Sukuk: an alternative capital structure for some

Paolo Curiel and Ibrahim Mardam-Bey, Taylor-DeJongh, Washington, DC

With liquidity still an issue, small and mid-size upstream oil and gas companies continue to feel a disproportionate impact of the ongoing financing squeeze from the debt crisis and the uncertainty in the capital markets.

While lenders and debt investors continue to show a willingness to provide capital to larger oil and gas companies, the same cannot be said for small and mid-sized upstream companies, those with leaner operating cash flows and a smaller asset base. Compounding the effect of the crisis, Basel III regulations are forcing lenders to deleverage and recapitalize, which will continue to leave, for the foreseeable future, many small and mid-sized companies in need capital-starved.

Against this backdrop, small and mid-sized oil and gas companies are facing the tough choices of curbing or postponing their development programs, or being acquired. In such a capital-constrained environment one would find the thought of a pool of capital sitting on the sidelines yet ready to be deployed and increasingly looking for opportunities, rather surprising.

Nonetheless, that pool of liquidity indeed exists, and it is large, available, and growing at a fast pace. The reason for it being largely untapped is that few have found the key to unleash it. That pool of capital is capital from Islamic financial institutions, and the key to unleashing it is the structuring of financial instruments that comply with these investors' requirements.

During times of abundant liquidity, the structuring of a non-conventional financial instrument would be perceived by issuers and borrowers as an unnecessary complication and almost entirely disregarded. These days such a large pool of liquidity cannot be overlooked.

Money looking for yield

The term Islamic financial investor refers to an entity that conducts its business in a way that is consistent with Islamic law (Shariah). Islamic finance is in many ways similar to conventional finance with one major difference that the financial product cannot be in conflict with Shariah law.

Many of the prohibitions dictated by Shariah law concerning the investment in industries that promote vices (for example: alcohol and gambling) or are related to other "impure" activities have become well-known. Also well-known is the ban on receiving and paying Riba, or interest.

Assets held by Islamic financial institutions are estimated by Standard & Poor's to far exceed US$1 trillion. This sizable figure is also growing at a very rapid pace. It is estimated that this market is growing at a compounded annual growth rate of roughly 15% to 20% percent per year and is poised to reach US$4 trillion in size by the end of the decade.

Islamic financial institutions are mostly concentrated in two geographic areas: Southeast Asia (Malaysia, the pioneer in this market, and Indonesia) and the Middle East (particularly Saudi Arabia, the UAE, Kuwait, and Qatar). A substantial trade surplus, derived mainly from hydrocarbon exports but also due to changing demographics, has fueled deposits into these financial institutions in recent years. Moreover, as Islamic financial institutions grow larger in size and recognition, Standard & Poor's estimates that 20% of banking customers will prefer an Islamic financial product over a conventional one with a similar risk-return profile.

An interesting fact surrounding Islamic financial institutions is their current level of liquidity. The two largest publicly-listed Islamic banks in the UAE, for example, have total deployed capital amounting to only four-fifths of their combined deposit base. As a consequence, these institutions have tremendous funds to deploy into new investments.

In addition, there is pressure to diversify its investments, which have historically been directed in large part towards the real estate sector. The burst of the real estate bubble starting in 2008 has more than ever highlighted the need to diversify and find alternative suitable long-term investment opportunities.

Thus far, however, the pace of deals being marketed to Islamic investors has not kept up with the growing demand for investment opportunities. Nonetheless, there is reason to believe that this trend will be reversed.

Bridging the gap: Enter the Sukuk

While fairly straightforward to understand, the prohibition to receive or pay interest raises, from a financial perspective, a complex dilemma. That is, how to structure Islamic-compliant instruments that allow, ceteris paribus, a risk/return profile to investors similar to the one provided by a conventional bond or loan, subject to the limitations afforded by the prohibition to charge interest. It is fair to say that this dilemma has been solved with the creation of instruments that provide bond-like risk/return propositions.

Among the different Islamic financial instruments, the Sukuk (which is the Arabic word for financial certificate) is very similar to conventional bonds, in that it provides a fixed income to the investor. Sukuk are the "catalyst" that has put Shariah-compliant finance on the global capital markets map.

The principle of Sukuk, as a financial instrument, can be easily understood by the capital markets and lies in the concept of asset securitization, which, simply put, is the monetization of an asset against future expected cash flows.

While a conventional bond contains a promise to repay a loan, Sukuk constitutes partial ownership in a debt, asset, project, business, or an investment. The Sukuk holder charges a rent to the issuer. Such rent payments resemble the payment of interest and are in most cases benchmarked against interest rates such as LIBOR. Importantly, the issuer then gives a binding promise to repurchase certain assets, achieving the necessary capital protection. Sukuk may be issued on existing, as well as specific, separable assets that may become available at a future date.

Sukuk have been issued by corporates, by projects, and by sovereigns, in different sectors ranging from, inter alia, real estate, energy, infrastructure, and financial services, and in different geographies. During the last decade (January 2001 through December 2010), Malaysia topped the list for global Sukuk issuance by volume (59%), followed by the UAE (16%), and Saudi Arabia (8%). It was recently reported that sovereigns such as South Africa and Ireland are seeking to raise a Sukuk.

The oil and gas sector is not new to the issuance of Sukuk. The first Sukuk ever was issued by Shell in the Malaysian market in 1990. US-based issuers have tapped the Sukuk market as far back as 2006, a time of relatively liquid debt markets.

At that time East Cameron Partners LP, an independent oil and gas exploration and production company, based in Houston, whose producing assets consist of two gas properties located in the shallow waters offshore Louisiana, was able to successfully raise US$166 million through an issuance of Investment Trust Certificates (Sukuk). The Sukuk financed the acquisition of a 50% net profit interest in the properties that were held by a third party, as well as to fund further development. The issuer was able to obtain an attractive cost of capital (yield of 11.25%) and maturity (legal maturity of 13 years and an expected final and weighted average maturity of 5.5 years and 3.5 years, respectively).

The requirements and characteristics of a Sukuk make the instrument particularly suitable for oil and gas transactions.

In general, integrating a Sukuk with other conventional facilities in a capital structure may result in complex inter-creditor arrangements. This is due to the above mentioned partial ownership requirement of the asset by Sukuk holders. In the petroleum sector, however, that challenge is effortlessly overcome, as oil and gas assets are discreet economic cash flowing centers that can be easily ring-fenced for the purpose of financing. This is not dissimilar from the practice of reserve-base lending (RBL).

The role of the Sukuk: How about the future?

With the retreat of traditional RBL institutions from the market, the Sukuk, a tried-and-tested instrument, and the Sukuk holders, a new class of hungry investors, are ready and have the potential to fill this financing void.

There are clear signs that this could indeed be the case. While price and tenors have been a challenge for making Sukuk competitive, there are indications that the rapid development of this nascent market is resulting in longer tenors and the progressive disappearance of the so-called Sukuk premium.

In addition, Sukuk have now also been tested through the last financial crisis. As with any conventional bond, some have performed well and some have not. Most important, in the instances where Sukuk have not performed, Sukuk holders have come to the negotiating table. One example is the case of Dana Gas, a UAE-based leading private sector natural gas company that is currently undergoing the restructuring of its USD 920 million Sukuk -- in a fashion identical to conventional bondholders.


African nations may turn to Sukuk to fund growth

An increasing number of African countries are considering issuing Sukuk (Islamic bonds) to fund their huge infrastructure investment needs and diversify their fiscal funding, according to a Feb. 22 report from Standard & Poor's Ratings Services.

In recent years, several African nations and institutions have announced their intention to issue Sukuk, including the Republic of South Africa, the Nigerian Central Bank, Senegal, and Mauritania. Following the Arab Spring, the rising influence of Islamist parties in some countries has also put the development of Islamic finance on their governments' agendas, the report says. For example, Egypt has recently presented a law allowing sovereign Sukuk issuance, which would help to finance the country's high fiscal deficits and also provide funding for the current account deficit. Similarly, Tunisia's 2013 budget law expects to finance its fiscal deficit partly by Sukuk issuance.

"We believe that Sukuk issued by African sovereigns could address an investor base in the Gulf Cooperation Council (GCC) countries or at the Islamic Development Bank (ISDB), which may be looking for sharia-compliant investment opportunities," said Standard & Poor's credit analyst Christian Esters. "Countries in the GCC generally benefit from strong current account surpluses, which we believe could make them potential investors in Sukuk issued in other regions. For countries with both fiscal and current account deficits, attracting foreign investors to sovereign Sukuk could provide fiscal funding, as well as help to cover external financing needs and support reserve-building."

Esters added, "While Islamic bonds can first and foremost give governments access to a new investor class and so diversify sources of fiscal funding, in some cases we believe that governments aim to establish a benchmark for the development of an Islamic finance market. Others may be responding to the desires of a [large] Muslim population or aiming to become a hub for the global Islamic finance market."

African governments issuing Sukuk could also wish to attract funding from the ISDB, the purpose of which is to foster economic development and social progress in member countries in accordance with Shari'ah principles, the report says. Of ISDB's 56 member countries, 22 are from Africa.

All sovereign Sukuk rated by Standard & Poor's to date benefit from credit enhancement from the sponsoring government or government-related entity. This allows S&P to rate the Sukuk on par with the rating on the sponsor, the report says.


Challenges to the full development of the Sukuk market remain. In the long run, the full growth of the Sukuk market may depend on the development of a secondary market. Most Sukuk investors traditionally buy and hold their position. This contributes to the absence of a well-developed secondary market.

More important for short-term success, the development of the market will be dependent on deals themselves finding their way to the market. There is indeed a skill and knowledge gap in the market that needs to be filled.

Despite a class of investors with ample liquidity and an appetite for Sukuk as an asset class and for exposure to the underlying assets, many potential oil and gas issuers are not aware of this liquidity avenue, and many misconceptions persist. These misconceptions, which generally relate to both Sukuk competitiveness and their suitability to being integrated into a company or project's capital structure, will likely be corrected as more issuers come to market. Getting potential issuers to market will require a class of professional deal makers with both intimate understanding of the oil and gas sectors and an understanding of the Sukuk market and the appetite of its investor class.

Success breeds success, and there are strong reasons to believe that the market dynamics of demand for capital and demand for yield, will do the rest. OGFJ

About the authors

Paolo Curiel  

Paolo Curiel is a vice president with Taylor-DeJongh. He has experience advising sponsors, governments, and lenders on structuring and executing project and structured financings and M&A transactions with a focus on energy and infrastructure. Prior to joining Taylor-DeJongh in 2005, he was an investment banker with PricewaterhouseCoopers Corporate Finance. Curiel has an MA degree in international business from the School of Foreign Service at Georgetown University in Washington, DC, and an economics and business degree from the business school of the Universita degli Studi de Firenze in Italy.

  Ibrahim Mardam-Bey

Ibrahim Mardam-Bey serves as group president at Taylor-DeJongh. He has extensive experience in international finance, merchant investment banking, and Islamic finance. As group president, he oversees new business origination and the build-out of new TDJ initiatives, including Sukuk finance. Mardam-Bey has arranged and raised financing (equity and debt) for multi-billion dollar projects and private equity funds. He is a member of the Arab Bankers Association of North America, the London-based Arab Bankers Association, and Young Arab Leaders. He holds an MA in international economics and a BS in finance from The American University in Washington, DC.

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