Behind the veil – Can Islamic finance live up to the sales pitch?
01 May 2014 13:09
by David Stevenson
Dismissed as a fad in some quarters, Islamic finance flourished during the downturn and has emerged as a significant practice for both Middle East and international firms. How sustainable is the workflow and what lies ahead for the key players?
‘You can’t be a credible financial centre without having a credible Islamic finance programme,’ says Qudeer Latif, head of Clifford Chance’s global Islamic practice. With studies expecting the Muslim population to grow twice as fast as the non-Muslim demographic over the next 20 years global financial institutions and governments are falling over themselves to offer Islamic finance products.
According to EY’s latest study of the global Islamic finance market, the total amount of Islamic assets held by commercial banks was expected to have grown by around 40% from 2011 to 2013, from $1.3trn to $1.8trn. 78% of international Islamic assets are held in Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey. In Qatar, for example, Georges Racine, director of Swiss firm Lalive’s Doha operation, says that Islamic banking has grown quicker than the banking sector as a whole over the past few years as a result of its government’s supportive measures.
Comments Racine: ‘The Islamic finance sectorin Qatar got off to a strong start this year with the announcement by the Qatar Central Bank of plans to issue a combination of conventional and Islamic government bonds worth $6.6bn, an amount significantly larger than past quarterly debt offerings.’
But with western economies showing clear signs of recovery, Sharia (Islamic) law limitations mean the scope of products available to investors is still a fraction of what is offered by conventional banking. Neil Miller, global head of Islamic finance at Linklaters, says that the Islamic finance product is best delivered unassumingly, without overstating its importance and complexity. ‘Going out there and over-exaggerating the intellectual effort is counterproductive,’ he says.
Nonetheless the growth of Islamic finance, by any yardstick, has been substantial. Dating back to medieval times when tradesmen from the Middle East engaged in financial transactions governed by Sharia law, it was not until the 1980s that Islamic finance really started to gain momentum. By the 1990s, the industry was no longer limited to niche banks as large western financial institutions started offering Islamic finance.
Arguably, Islamic finance has capitalised on the mistrust generated by the recent global economic crisis, which saw western financial systems crippled by speculative trading, a practice prohibited by Sharia law. But while deeming certain financial instruments haram – or forbidden – can safeguard against huge losses on a bank’s balance sheet, making Islamic financial products Sharia-compliant can be far from straightforward.
Bouncebackability: Dubai’s recovery continues
When Dubai’s property market collapsed spectacularly in 2009, with 60% wiped off the price of real estate, many thought that the heady days of legal work in the jurisdiction would never return. But the Gulf state has seen a reversal of fortunes in the last couple of years, with signs of modest recovery in 2012, and last year even real estate came back, despite almost crippling the country when construction company Dubai World needed a $10bn bailout from Abu Dhabi in 2009. Advisers are also reporting a marked uptick in capital markets instructions as well as general transactional work.
The growth in capital markets work was illustrated by the listing of the first real estate investment trust (REIT) in the Dubai International Financial Centre (DIFC) in April. This was both the first Nasdaq Dubai IPO since 2009 and the first Sharia-compliant, regulated REIT to be incorporated in the DIFC. A K&L Gates capital markets team led the advice on the listing, headed by partner Owen Waft, while SHUAA Capital and Emirates NBD were advised by Herbert Smith Freehills US capital markets partner Alex Bafi on the deal.
But this positive outlook is not shared by all legal advisers based in the jurisdiction. Hamish Walton, a partner at King & Wood Mallesons SJ Berwin in Dubai, says: ‘The level of deal activity is never going to be the same as you see in western markets due to legal barriers and risks. About four out of five deals fall over, many half way through. This is not a huge market for M&A and private equity.’ Local ownership rules may dissuade private equity investment in Dubai and until long-awaited company law legislation is passed, this position looks unlikely to change.
But Dubai’s strength (and its biggest weakness) is real estate and construction, and it is this area that is showing the clearest signs of recovery. Michael Kerr, head of the Middle East practice for Dentons, says: ‘Our construction and finance teams have been involved in a number of restructuring and rescheduling of moth-balled real estate developments now being revived.’
Dubai is due to host Expo 2020, which will mark the first time the trade fair has ever been held in the Middle East. Richard McLerie, general manager at legal recruiter JLegal, sees this event as a stark contrast to Qatar hosting the 2022 World Cup. ‘The great thing about Dubai is that they don’t muck around with building the sites there. The main difference in comparing Expo to the Qatar World Cup is that it is my understanding that the Qataris have been very slow to start the work, whereas Dubai is past the planning stage,’ he says.
The same but different
An Islamic finance product is essentially the same as its western counterpart ‘but to make it Sharia-compliant you add an extra layer of complexity’ according to Muneer Khan, partner at Simmons & Simmons. This additional layer is designed to satisfy the scrutiny of Islamic scholars, who sit on the boards of banks and approve products. Most tend to have a legal qualification, and in some cases a doctorate in economics, as well as a deep understanding of Islam, so they understand the need for Islamic financial lending from a secular and a religious viewpoint.
There is a shortage of experienced scholars, with many sitting on more than one bank board, potentially causing conflicts of interest. According to Latif: ‘It’s very hard for them not have a conflict of interest.’ However, some jurisdictions, such as Oman, have put measures in place to prevent scholars moving between banks, reducing the chances of conflicts.
Nonetheless, Hossam Abdullah, head of Islamic finance at Kuwaiti firm ASAR – Al Ruwayeh & Partners, says: ‘Boards of Sharia scholars at financial institutions rule on whether activities and products follow religious principles such as bans on interest payments and pure monetary speculation. They are also involved in audits that determine whether the institutions are operating in a Sharia-compliant manner. At the same time, the scholars are on the payroll of the Islamic banks, which they vet, an arrangement contrary to good governance, according to a statement by the Governor of the Central Bank of Kuwait.’
An added complication is that scholars can differ in their opinions. ‘The UAE does not have a central Sharia board or committee, and therefore it is up to the individual Sharia boards of each bank to decide what is permitted for that bank. As a result one bank may allow a structure or product while another may not,’ says Jody Glenn Waugh, a banking partner at Middle East firm Al Tamimi & Company. Most advisers have longstanding relationships with Islamic scholars and Baker & McKenzie banking partner Bilal Kahlon, who is based in its Bahrain and Doha offices, says: ‘We get involved with the scholars on each deal from the very beginning.’
‘We take products to scholars; we know how the scholars work, we know what is important to them and what their concerns are likely to be. It tends to be a considered and very positive process getting these products approved,’ says Nadim Khan, head of Islamic finance at Herbert Smith Freehills (HSF). He notes that while scholars acknowledge the need to increase the range of products, they will not do so by compromising their integrity.
Islamic finance products include murabaha, where a bank buys an asset for a third party and sells it with a mark-up rather than lending with interest; mudaraba and musharaka, in which partners provide capital to a Sharia-compliant business and profits are distributed based on ratio of capital provided; leasing or rental contracts, ijara; istisna, which is a contract where a commodity or an asset is delivered at a pre-determined future time at an agreed price – it can be combined with ijara to finance greenfield products; and finally, the sukuk - the Islamic bond which was first issued in Malaysia in 2000 before first appearing in the Middle East in Bahrain in 2001.
One of the largest murabaha transactions of 2013 was the $645m Mobily deal, involving Saudi Arabian telecoms company Etihad Etisalat (Mobily) buying products from Ericsson and Nokia Siemens. Latham & Watkins advised Mobily, led by Dubai-based partner Craig Nethercott, while Allen & Overy (A&O) advised the arrangers, Crédit Agricole and Deutsche Bank, through Islamic finance specialist Atif Hanif.
The ijara is often used in conjunction with sukuk issuance, although Shearman & Sterling used a two-tranche ijara lease financing in its advice to Asian Development Bank, Islamic Development Bank and a consortium of Pakistan financiers on the financing of the two wind power projects in Pakistan in June 2012. In this deal, the Pakistan financiers also used musharaka funding.
The Fauji Foundation was the principle sponsor of the project and was advised by Pakistani practice Orr, Dignam & Co.
Of the available products, the sukuk was undoubtedly the game changer for Islamic finance. Unlike a conventional bond, a sukuk’s value is based on an underlying asset and is not simply a debt instrument. The model bears some comparison to securitisation in that it monetises an asset’s future cashflow and constitutes partial ownership in an asset from which ‘rent’ rather than interest is paid. Although Malaysia leads the world in sukuk issues, accounting for around 65% of the total, it is considered an insular market, mainly confined to local borrowers and investors.
Last year, the Crown Prince of Dubai, Sheikh Hamdan bin Mohammed bin Rashid Al Maktoum, launched the Dubai Centre for Islamic Banking and Finance with the aim of establishing Dubai as the world’s capital for Islamic finance. Although it has yet to win this crown, last year Clifford Chance, led by Stuart Ure and Latif, advised Sharjah Islamic Bank on its $1.5bn sukuk issue on both Nasdaq Dubai and the Irish Stock Exchange. Dentons, led by banking partner Qasim Aslam, advised the lead arrangers, HSBC and Standard Chartered Bank, on the deal.
Increasingly, sukuk issues are making headlines. In April, A&O and Latham took the lead roles in advising on Saudi Electricity Company (SEC)’s $2.5bn international sukuk issue, the largest-ever Rule 144A sukuk offering, which will allow it to be sold to international investors. Hanif led the A&O team, in association with local firm Zeyad S Khoshaim Law Firm in advising SEC, while Latham picked up a role for the joint lead managers, Deutsche Bank, HSBC and JPMorgan, from its New York, Dubai and London offices led by Harj Rai, Nomaan Raja and Lene Malthasen. This bond had a 30-year tranche, which is the longest tenure of any international sukuk issue and matches the 30-year sukuk issue by SEC in 2013.
‘Given the interest in last year’s landmark offering it is no surprise that investor demand has once again been strong for this follow up issue,’ says Hanif. ‘This underlines the international investment community’s growing familiarity and comfort with Islamic products.’
Global assets of Islamic finance
Source: The Banker, EY
Sukuk global issues
Source: Zawya Sukuk Monitor, Islamic Financial Information Service
Innovation the key
To reap the benefits of Islamic finance, law firms have to develop new structures rather than regurgitating commoditised products. For example, sukuk have developed from being linked to solely tangible assets to a hybrid system where up to a third of the underlying assets can be intangible. The use of mobile phone airtime as an intangible asset was a major step in the creation of hybrid sukuk and developing a hybrid now would cost around $250,000 in legal fees, according to leading Islamic finance advisers – a lucrative market. One reason why even a standard sukuk generates more fees is that it comprises more separate documentation than a conventional bond.
White & Case advised on telecoms company Etisalat’s syndicated financing in 2007 using mobile airtime as an asset, with Baker & McKenzie acting for the mandated lead arrangers, which included ABN Amro and Calyon. With mobile airtime established as Sharia-compliant, in 2010 Etisalat adopted the structure for its sukuk programme but no issue was made until another telecoms company, Ooredoo, issued a $1.25bn sukuk in December last year. Latham advised Ooredoo on this deal, led by Nethercott and Rai. Clifford Chance, led by capital markets partner Debashis Dey with Islamic structuring advice provided by Latif, advised the arrangers, DBS Bank, Deutsche Bank, HSBC Bank, QInvest and QNB Capital.
Another example of intangible assets being used in Islamic finance was the $800m Dubai Salik financing in 2012, the world’s first Islamic road toll financing. Advisers on this deal included Dentons’ Aslam, who advised Citigroup, Dubai Islamic Bank, Emirates NBD and Commercial Bank of Dubai. Other advisers to the arrangers on this deal included Nadim Khan for HSF.
‘You can structure sukuk with all manner of underlying assets, including airline tickets, airtime and hydrocarbons. Lawyers and Sharia structuring advisers continue to try and push boundaries on behalf of their clients, but it is essential that all parties fully engage not only with the Sharia scholars but also with industry participants. Failure to do so will result in structures being criticised and open to attack,’ says Bilkis Ismail, counsel at King & Wood Mallesons SJ Berwin based in Dubai. ‘Airline tickets’ is a reference to the Dubai-based airline Emirates’ sukuk last year that was structured around ticket sales. The deal was led by A&O’s capital markets partner Anzal Mohammed and was worth around $1bn.
Linklaters represented the underwriters on this deal, including Abu Dhabi Commercial Bank, Abu Dhabi Islamic Bank, Citigroup, Emirates NBD Capital, Standard Chartered Bank, and the team was led by Richard O’Callaghan. Walkers Global acted for the Emirates on its issuance through Medjool, the Cayman issuer vehicle.
Other examples of innovative sukuk issues include the one made by Dana Gas last year, which was led by Hadef & Partners’ head of banking Alan Rodgers and Latham corporate partner Bryant Edwards. This deal is notable because it restructured a sukuk through the exchange of Dana Gas’ existing sukuk certificates with two new tranches, one convertible into equity and one non-convertible. The deal was worth $1bn and was the first of its kind in the Middle East.
But despite some seemingly groundbreaking projects in Islamic finance, others aren’t convinced by how much true innovation has occurred. ‘In terms of absolutely new products, I don’t think that’s happened at all,’ says Miller, arguing that the last really groundbreaking development was the sukuk itself. What has followed, he says, is more of an evolution of existing products.
One nascent area is Islamic derivatives – on the face of it impractical because derivatives imply speculation and would therefore be a haram practice. But Islamic derivatives are a form of hedging against a real economic risk that all banks and businesses face. The International Swaps and Derivatives Association (ISDA) has come up with a standard set of rules specific to them.
‘In the UAE there is an inherent risk of derivative transactions being found to be speculative or uncertain, which can impact on enforceability,’ says Al Tamimi’s Waugh. ‘In saying that, derivative transactions are very common here and most are fairly vanilla structures, hedging an actual commercial risk, for example currency or interest rate fluctuations, and therefore the risk is arguably lower. Another aspect to this is Sharia-compliant derivatives, which again arguably lowers the risk due to the structures and underlying assets utilised.’
Simply put, if an institution is involved in a transaction and it has currency exposure, it can hedge that exposure but the transaction has to be carefully structured. These are bespoke products for sophisticated customers and can command relatively high fees.
Outnumbered: the latest Middle East arrivals
Despite repeated claims of over-lawyering in certain jurisdictions in the Middle East, there have been some significant office openings by international and regional firms in the last year, almost exclusively in Qatar.
UK-top 25 firm Addleshaw Goddard opened in Qatar last May. The office is being led by Hussein Damirji, formerly a partner at US law firm Patton Boggs, who specialises in corporate, commercial and high-net-worth individual investment. The firm also brought in Martin Brown, who joined the firm from Dentons’ Doha office, where he was a partner. This was Addleshaws’ third new Middle East office in three years, following Dubai in September 2012 and Oman in January 2013.
CMS Cameron McKenna also launched its Middle East presence via an office in Dubai in September 2012 and has expanded into Oman more recently. It opened an office in Muscat in February 2014, focusing on the firm’s core strengths of energy, projects and financial institutions. This office is closely linked to the Dubai office, with the team being led by Dubai managing partner Matthew Culver. The firm also brought in local expertise in the form of consultant Amur Al Rashdi, who joined from domestic outfit Khalifa Al Hinai.
Regional leader Al Tamimi & Company opened in Oman in October last year, bringing in Ahmed Saleh, an associate from Dentons, to lead the office. In the same month, the firm consolidated its position in Iraq with an office opening in Erbil, in the Kurdistan region of the country. Al Tamimi first opened in Baghdad in 2004 and its offices are run by Jordanian partner Khaled Saqqaf.
UK top-50 firm Charles Russell also opened in Qatar last December, with partner Simon Green, head of real estate and construction for the Middle East, heading the office. The firm’s platform will be based around those two practice areas and is the firm’s second office in the Gulf after opening in Bahrain in 2006.
Aside from office openings, there have been a number of key lateral hires in the region over the past 12 months. The most notable was Baker Botts taking on an eight-partner team from Norton Rose Fulbright’s Dubai and Riyadh offices last summer, including Mark Bisch, Jonathan Sutcliffe, Joseph Colagiovanni, Hassan Elsayed, Richard Devine and Philip Punwar in Dubai, and Sam Eversman in Riyadh. The partners are now spread between Baker Botts offices in Abu Dhabi, Dubai and Riyadh.
Dentons has lost lawyers to rival firms in the past year but also made some significant Middle East hires itself following its tripartite merger a year ago. It recruited Vinson & Elkins’ Abu Dhabi managing partner, Jonathan Nash, in December last year, shortly after taking on DLA Piper construction partner Ian Dalley in the same jurisdiction, indicating the intent of the global firm to invest in the Middle East.
Islamic finance is now a truly global phenomenon, with the UK planning to release its own sukuk next year, and Luxembourg, South Africa and Hong Kong also recently putting in measures to tap into this growing market. Hong Kong passed a bill in March that will allow its government to raise around $500m via sukuk, while Luxembourg has a similar bill currently passing through parliament. And South Africa plans to issue its debut international sukuk in 2014.
Muneer Khan at Simmons says that a UK sukuk has been on the cards for some time. ‘The idea of the sukuk was kicked off under the previous government and there was a detailed process of consultation. However, for a number of stated reasons it did not previously proceed,’ he says. Miller of Linklaters has been advising the Government on the issue, with a team led by City capital markets partner Elaine Keats. The sukuk is understood to be worth £200m, with HSBC providing financial advice.
The UK remains important in the context of Islamic finance, with the London Stock Exchange second only to Malaysia by number of listed sukuk. By consensus, this goes far in cementing London’s position as a leading global financial centre.
The attraction of the west to Islamic finance products is clear: it gives governments access to additional forms of financing and the high level of liquidity in the Middle East.
‘There is a sense that Islamic finance fared a bit better in the economic downturn as its main characteristic is having a real asset or business interest at the centre of the financing structure – a solid interest rather than vapour, meaning that it has steered away from problematic and highly structured derivatives products,’ says Dentons’ Aslam. ‘The markets liked that self-controlling feature at such a delicate time for the global economy.’
According to Rodgers, Islamic financing is increasingly being used for funding major projects where conventional western banks may be unable or unwilling to exceed their regional or territorial boundaries. It can generally be incorporated into infrastructure financing, asset financing, and real estate financing and, as a form of structured financing, it can sit side by side with conventional financing. As such, most of the major financial institutions have an Islamic offering. That said, HSBC recently shut down its retail Islamic funding offering, although this made up for less than 1% of its total Islamic finance revenues and the consensus is that the local banks control the retail segment of the market. HSBC is still very much in the game when it comes to wholesale Islamic banking.
Any suggestion that Islamic finance has seen its peak is soundly rejected by legal advisers involved in the industry. While it is true that only between 1% and 2% of global assets are Sharia-compliant, the industry is growing and is here to stay.
‘I’ve been involved in the industry for 12-13 years now, I’ve heard people saying throughout that time that this is a passing fad and it’s going to fizzle away because it’s more expensive, but there’s a critical mass. There are hundreds of Islamic financial institutions, hundreds of Sharia-compliant funds and it continues to grow,’ says Simmons’ Muneer Khan.
HSF’s Khan shares this sentiment: ‘It would be wrong to dismiss it as a fad. You only have to look at the geographies participating or announcing plans to participate in the sector. The UK and Hong Kong have approved legislation facilitating sukuk issuance and Luxembourg is close to doing so.’
But problems remain. ‘Islamic finance does not have the same bandwidth of products that you have in conventional banking. We’re not there yet,’ he says.
One symptom with this lack of products is, according to Latif, a tendency for investors to buy and hold products rather than sell them on to the secondary market, partly due to lack of supply and because Sharia principles frown on trading securities in many contexts.
Another concern, according to Miller, is the amount of law firms claiming to have expertise in Islamic finance. Innovation in this area is where the truly significant fees come from – simply jumping on the bandwagon and churning out commoditised murabahas and ijaras will lead to pricing pressure and profit drain. ‘There are people who talk Islamic finance up and haven’t got the resources,’ he says. ‘You get new entrants into the market, but if they haven’t got track record or experience they’re going to find it very difficult. There are a few firms that have tried to operate in this space and failed.’ LB
Sukuk listings at London Stock Exchange
Source: London Stock Exchange