In little over four years Islamic finance has grown into a mainstream international capital market capable of launching and absorbing multi-billion dollar deals. Many believe it is on the cusp of becoming a global asset class. But others fear that development will be stymied by a lack of standardisation across products.
Here is a minor mystery: how is it that an investment bank with no demonstrable track record in the Islamic finance market, and which has no cash equities franchise, can execute the largest equity-linked Islamic sukuk transaction ever completed in the Middle East?
That is precisely what Barclays Capital achieved at the beginning of 2006 when, alongside Dubai Islamic Bank (DIB), it led the $3.5bn pre-IPO convertible sukuk for the Dubai Ports, Customs & Free Zone Corporation.
In terms of its size, the transaction comfortably eclipsed the previous largest sukuk, which was a $1bn issue for Dubai Civil Aviation, also structured and led by DIB.
The Dubai Ports sukuk formed part of the financing package supporting the acquisition of the UK shipping and ports group, P&O, and complemented the $6.5bn five year senior debt facility arranged by Barclays Capital and Deutsche Bank.
"There were a number of reasons why we won the mandate for the sukuk," explains Jean-Marc Lejeune, a director at Barclays Capital in Dubai. "For a British target the size of P&O, Barclays Capital was a logical choice in terms of acquisition finance. But when it came to structuring the sukuk financing, Barclays Capital came without any preconceived ideas. I think our openness to any kind of structure was a key element in winning the mandate. Although we felt that it would be important to offer an equity element, when we started talking about a pre-IPO convertible with our leverage finance team we weren't considering an Islamic financing structure."
The structural complexity of the Dubai Ports transaction did nothing to dampen demand for the sukuk, with a substantial oversubscription allowing for the deal to be increased from an originally indicated $2.8bn, and for pricing to be reduced to 200bp over mid-swaps, compared with guidance of between 250bp and 350bp.
According to Barclays Capital, over 150 investors participated in the transaction, with the Middle East accounting for two-thirds of demand and the remainder coming from Europe, Asia and the rest of the world. Islamic and conventional banks took up about 50% of the issue, with retail investors, asset and fund managers accounting for the balance.
With demand for equities in the Gulf (and especially in the UAE) rampant at the time of the transaction, a key element of the sukuk was its unique convertible structure allowing for partial redemption of up to 30% in the form of equity shares of the Dubai Ports entities as and when they go for a qualifying public offering (QPO) within the next three years. A QPO is defined as either an initial or a secondary public offering.
Another novel attraction of the structure was the incorporation of the so-called long term "lookback right". This entitles holders of the sukuk at maturity to participate in any QPO taking place within 12 months of the original note maturing. As a Barclays Capital briefing on the deal explains, "if no QPO takes place before the final redemption date, investors will be compensated with a higher yield."
A number of key lessons can be drawn from the Dubai Ports sukuk. It demonstrated that truly jumbo-sized transactions can be executed and placed globally. It illustrated that complex hybrid structures can successfully be fused with shari'ah-compliant transactions.
It also showed that borrowers and their advisors are receptive to novel structures and are able to understand and apply in double-quick time. As Lejeune says, a transaction such as the Dubai Ports deal could have been expected to take months between conception and execution. "We described the structure in a half page document, and the client liked the idea," he says. "Three days later we came back with a one page term sheet. Three days after that we expanded the idea into a two page term sheet and the client was very keen to move forward with the transaction."
If there has been a disappointment associated with the Dubai Ports deal it is that it has not been followed by anything like a flood of corporate sukuk targeted at the global investor community.
True, another twist on the sukuk theme came in August when the Qatar Real Estate Investment Company (QREIC) became the first Qatari corporate borrower to tap the market. Led by Qatar National Bank and Qatar National Bank al Islami, this was structured as a three tranche offering with further tranches due to follow the original $100m deal launched in August, which was more than twice oversubscribed.
But strip out the jumbo Dubai Ports deal, say some bankers, and total volumes in the public sukuk market in the Middle East have remained modest. Figures published earlier this year by Moody's bear out the observation. In May, the agency advised that of $41bn in global issuance, only $11bn had been accounted for by borrowers in the Gulf, with Malaysia continuing to account for the lion's share of the Islamic primary market.
That frustrates practitioners who have honed their shari'ah-compliant expertise and are now waiting for dealflow to put those skills to the test. "There has been more noise than substance about Islamic financing in the capital market," says one Dubai-based banker. "Going to Islamic banking conferences reminds me a bit of the Barcelona securitisation conference, where the number of underwriters is generally higher than the number of deals there are to underwrite."
Others disagree. At Deutsche Bank in Dubai, managing director of global markets for Middle East and North Africa Ricardo Honegger describes the market for Islamic finance as one that is growing at the speed of light. "Three or four years ago the Islamic market was a tiny part of international banks' business," he says. "Today it is an area that is impossible to overlook."
The potential of Islamic structures, say bankers, is an area that no international bank can afford to neglect not because they necessarily agree with the ethical objectives embedded within shari'ah-compliant techniques. Indeed, it would be difficult for Western bankers to pretend to harbour ideological misgivings about riba — which refers to the payment and receipt of all interest, rather than to usury.
The reason bankers can no longer afford to view Islamic finance as an obscure niche is a purely pragmatic one, given the increasingly extensive reservoirs of liquidity within the Muslim world that are barred from conventional fixed income markets.
Nor can intermediaries ignore the depth of the Islamic investor base. Borrowers are also coming to understand that Muslim investors represent a potentially immense source of untapped demand for instruments tailored to their religious preferences.
"Increasingly, we will see borrowers with no Islamic background in any shape or form exploring this market because it opens up the possibility of accessing an investor base that would otherwise be closed to them," says Deutsche's Honegger.
At the same time, Honegger says that for borrowers there is no longer a significant price differential between the conventional and the Islamic markets. "So the Islamic market provides an additional distribution channel at little or no incremental cost to the borrower," he explains.
Some issuers from outside the Middle East have already started to explore the option of shari'ah-compliant bonds as a means of tapping into a new investor base, most notably the German Land of Sachsen Anhalt, which in 2004 launched a lease-backed Eu100m sukuk arranged by Citigroup. "In that instance, although the lead bank had its own shari'ah advisory board, the issuer itself had no direct experience of Islamic finance," says Assem Kabesh, chief business development officer at the Dubai International Financial Centre.
Others agree about the potential for the application of shari'ah-compliant mechanisms by borrowers from well outside the Muslim world. "The deals that we have seen so far have been very small transactions designed to test the market," says Barclays Capital's Lejeune. "But we are now looking at some potential transactions that are much bigger than test-case categories."
That may be, but others say that there are still a number of formidable hurdles standing in the way of the development of a larger and more liquid Islamic capital market. Foremost among these is the diversity of opinion that continues to split Islamic scholars on what is and is not permissible under shari'ah law. "We are on the cusp of a new global asset class developing," says Peter Burnett, executive chairman of UBS's Middle East operation. "But the one thing that will hold the Islamic market back is the absence of a coherent set of rules defining what is shari'ah compliant. For the time being, what works in Malaysia may not work in Saudi Arabia and what works in Kuwait may not work in Bahrain."
Even within individual markets, standardisation of products remains some way off, which will inevitably add costs to borrowers, with each new transaction and structure needing to be approved by shari'ah scholars. "The Sabic sukuk established a template that others can follow, although each new issue will still require a certain amount of customisation," says Rajiv Shukla, director of debt capital markets at HSBC in Riyadh.
However, scholars vetting new issue proposals today are increasingly sophisticated and receptive to new ideas, which suggests that the foundations have been laid for innovation and expansion in the market for shari'ah-compliant deals. "There is a whole new generation of Islamic scholars active in the financial sector who not only have degrees in Islamic studies and Islamic finance, they also have degrees from Oxford and Harvard," says Jeffrey Culpepper, head of Merrill Lynch's global markets and investment banking operations in the Middle East. "So even though they are strict about shari'ah principles they are increasingly willing to push the envelope in terms of structural innovation."