Sukuk Finance Roundtable: Understanding the structures, considerations and trends behind this emerging sector
Published 15th September 2021
The Energy Council hosted a virtual roundtable with industry leaders on Sukuks – an Islamic financial model that mimics bond markets to provide a fixed-rate of returns and maintain Shari’a compliance. Daniel Fox-Davies (Fox-Davies Capital), Ibrahim Mardam-Bey (Merchant-Edge LLC), Ayman Khaleq and Amanjit Fagura (Morgan Lewis) chaired a discussion alongside Oil & Gas organisations, investors and financiers. We covered a range of topics that we summarise below.
Defining A Sukuk
For all intents and purposes, a Sukuk in this context will be defined in accordance with the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) that states it is:
“Certificates of equal value representing undivided shares in ownership of tangible assets, usufruct and services or (in the ownership of) the assets of particular projects or special investment activity… in receipt of the value of the Sukuk, the closing of subscription and the employment of funds received in the purpose for which the Sukuk were issued”
Most Sukuk are ‘leasing-based’ from the Ijara model, however within the above definition and due to the inherent flexibility of Sukuks, there a range of models that may apply, namely: Ijara Sukuk (leasing), Manfa’at Al-Ijara Sukuk (certificates of ownership of usufructs), Salam Sukuk (deferred commodity delivery), Istisna’a Sukuk (project finance), Mudaraba Sukuk (partnership or finance trusteeship), Murabaha Sukuk (purchase order), Musharaka Sukuk (joint venture).
In each case, the central component is that there must be a Shari’a compliant asset backing the Sukuk, therefore no casinos or alcohol production companies, for instance. A Sukuk is, in essence, medium to long-term trust certificates that represent ‘undivided shares in the ownership of tangible assets or a specified investment activity’. While these are considered to be an ‘official undivided title over an asset or right’, it is different and separate to an asset’s legal title.
These are risk-sharing partnerships between issuers and investors, with these risks and rewards tied to the performance of underlying assets – ‘performance’ in this context refers to the capacity to ‘mimic conventional fixed-income securities’.
Principal Sukuk Structures
As one industry leader noted, “the choice of Shari’a-compliant structure will depend on, inter alia, the nature of the business, the industry and stage of industry life cycle of the corporate/target.” This entails that when deciding on and developing a Sukuk, one must consider the array of legal, regulatory or Shari’a considerations, together with the underlying considerations of the asset.
There was a cautionary call for any issuer to take into account some of these considerations when choosing a suitable structure: the nature of the asset one is raising finance for; that the underlying asset must be Shari’a compliant; that a transfer of title is necessary; are the asset encumbered or subject to security concerns; local law considerations; and, will the Sukuk be tradeable or not.
It should be noted that prior to any structuring, it is standard practice to obtain a certification or ratification of Shari’a compliance by a Shari’a advisory firm. Such a firm will work with one’s legal and financial representatives to build the most relevant structure on top the chosen Sukuk model.
Herein are a number of the structures deployed in the development of a Sukuk: the ‘Murabaha’ is suitable for corporates with a Shari’a-complaint commodity that provides that relevant source of revenue; ‘Standard Ijara’ is utilized for the sale and leaseback of tangible assets and/or usufruct rights; a ‘Musharaka or Mudaraba’ is naturally suitable for subordinated, equity-linked instruments that can be used wherever senior or unsecured debt instruments are required; a ‘Wakala’ is similar to the ‘Mudaraba’ however based within an investment agency’s portfolio; or an ‘Istisn’aa’, is used for greenfield project finance or pre-export finance transactions that require significant procurement or resources.
Although most Sukuks require a form of asset-backing, those that are “asset-light” have the possibility to utilize a hybrid model. To this end, a Special Purpose Vehicle is created that is issued certificates for the “undivided asset or security” as the representative of the Sukuk.
Together with considering these structures and models, an issuer must deliberate on the potential legal considerations that one may encounter in a chosen jurisdiction: companies’ laws, capital markets laws, securities laws, civil laws, tax efficiencies, costs of legal transfers, the capital market requirements, and the registrations and filings.
While the complexities of the Sukuk are broad, these complexities are tied to the flexibility of the frameworks and work to assist the issuer in finding the most preferable framework for their needs. The one foundation that should be considered above all else, unsurprisingly, is the Shari’a nature of the asset.
In 2007, Sheikh Taqi Usmani, a global authority on Islamic finance and chair of the Shari’a Board at the AAOIFI, caused waves within the world of Islamic finance by announcing that “85% of Sukuk are not Shari’a –compliant”. The consequence was a re-examination of the standards applied to the issuance of Sukuks, leading to asset-backed Sukuks being viewed more favourably since the asset can objectively be viewed as Shari’a-compliant or not.
Following Sheikh Usmani’s statement, the AAOIFI issued recommendations in how to: conduct the transfer of title; that no debt or revenue streams are permitted; must make available a ‘profit equalization reserve’; exercise a price for fair, market value or for an asset’s nominal value. In the case of a ‘Mudaraba, Musharaka or Wakala’ the fair market price is permissible. In the case of an ‘Ijara’, the nominal value is permissible.
As with all investments, one must consider that there are external factors weighing in on the decision and that may affect the outcome. One of the most obvious is to consider, ‘does the Sukuk have legal validity in the jurisdiction?’ Most transaction documents are governed by English Laws, except for ‘documents that deal with local assets as form of security, or in sale-and-lease back agreements – Ijaras.
Beyond this, one must seek out tax structures that are preferable to the Sukuk, as many nations do not recognize a Sukuk in-line with conventional capital gains or sales taxes or stamp duties. The UK is leading the way by “abolishing double stamp duties for Shari’a-compliant mortgages and companies can obtain tax breaks for profit payments under Sukuk in the same way as coupon payments under conventional bonds”.
Sukuks are generally hindered by their inability to standardize the frameworks for wider use, despite their ability to provide mitigate risk in cyclical markets. In response to the growing international interest in the market; in 2014, the Dubai Financial Market introduced standardization for those listed on their platform, and in October 2020, the International Islamic Financial Market in Bahrain announced a standardization for their Ijara product. An issuer must consider the ‘relationship with conventional financing’, in which a Sukuk may face inter-creditor and priority issues, that security structures may not be recognized by Shari’a, and how sharing of enforcement proceeds may affect the treatment and recovery of interest.
$130 billion dollar market.
25% YoY market growth expected over the next 5 years.
Asset-backed Sukuks have outperformed their contemporary assets during financial crises over the last 2 decades.
Developing Trends in the Sukuk Market
The Sukuk market is experiencing a wave of favourable interest in recent years, with the $130 billion market expected to grow 25% year-on-year over the next 5 years. The reasons for this are quite simple, over the last two decades, asset-backed Sukuks have outperformed their contemporary assets during financial crises.
Thus this provides promise to investors who are looking to maintain their yields and ensure higher, risk-adjusted returns – by enforcing a flexible and favourable Sukuk structure.
These “provide unique features to the issuers, in terms of accessing a completely alternative investor market and being priced at commensurate risk/reward levels at non-equity rates. Effectively issuing a debt instrument that are priced fairly, relative to risk.”
Additionally, their rise in prominence has been a response by Islamic oil producing states, as they prepare to diversify away from oil and gas, who have begun approaching the capital markets for issuances.
One major barrier to continued growth is a stark supply and demand problem, with demand vastly outstripping supply. The reason for this is that most Sukuks are buy-and-hold commitments, that are purchased for their yield, their Shari’a compliance and the scarcity of the product. Therefore, the Sukuk holders are seeking consistent returns over time, far more so than an exit in the short-term.
Naturally, any asset must negotiate and seek to mitigate their exposure to risk. With a Sukuk structure this risk is most often related to the region in which a Sukuk operates, typically as they are subjected to political and economic conditions in the Middle East, or indirectly subject to many of the economic and political risks associated with emerging markets – that may directly affect the Sukuk.
Secondly, there is risk related to the issuance of certificates, as these certificates have ‘limited recourse obligations’, and that they may not be modified without the consent of all certificate holders. Therefore, the “transferability of the certificates may be limited under the applicable securities and tax laws, which may adversely affect the value of the certificates”, further complicated by the reality that there is no assurance that certificates will be compliant with the principles of Islamic finance.
Key Considerations, All things Considered
Returning to the basis of what constitutes a Sukuk, the focus of the structure is “all about the asset”. The implications for the Sukuk thereafter depend on: if the structure is asset-backed or asset-based; if there is asset recourse or is there senior unsecured recourse; if the focus is toward the asset or toward the balance sheet; what are the present rights against what the future rights may be.
Asset-based recourse only occurs when there has been a ‘true sale’, whereas security-based exists only when securitization has been utilized. When it hasn’t, a Sukuk becomes like any other unsecured creditor.
There is was belief by many attendees that the market is set for rapid growth over the coming years, mostly due to their superb flexibility that allows for ‘out-of-the-box’ thinking to benefit of all parties. The benefits can range from addressing: issuer needs, lighter covenants, lighter amortization, grace periods, kinds of payback mechanisms, kinds of reserve accounts, the capacity to combine ‘asset-backed’ with ‘asset-based’, and the mix of risk profiles.
From an investors perspective, there is direct and transparent recourse to whatever the security package may be and is priced accordingly.
Financiers will be looking to evaluate Sukuks in terms of their access to capital markets, and as an alternate mechanism or solution to their other products. The process for financiers typically takes between 90-120 days, depending on the jurisdiction, quality of data and the complexity required for the issuer’s needs. It must be noted that a Sukuk does not provide cheaper access to capital markets, however it’s risk/reward profiles are commensurate with conventional markets.
Most of the growth will be within the oil and gas sector and renewable energy sector, agriculture and its periphery industries, water and water infrastructure, or simply where companies are seeking greater cash-flows and offtakes.
These structures may seem quite foreign to most, but practically they provide a diverse and secure method to provide returns. And they can bridge the gap between Islamic clients and non-Islamic clients who wish to conduct business together.
Meet the Round Table Participants:
Managing Director, Fox-Davies Capital
Managing Partner, Morgan, Lewis & Bockius
Morgan, Lewis & Bockius