contractual arrangements and economic returns available within Islamic structures. The development of the Islamic financial market and industry professionals operating within it has led to a reduction in the costs associated with structuring and documenting Sharia-compliant products, adding to the benefits of more attractive yields driven by pent-up demand. All of these factors may encourage more companies to look to Sharia-compliant methods of financing.
Perhaps the biggest fillip for the industry has come with the announcement that the UK government intends to issue a Sukuk by 2015. Whilst the UK government won't be the first government in Europe to issue Sukuk (Saxony-Anhalt was in 2005) it will be the largest and most significant to date. The projected issue size may be relatively small (estimated at £200m) for a government issuance, but it nevertheless illustrates the commitment of the UK to develop Islamic finance beyond its traditional jurisdictions and to encourage other UK companies to consider Islamic finance as a viable option in the future. In order to do so, companies may need to be creative in identifying assets to be utilised within a particular Islamic structure but, as we have seen above, the ground-work has been laid.
As the Islamic finance industry continues to develop and confidence returns to the world economy more generally, there are many opportunities for issuers to raise capital by Sharia-compliant means. Whether this occurs through Sukuk issuance or by other Sharia-compliant structures any potential issuer will need to be able to identify assets that will underpin the structure selected. Greater creativity and a deeper understanding of Islamic finance by industry professionals should enable potential issuers to identify asset classes that they had not previously considered and therefore allow them to give serious consideration to Sharia-compliant funding opportunities.
Robin Bayley is a partner in the Project Development & Finance Group of Shearman and Sterling LLP based in the Abu Dhabi office. Robin specialises in complex, multi-source financings involving banks, export credit agencies, Islamic finance and project bonds. (firstname.lastname@example.org; +971 2 410 8120).
Barry Cosgrave is a senior associate in the Finance Group of Shearman & Sterling (London) LLP based in the London office. Barry specialises in Islamic finance, restructuring, capital markets and structured finance. (email@example.com; +44 207 065 5964).