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10| pfi | Middle East Report 2010 Sukuk

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 Islam- ic structures such as sukuk. Equally, investors have bought them without taking the trouble to fully under- stand 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 there- fore had no claim to the underlying itself when the sukuk came up for restructuring.

Instead, the underlying – usually property – was trans- ferred to an SPV to hold on behalf of the investors. This misunderstanding about how a sukuk restructuring would play out was responsible for considerable resent- ment 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. West- erners assumed a sukuk was essentially just a more secure version of a bond. Islamic investors, understand- ing Islamic finance as always being asset-based, assumed a default would leave them in possession of the under- lying. 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 restruc- turings 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 Buck- ley, 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 illiq- uidity 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, ques- tioning the viability of the sukuk product and conclud- ing that something that had been presented as a low risk product was, in fact, the opposite.

Many investors in sukuk believed they had recourse to the

underlying assets.

The Dubai-based banker dismissed the issue as a media creation, saying: “I don’t believe Sharia-compliant com- panies will be more prone to restructuring than tradi- tional 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 struc- tured 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, tra- ditional 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. Pro- portionately 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 like- ly 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-com- pliant 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. But for the mar- ket 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.

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