Islamic finance has always been associated with the Middle East, and to a greater extent, Asia. However, issuers are beginning to venture into new territory, and with this, come new instruments to satiate investor appetite. In a bid to open up to new investors, NAZNEEN HALIM learns that the Islamic markets can no longer isolate themselves from America.

Like it or not, the US has sealed its status as a world economic superpower. Even in dire times, the whole world is eagerly watching corporate America’s every move. In all fairness, the US has never entirely ignored the concept of Islamic finance — with US government-sponsored entity Freddie Mac attempting to inject Shariah principles into its products back in 2002 to gain appeal among the American Muslim population. They have, however, been sitting on the bleachers for too long now; and in this symbiotic and inter-dependent world economy, being on the bench means losing out.

With the dour perception in America surrounding the Muslim world, and naturally everything associated with it, one would wonder why corporate America would want to give Islamic finance a chance. However, from a financing perspective, investors know that healthy yield and sound structure make for good investment. How then will Islamic finance warm up to America and vice versa? With a little bit of coaxing and a whole lot of appeal, of course.

Enter 144A Sukuk, which essentially allows issuers to market their papers to onshore US investors. Under the US securities law, by complying with 144A, the Sukuk gains par with conventional bonds in terms of documentation, legal framework and disclosure levels.

144A appeal
Not to be confused with rule 144, 144A in essence provides issuers with a safe harbor from the registration requirements of the Securities Act of 1993 for certain private re-sales of restricted securities to qualified institutional buyers (QIB), that is, institutional investors with over US$100 million in investable assets. Banks and savings and loan associations must also have a net worth of at least US$25 million to qualify for QIB status.

Numbers have shown that the adoption of Rule 144A has effectively increased the liquidity of the securities affected as it allows institutions to trade securities among themselves, and enables foreign companies to sell securities in the US capital markets. According to Richard O’Callaghan, capital markets partner at Linklaters, issuers choose to access 144A paper to gain deeper liquidity, competitive pricing and an extended tenor. It also widens the potential investor universe, which in turn will bring liquidity into the markets and up trading volume.

Isam Salah (caricature), senior finance partner at King & Spalding, concurs, stating that secondary trading is expected to increase with the proliferation of 144A-type Sukuk: “Rule 144A has been in existence for many years now, and there have been hundreds of conventional debt offerings sold in reliance on this Rule. If an increasing number of Sukuk are sold under Rule 144A, secondary trading will certainly be facilitated, as all 144A instruments are held within a depositary and are available to be traded on an electronic basis by qualified institutional buyers.”

Playing the Devil’s Advocate
Despite this, the market has only seen five 144A Sukuk issuances between 2006 and 2010 (see table), pioneered by the East Cameron Gas Sukuk issued on the 15th June 2006. It also happened to be the first Sukuk to face a default in 2009. This however had nothing to do with the paper’s structure or pricing, but was a bad bet to begin with — based on the issuer’s credit profile and nature of business.

While Rule 144A provides the opportunity for Islamic papers to be placed on par with conventional debt papers, what the Islamic community is perhaps not ready for are the stringent disclosure standards that come with such an issuance. “The standard of disclosure in a 144A Sukuk prospectus is driven by the securities law regime in the US and concerns re-increased liability for all parties. What this means is that a 144A deal, Sukuk or conventional bond, will normally include a greater level of prospectus disclosure that would typically not be seen for a non-144A Sukuk or bond,” O’Callaghan elucidated.

However, he clarified that the ongoing disclosure regime is principally driven by the requirements of the stock exchange on which the Sukuk are listed, and not the fact that the deal was sold under 144A, that is, the procedure would be the same whether or not the Sukuk was sold under 144A.

Nida Raza (caricature), senior vice president of capital markets at Unicorn Investment Bank (UIB), affirmed the reluctance of most issuers when issuing 144A paper with regards to disclosure levels, stating: “The concern of some issuers is the level of transparency that is required, including financial statements and ongoing disclosure requirements, and this can sometimes act as a deterrent for using the 144a format.”

Nida was referring to the recently-issued Dar Al Arkan Sukuk, in which UIB acted as joint manager and sole Shariah advisor. She also revealed that certain sensitivities with regards to providing a corporate guarantee to the structure to achieve pari passu ranking to the current and future obligations of Dar Al Arkan had also arisen during the structuring of the deal. This, however, is a relatively common occurrence in these sorts of transactions, Nida assured.

Isam of King & Spalding also revealed a potential turn-off for underwriters with regards to 144A paper, as the underwriter in the deal generally absorbs more risk because they are buying for their own account and re-selling to qualified institutional buyers at their own risk: “Underwriters were probably unwilling to take such risks when Sukuk were new to the market, and potential qualified institutional buyers at that time were not comfortable with such instruments.
In addition, an underwriter would probably not undertake a debt offering on the basis of Rule 144A for an issuer that is small or unsophisticated. These two factors suggest why there have been only a limited number of offerings under Rule 144A to date, and why such offerings may increase in the future — when underwriters become more willing and familiar with the concept of risk,” he added.

The intrepid ones
On the 16th April 2009, the Government of Indonesia issued a US$650 million Sukuk which was oversubscribed by 7.3 times at US$4.76 billion. This was the republic’s third Sukuk issuance in ’09, and its first government-issued 144A paper. The bonds were sold at par value with a fixed rate yield of 8.8% a year.

According to a banker involved in the deal, the nature of the paper had played a major part in the Sukuk’s appeal to foreign investors: “This was the first US dollar Sukuk issued globally in over a year, and was open to both conventional and Islamic investors. Another attractive factor was the Sukuk’s pari passu ranking with the republic’s conventional bonds.”

In April, Saudi Arabia also witnessed its first 144A Sukuk; the much-coveted US$450 million Dar Al-Arkan hybrid Sukuk. The kingdom’s debut in the US markets was highly successful, according to the deal’s managers UIB, with Nida saying the Dar Al-Arkan Sukuk was able to emerge as the first 144A Sukuk issuance in 2010, and the first since the Dubai debacle primarily as a result of the issuer’s strong business model.

“While the regional real estate sector had, to an extent, suffered from the global financial crisis, Dar Al-Arkan’s business focus on the underserved middle income residential real estate sector in Saudi Arabia, and its prudent management of its business, has allowed the company to remain highly profitable. “Secondly, the housing demand in Saudi Arabia as well as the quality of the assets on Dar Al-Arkan’s balance sheet allowed it to tap the market despite the difficult market conditions,” Nida elucidated.

According to Nida, the deal’s issuers had always planned for the deal to be 144A compliant to raise the international credit profile of Dar Al-Arkan, to widen the Sukuk’s investor universe and to appeal to the large sub-investment grade investor community in the US. “We do see future GCC and Saudi Arabia deals choosing the 144A compliance as larger investor participation will inadvertently boost the aftermarket performance of capital markets transactions,” she revealed.

Uncle Sam’s way
What Rule 144A essentially provides is the opportunity for Islamic papers to be placed on par with conventional debt papers, creating a level playing field among the international investor community. From a conventional investor’s point of view, such issuances blur the line between traditional bond structures and the relatively alien concept of an Islamic bond, thus playing up the familiarity factor and inadvertently increasing its appeal.

Rule 144A also in some sense provides added investor protection by increasing pressure on the paper’s underwriters to conduct sound and transparent business dealings and an added sense of responsibility towards the deal’s outcome. Secondary market liquidity is also expected to be achieved via the issuance of such papers, as listing opportunities and investor diversity increase trading volume and breathe life into the non-existent secondary Islamic markets.

Industry players such as O’Callaghan (caricature) believe that the future is bright for 144A Sukuk, and although the trend may not pick up immediately, Islamic issuers will be keen on such options as the market continues to internationalize: “In the case of Saudi Arabia, it is evident that the authorities are trying to develop the local Sukuk market, and I believe there are other similar transactions in the pipeline.”