05 July 2011
The author brings for the first time the three approved and most restructuring approaches: 1) Debt/Equity SWAP 2) Extending Maturity, 3) Haircut
By Mohammed Khnifer
MSc Investment Banking and Islamic Finance
With the recovery of Islamic debt market and the continuous default rate of junk & small issuance sukuk, one should take notice to the growing niche market of restructuring debt in a sharia compliant manner. In this column, we provide a detailed insight to sukuk restructuring after defaults which many of the industry players are not aware of.
When I wrote an article almost a year ago on the confirmed default rate of sukuk (21 cases in the last 21 months), no one paid attention as these default events spurred from small firms facing difficulty in generating operating profits. In Asia, we have seen new trend where boutique investment banks have became specialist in assisting those low credit quality issuers to tap the market, creating unseen junk sukuk market. By now, every now and then we hear a default event from those originators who obtained credit ratings. That of course will not disturb the healthy pipeline of sukuk this year. Confidence has returned to the market after Nackeel has managed to complete its debt restructuring. Under the proposal, trade creditors would receive repayment through 40 per cent cash and 60 per cent in the form of a $1.63 billion Islamic bond, expected by the end of the first half.
Nonetheless, few universal and boutique household names are making their mark in a growing business: Islamic Debt Restructuring.
When I initiated a series of research on the so-called defaulted Sukuk two years ago, many scholars I contacted told me that we would first have to wait and examine the cases. In other words, they needed some time to come up with innovative Shari'ah restructuring plans. The problem was that they had never seen large scale default events before; hence their task was how to make the conventional restructuring approaches Shari'ah-compliant.
Now for the first time, the Islamic finance industry has had a firsthand look at these details. Basically, there are three main approaches: haircut; extending the maturity of Sukuk addition by two or three years; debt/equity SWAP.
After examining most of these options, I believe that approach one does not guarantee the recovery of the principle. Worse, they will recover 70 - 80 per cent without any profits. Approaches two and three also do not guarantee the recovery of the principle, but it depends on the flexibility of the agreement after cancelling the original contact.
Haircut
Haircut is when the capital providers (i.e. Sukuk holders) agree to make a discount in order to get early settlement (Tanazul), according to AAOIFI standards.
Sometimes certificate holders are forced to go down the haircut route when the originator is in severe financial distress, i.e. there is hardly any cash flow from the underlying assets of the Sukuk (the asset-based type). Therefore, extending the maturity of the Sukuk is not an option.
To give an example from the conventional financial system, Argentina offered last month a 66 per cent haircut on its defaulted bonds.
EXTENDING MATURITY
Certificate holders opt for this approach when the financial position of the company is too strong. Nonetheless, this will raise the issue of opportunity cost for the Sukuk holders. Should the same situation happen with bonds, the originator will increase the interest rate on the coupon payment in order to compensate them for the opportunity cost. However, with Sukuk, this is not permissible. So, the question is how to come up with a Shari'ah-compliant solution for the opportunity cost?
It depends on the nature of Sukuk. If they are Ijarah Sukuk then extension means extending the lease contract, which can be on new conditions which may include a higher rent. If they are Musharakah Sukuk, then the term can be extended and the ratio of sharing profit may be changed.
For instance, Nakheel, the builder of the palm-shaped islands off Dubai's coast, plans to issue bonds this year to settle its debt to contractors. The company said that trade creditors would be offered 100 per cent recovery of their claims - 40 per cent through a cash payment and 60 per cent through a publicly tradable Sukuk, paying a 10 per cent return annually. In my view, Nakheel decided to pay this high rate of return in order to compensate the Sukuk holders for the opportunity cost.
DEBT-FOR-EQUITY SWAPS
In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company. Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors.
This is where we see Shari'ah restructuring innovation coming into play.
While we have "hybrid/ clustered " sukuk where debt is involved, most of these notes are equity as you take ownership in the underlying assets. In case of default, you can convert equity (of the underlying assets) into another form of equity (of the originator) at a formula agreed to both parties.
Dr Mohamed Elgari concurs with my interpretation. He said, "Since the Sukuk holders do own assets which can be sold to the originator or the third party then they can use the value to purchase shares (i.e. convert to equity) of the originator who is now the purchaser of these assets."
As we explore the restructuring approaches for any defaulted Sukuk, one should mention the choice of replacing the old securities with new issuance (i.e. Re-financing). For example, you can issue new Sukuk in order to repay or redeem the old Sukuk.
The Sukuk industry is on its way to maturity, despite the fact that there is a need to educate investors on these sophisticated instruments.
Updated BioNote
Mohammed Khnifer is regarded as part of a second generation of Islamic banking practitioners, who come with a solid academic background in Islamic finance. He is a holder of an MSc. in Investment Banking & Islamic Finance from Reading University and is a Chartered Islamic Finance Professional (CIFP) from INCEIF. He is an External "Islamic Finance" Expert at the New York-based Edcomm Group Banker's Academy. During the past 7 years, he became one of the most prolific and well-known researchers & media figures, specializing in Islamic Finance today. Later this year, he is expected to earn his MBA in Islamic Banking & Finance after he won the Silver Scholarship Award from Bangor University. He can be contacted at mkhnifer1@ gmail.com
© Zawya 2011
The author brings for the first time the three approved and most restructuring approaches: 1) Debt/Equity SWAP 2) Extending Maturity, 3) Haircut
By Mohammed Khnifer
MSc Investment Banking and Islamic Finance
With the recovery of Islamic debt market and the continuous default rate of junk & small issuance sukuk, one should take notice to the growing niche market of restructuring debt in a sharia compliant manner. In this column, we provide a detailed insight to sukuk restructuring after defaults which many of the industry players are not aware of.
When I wrote an article almost a year ago on the confirmed default rate of sukuk (21 cases in the last 21 months), no one paid attention as these default events spurred from small firms facing difficulty in generating operating profits. In Asia, we have seen new trend where boutique investment banks have became specialist in assisting those low credit quality issuers to tap the market, creating unseen junk sukuk market. By now, every now and then we hear a default event from those originators who obtained credit ratings. That of course will not disturb the healthy pipeline of sukuk this year. Confidence has returned to the market after Nackeel has managed to complete its debt restructuring. Under the proposal, trade creditors would receive repayment through 40 per cent cash and 60 per cent in the form of a $1.63 billion Islamic bond, expected by the end of the first half.
Nonetheless, few universal and boutique household names are making their mark in a growing business: Islamic Debt Restructuring.
When I initiated a series of research on the so-called defaulted Sukuk two years ago, many scholars I contacted told me that we would first have to wait and examine the cases. In other words, they needed some time to come up with innovative Shari'ah restructuring plans. The problem was that they had never seen large scale default events before; hence their task was how to make the conventional restructuring approaches Shari'ah-compliant.
Now for the first time, the Islamic finance industry has had a firsthand look at these details. Basically, there are three main approaches: haircut; extending the maturity of Sukuk addition by two or three years; debt/equity SWAP.
After examining most of these options, I believe that approach one does not guarantee the recovery of the principle. Worse, they will recover 70 - 80 per cent without any profits. Approaches two and three also do not guarantee the recovery of the principle, but it depends on the flexibility of the agreement after cancelling the original contact.
Haircut
Haircut is when the capital providers (i.e. Sukuk holders) agree to make a discount in order to get early settlement (Tanazul), according to AAOIFI standards.
Sometimes certificate holders are forced to go down the haircut route when the originator is in severe financial distress, i.e. there is hardly any cash flow from the underlying assets of the Sukuk (the asset-based type). Therefore, extending the maturity of the Sukuk is not an option.
To give an example from the conventional financial system, Argentina offered last month a 66 per cent haircut on its defaulted bonds.
EXTENDING MATURITY
Certificate holders opt for this approach when the financial position of the company is too strong. Nonetheless, this will raise the issue of opportunity cost for the Sukuk holders. Should the same situation happen with bonds, the originator will increase the interest rate on the coupon payment in order to compensate them for the opportunity cost. However, with Sukuk, this is not permissible. So, the question is how to come up with a Shari'ah-compliant solution for the opportunity cost?
It depends on the nature of Sukuk. If they are Ijarah Sukuk then extension means extending the lease contract, which can be on new conditions which may include a higher rent. If they are Musharakah Sukuk, then the term can be extended and the ratio of sharing profit may be changed.
For instance, Nakheel, the builder of the palm-shaped islands off Dubai's coast, plans to issue bonds this year to settle its debt to contractors. The company said that trade creditors would be offered 100 per cent recovery of their claims - 40 per cent through a cash payment and 60 per cent through a publicly tradable Sukuk, paying a 10 per cent return annually. In my view, Nakheel decided to pay this high rate of return in order to compensate the Sukuk holders for the opportunity cost.
DEBT-FOR-EQUITY SWAPS
In a debt-for-equity swap, a company's creditors generally agree to cancel some or all of the debt in exchange for equity in the company. Debt for equity deals often occur when large companies run into serious financial trouble, and often result in these companies being taken over by their principal creditors.
This is where we see Shari'ah restructuring innovation coming into play.
While we have "hybrid/ clustered " sukuk where debt is involved, most of these notes are equity as you take ownership in the underlying assets. In case of default, you can convert equity (of the underlying assets) into another form of equity (of the originator) at a formula agreed to both parties.
Dr Mohamed Elgari concurs with my interpretation. He said, "Since the Sukuk holders do own assets which can be sold to the originator or the third party then they can use the value to purchase shares (i.e. convert to equity) of the originator who is now the purchaser of these assets."
As we explore the restructuring approaches for any defaulted Sukuk, one should mention the choice of replacing the old securities with new issuance (i.e. Re-financing). For example, you can issue new Sukuk in order to repay or redeem the old Sukuk.
The Sukuk industry is on its way to maturity, despite the fact that there is a need to educate investors on these sophisticated instruments.
Updated BioNote
Mohammed Khnifer is regarded as part of a second generation of Islamic banking practitioners, who come with a solid academic background in Islamic finance. He is a holder of an MSc. in Investment Banking & Islamic Finance from Reading University and is a Chartered Islamic Finance Professional (CIFP) from INCEIF. He is an External "Islamic Finance" Expert at the New York-based Edcomm Group Banker's Academy. During the past 7 years, he became one of the most prolific and well-known researchers & media figures, specializing in Islamic Finance today. Later this year, he is expected to earn his MBA in Islamic Banking & Finance after he won the Silver Scholarship Award from Bangor University. He can be contacted at mkhnifer1@ gmail.com
© Zawya 2011
