Bankers and lawyers get huge fees… So should we just sit in front of the mosque door and beg…?
Sheikh Hussain Hamed Hassan1
Every year in Bahrain, the Islamic finance industry gathers at the World Islamic Banking Conference, the WIBC. In November 2010, despite the dark clouds of austerity looming over the world’s economy, a group of young bankers and lawyers from Dubai battled through the heaving crowds at the Gulf Hotel. While presentations from the industry’s Who’s Who took place in the main ballroom, in the adjoining exhibition hall impromptu networking was in full flow. As the WIBC participants banged elbows around the coffee and croissant stand, catching up on the latest people moves and deals, with others jostling for space in corridors hoping to notice and be noticed, it cannot have failed to escape the casual observer that Islamic finance was very much alive and kicking.
The group from Dubai – all of whom attended the Masjid Al-Samad, a single mosque in the heart of the tiny Arabian Gulf state’s expat community – were bemused and fast running out of business cards. ‘What the hell is going on?’ asked one of the Samadiites. ‘It’s insane. I can’t even get a coffee around here.’
The same could not have been said of the previous year, when the industry was feeling the effects of the global economic meltdown, and high profile sukuk – or Islamic bond – defaults were taking place against a backdrop of allegations of corruption and mismanagement in Gulf-based family offices and financial institutions,2 both conventional and Islamic. That year, the WIBC had been a little more subdued, a little less manic, and the annual back-slapping that was the various industry award ceremonies had not been quite so glitzy. Indeed, the 2009 keynote speaker at the WIBC had been the outspoken doom-monger and critic of the modern financial services industry, Nassim Nicholas Taleb, the ground-breaking author of Fooled by Randomness and the celebrated The Black Swan.3 Yet in 2010, with the feel-good factor inexplicably returning to the Islamic finance industry, despite unresolved bearishness in the conventional industry, the event organizers decided to draw the crowds with a bullish emerging markets investment guru, Mark Mobius, of the global fund management company Franklin Templeton Investments.
He proved a good draw. Islamic institutions wanted reminding that they had something of distinct value to offer their customers, and the emerging markets represented the front line of their campaign. They wanted to believe they were immune from the global financial crisis. They weren’t, of course, but there was no denying they hadn’t suffered appreciably from exposure to the toxic waste that had infected the world’s largest financial institutions such as subprime mortgages and credit derivatives, the ‘weapons of mass destruction’ that investor Warren Buffett had warned against.4
Every year, the WIBC works with a management consulting firm – in recent years McKinsey & Company or Ernst & Young – to publish the World Islamic Banking Competitiveness Report, a 130-page collection of standard consulting fare in the form of pie charts, three-dimensional bar graphs and the ubiquitous and increasingly wacky matrices so beloved of consultants. The report has become something of an industry fixture and is presented at the annual conference at a plenary session by a partner from the consulting firm. By late 2010, a number of key themes and trends were being identified: Islamic banks continued to experience robust asset growth and outperformed their conventional counterparts; Islamic ‘windows’ of conventional banks – that is, a separate area within a conventional bank that offers Islamic products – continued to grow rapidly, constituting an increasing share of the overall Islamic banking landscape; and Islamic banks remained relatively unsophisticated and had limited access to Sharia-compliant instruments that hedge their macroeconomic exposures, like mismatches between their balance sheet assets and liabilities, or other ‘gap’ risks within their treasury operations and proprietary trading desks.
In previous years, the report had focused on the global sukuk market, which had grown exponentially since 2001 but which had lately been experiencing a slowdown in new issuances from governments and corporations looking to tap public markets for new debt. It had also been one of the first to champion the idea that the majority of GCC-based investors would buy Islamic products if those products demonstrated the same price, performance, liquidity and other attributes of conventional products.
However, it had not been until a slick Anglo-Saxon SWAT team from Deutsche Bank arrived on the scene in 2004, launching a range of Islamic derivatives products, that the industry finally took notice that constraints in offering new products had always been on the supply side. In other words, banks had not previously figured out how to design and engineer new Islamic products – ‘structuring’ as they termed it – to issue the most sophisticated products required of investment banks: those infamous weapons of mass destruction. In contrast, on the demand side, customers had been waiting patiently for instruments to hedge their exposures to foreign currencies, interest rates, commodity prices, share volatility – all in a Sharia-compliant package.
And that day had arrived.
* * *
By the mid 2000s Islamic finance was entering adolescence, with none of the growing pains that this should have entailed. A uniform blandness swept through the industry: banks would fund each other by offering simple money-market lines using commodities as the underlying asset, a so-called commodity murabaha transaction. Depositors would place their money with banks and earn a return linked to these commodity transactions. Home financing was inflexible and expensive, perhaps because Islamic banks had not learnt how to protect themselves, or hedge, against significant macroeconomic exposures to currency fluctuations, borrowing rates and other market movements. Corporate loans would either be made using the ubiquitous commodity murabaha or through the equally clumsy sale and leaseback of the borrower’s assets. It was dull, it was expensive and no one cared.
Yassine Bouhara sat in a glass-screened corner office in Deutsche Bank on London Wall and wondered why no one had taken the Islamic finance industry by the scruff of its neck and shaken it up. The Francophone Swiss of Algerian origin had joined Merrill Lynch in Frankfurt at the age of twenty-three to trade equity derivatives, just as the market began to take off. By 1996, Deutsche Bank was greedily eyeing up merchant banks and securities houses with the intention of joining the exclusive club of bulge-bracket investment banks. Bouhara’s and Deutsche’s ambitions collided, and he jumped ship to rise to the post of Global Head of Equities in London.
Here at Deutsche Bank, on a trading floor the size of a football field, he was an emperor, and he hadn’t even turned forty. But it wasn’t enough. He had conquered the conventional world, but not the Islamic. No one had conquered that. Why were there no simple Islamic securities traded on a stock exchange, structured investment products or treasury management and liquidity products? Where were the Sharia-compliant cross-border mergers and acquisitions? The Islamic mortgage companies?
Bouhara was a fast-talking star of the equity derivatives industry, famed for his rapid rise to the top and his single-minded pursuit of profit. His early career had been forged in the white heat of the trading floor, and he revelled in recounting his salad days as a non-English speaker overcoming the odds in an Anglo-Saxon trading environment. With his penchant for oversized watches, expensively tailored Super-180 cloth and island properties in Dubai, it was clear that the glam years of investment banking had been good to him.
But now, having achieved so much, he was searching for something more, and one day his private banking colleagues in Bahrain came calling. Knowing of his desire to create a stir in the Islamic markets, they brought a unique proposition to him: an ultra high net worth merchant family from Saudi Arabia, looking to set up a dedicated Islamic finance consulting firm, and to finance real estate in Islam’s holiest city, Makkah.
That merchant family were the Binladins, half-brothers to the infamous Osama, and owners of Saudi’s largest contracting firm, the Saudi Binladin Group. The Binladins had a unique proposition: having already endowed a chair at the University of Oxford to promote the Islamic finance industry, they were keen to extend their reach beyond the world of academia. And so they asked their private bankers whether they might work with them to create an entity dedicated to research and development in Islamic finance, a think tank.
At first, Deutsche’s private bankers struggled with the concept. It wasn’t just that the Binladins shared a name and bloodline with the world’s most wanted man, and that Deutsche Bank would by association be thrust into the limelight, outside the comfort zone of the secretive world of private wealth management. It was also that these Geneva- and Bahrain-based relationship managers – hired for their ability to tell a Monet from a Manet – had no training in the technical discipline of Islamic products and thus had no idea where to start. The joint venture entity they set up with the Binladins and Oxford, named Dar Al Istithmar – the House of Investment – lacked teeth, populated as it was by academics with no experience of the commercial environment, and borrowing its intellectual property from its largest shareholder, Deutsche Bank. Its status as a think tank certainly created a halo for its shareholders, but wasn’t making them much money.
When you need to make money, you turn to a man who knows how to make it. Could Yassine Bouhara, a member of the bank’s Executive Committee – the body populated by the bank’s most senior executives and ultimately responsible for the investment bank’s activities – create one iconic deal to set the Islamic market alight? Could he, a conventional banker, establish the Islamic credentials of the Dar Al Istithmar joint venture and its benefactors?
Bouhara put into motion a plan of action for which perhaps no one in the bank was better suited. Deutsche would work with this client, he assured them, and he would put his top guys on it. His top guys meant the equity derivatives team, already known to house some of the bank’s proven ‘rocket scientists’ and seemingly with a licence to pursue opportunities wherever they may be. Entrepreneurship was the watchword for his people.
‘Do not be ’eld back by ze bondareez of your job’, he would advise his rocket scientists in an impenetrable French accent. ‘Mek mo-nay’, he would tell us. The word ‘mo-nay’ would often be accompanied by a proffered hand, thumb and first finger rubbing together to emphasize the importance of all that investment bankers live for.
Two years previously, his team had launched an Islamic exchange-traded fund – a certificate typically traded on a stock exchange whose price mirrors the performance of an underlying basket of equities. As the underlying equities rose in price, the certificate would also rise in price, like a stock in its own right – a neat way of investors participating in the returns of a group of shares, or perhaps an entire market. Whilst Bouhara’s structuring specialists may not have understood the Islamic finance industry profoundly, they were at least capable of devising solutions to problems within specific parameters, and their complex skill set was their ticket to ‘meking mo-nay’. The exchange-traded fund had proven a success and Bouhara knew that the approach from the Binladin family was his opportunity to make a meaningful impression on the industry beyond merely an opportunistic one-off product.
The Binladins were Saudi’s biggest builders, responsible for some of the most expensive real estate in the world located in the holy cities of Makkah and Madinah in the Kingdom of Saudi Arabia. The three brothers Bakr, Yahya and Shafig Binladin had, not surprisingly, distanced themselves from Osama, and played extensively on their business relationships with the family of US President Bush and other leading American politicians and businessmen. Bouhara was certain that the brothers would bring him into the fold of the region’s leading ultra high net worth merchant families, princes and sheikhs. All he needed was one deal, the one that would put Deutsche on the Islamic map.
At a beachfront restaurant table at the Dubai Ritz Carlton in late 2004, I sat down with a colleague and Bouhara to wait for a representative of the Binladin Group to arrive. Bouhara outlined his vision of the future to us, his manner intense and engaging. The Binladins were about to offer him a mandate to finance the construction of a series of towers in the holy city of Makkah. Naturally, the financing would have to comply with the Sharia, but the Binladins wanted more than that. They wanted the industry to look up to this transaction and deem it worthy of replication. The assets that it would finance would be of the highest quality, in perhaps the most iconic city in the world, certainly one to which no Western investment bank had previously been invited to conduct business.
‘Ze Meedle East is fool of bool-sheeters’, he began, manically waving his hands, lengthening and drawing out the word ‘bool-sheet’. ‘I do not want you to care about ze titles, ze name-dropping, if you tell everyone “I know zees sheikh, zat sheikh, lalala”. I. Do. Not. Care.’ Bouhara was just warming up, a flash of his monstrous Audemars Piguet visible under his cuff as he gesticulated wildly each time he said ‘lalala’, a Bouharaism for ‘et cetera et cetera’.
‘Do your job, be technee-cally excellent, ozerwise everyone zay, “Ere eez zis bool-sheeter again wiz ’iz bool-sheet, lalala”. And zay will come banging on my door zaying “Oo eez zees guy you ’ire?”’
Bouhara’s dream was to commoditize the industry so that Muslim buyers of Islamic financial services could walk into a bank, or better still go online, picking and choosing produce like fruit in a supermarket. He didn’t want vacuous salespeople – bool-sheeters – to forge this new frontier, he needed technical experts.
‘Look at ze Beeg-uh-Mac-uh,’ said Bouhara. The Big Mac? My colleague and I looked at each other. Were we still talking about Islamic finance?
‘It is ze perfect product. Everywhere I go in ze world, I find ze same Beeg-uh-Mac-uh, manufactured to ze same stondard. I want you to create a factory of Eeslameec product like ze Beeg-uh-Mac-uh.’ He would populate the Islamic team with first-class front office specialists, with technical credibility in their chosen product disciplines. Whether you bought his product in London or the Middle East, its quality would be the same. It was a radical departure for a region predisposed to mediocrity in financial services.
In the moments before his client arrived, he emphasized how career defining this particular transaction would be. How it would put Deutsche Bank, and us, on the map. ‘Do you want to be anuzzer expat wiz ze expat disease and walk around town saying pee-pul want to ’ave lunsh wiz me because I am from Deutsche Bank, lalala? Non. Back ’ome, you are eensig-neef-icant. Do not be like ze bool-sheeters ’oo claim zey ’ave a lot of mo-nay. Zay to zem: where eez eet? Where eez your f***ing Ferrari? I cannot protect you from ze mob back ’ome, once you ’ave lost credibility.’
His voice dropped from a high-pitched rant and he leant forward, still intense in manner, but now quieter and more deliberate. ‘So be focal-ized. Mek mo-nay. Zen I mek you rich.’ He leant back, eyes sparkling and teeth bared in a wide grin, satisfied that he had captured the imagination of his rapt bankers, daring them to dream of a new frontier that they would control.
His client arrived and after brief introductions Bouhara flashed his trademark smile and left us to talk business. Deutsche would be getting the mandate to finance the towers in Makkah, but the instrument we would create needed to be special. It needed to set a new trend and make its originator a pioneer. The Binladins wanted their best customers to be rewarded: if they bought the bond to finance the project, then those customers should be granted a unique preferential status to purchase the very best luxury apartments with the world’s most expensive view. If Deutsche could make this happen, it would be rewarded with even bigger future mandates, with the potential to leapfrog its way to becoming the region’s leading investment and private bank.
The Saudi government had awarded the Saudi Binladin Group a contract to construct the Abraj Al-Bait, a series of seven gigantic towers overlooking the holy mosque at the centre of the Islamic world, the Masjid Al-Haram. At the centre of the Haram is the Kaaba, the cubic structure draped in black cloth that Muslims claim has been in existence since the time of the Prophet Abraham, towards which 1.6 billion Muslims turn five times a day to offer their daily prayers, and to which every Muslim with means is obliged to make a pilgrimage once in his or her life.
It would be a project of immense significance, breaking a multitude of records in its vast construction, and yet – perhaps more crucially – sealing a break with Makkah’s historical past. No more rundown hotels, crumbling old buildings, and low-tech low-rise anonymity. Fifty yards from the gate of the Masjid Al-Haram, Abraj Al-Bait would herald the advent of a new era in the world’s holiest city – brash, high tech and progressive. A symbol of modernity for the world to marvel at. A place where the rich could entertain and be entertained, could worship from the comfort of microchip-controlled seven-star luxury, where piety and wealth were not mutually exclusive. The project would drag Islam kicking and screaming into the modern age whether it liked it or not, and in the process would destroy any symbols of its heritage. Not even the hills around Makkah would be safe, detonated into a billion pebbles, whilst old forts and other buildings of immense historical and architectural significance would be obliterated for ever.
At the centre of the towers would be the Makkah Royal Clock Hotel Tower, the tallest clock tower in the world, apparently modelled somewhat bizarrely on London’s Big Ben and housing two million LED lights on each of its four faces. On completion, the towers project would house the tallest and largest hotel in the world, have the world’s largest building floor area, and the second tallest tower in the world. After circumambulating the Kaaba in a millennia-old ritual believed to have been initiated by the Prophet Abraham, the devotee could stroll into an air-conditioned, marble-lined mall and sip a skinny Frappuccino® from a cardboard cup.
Deutsche Bank would be right there at the inception of this new era.
Deutsche set to work by employing the services of some of the region’s leading scholars led by a Dubai-based Egyptian named Dr Hussain Hamed Hassan. Despite his advancing years, Sheikh Hussain’s impressive work ethic and intellect proved to be a surprise to the bankers from Deutsche. He took on the role of chairman of the three-man Sharia panel, conveying the salient transaction details to his colleagues in an attempt to find a contractual structure that worked from a commercial and Sharia perspective.
The transaction proved troublesome: there were limited precedents for similar types of real estate financings in Saudi Arabia, and Makkah in particular was subject to specific restrictions on foreign ownership and investment in the sector. An international capital markets issue was one thing, but a tradeable security with attached rights to subscribe to underlying real estate added an additional degree of complexity. Saudi’s complex tax laws proved unhelpfully vague, and the tax advisors found themselves unable to draw definitive conclusions about the treatment of this instrument by the Kingdom’s Department of Zakat and Income Tax. In the end, it took two years of legal, tax and Sharia structuring to meet all the commercial parameters, and both the client and its bankers grew weary of the deal with its increasingly complex web of sub-companies and sub-agreements.
‘I don’t understand why you guys need to overanalyse things’, complained the Binladin Group’s in-house finance manager. ‘Just do the deal. Draft up the docs with a structure that roughly works and print the damn thing.’
The bankers were reluctant to proceed with an approximate solution. For the head of Bouhara’s structuring team, Belgian equity derivatives specialist Geert Bossuyt, who would go on to co-found Deutsche’s Islamic finance team, approximate was not a word he understood. It had to be perfect or nothing. With a background in actuarial science, and a training in Luxembourg-based tax-efficient investment products, creating a financial instrument was a precise science, not an art, and there could be no compromise. This had to be an instrument worthy of selling to the international investment community, and Bossuyt’s impeccable north-European logic would allow for no gaps or fault lines in the products his team would create.
After two years of back and forth between the client, legal counsel, tax advisors and the regulatory authorities in Saudi and Bahrain, Sheikh Hussain was finally able to settle on a legal structure that would also meet the requirements of the Sharia. The overall transaction structure would be governed by a type of contract known in the Sharia as a mudaraba – an investment partnership whereby investors place money with a manager who invests or manages that capital on their behalf to produce a return. The connection with classical Islamic commerce could not have been closer: the Prophet Muhammad himself had been a mudarib, a manager of other people’s capital. The ensuing certificate, or sukuk, would be called a sukuk al mudaraba. To complicate matters, the holder of the sukuk would have additional rights to buy apartment units in the Safa Tower, the first of the seven towers to be constructed. Thus the bond financier could leapfrog the queue to buy this iconic real estate.
Whilst the investment contract would be the principal document governing the nature of the sukuk investment (mandating the investment manager to invest the proceeds in a real estate development project), underpinning it would be a network of companies and contracts to effect the required commercial outcome within the boundaries of oftentimes awkward jurisdictional and tax parameters.
On the issue date of the sukuk, investors would advance US$200 million to the issuer, a Bahrain incorporated ‘special purpose vehicle’ – a financial shell company specifically set up to hold legal title to the real estate asset in favour of the investors – and the issuer would enter into an investment agreement with the sukuk holders, appointing the issuer as their manager to invest in the development and sale of units in the Safa Tower. Each sukuk investor would additionally receive a subscription right attached to the sukuk, granting him the right to buy a long lease on certain units of real estate in the Safa Tower.
Then the legal structure gets labyrinthine. In turn, the issuer as agent for the sukuk holders would invest the proceeds into a sub-investment agreement with a sub-manager, since the issuer (remember, this is just a shell company to represent the sukuk holders) cannot actually build the tower itself. So it appoints a Saudi contracting company owned by the Binladin Group under a type of construction contract – known in the Sharia as an istisna – and the capital under this agreement would be disbursed according to a schedule of construction milestones over a two-year construction period. But since the whole of the $200 million construction cost is injected by investors into the issuer on day one, a large amount of capital sits around remaining undisbursed to the contractor during the construction period.
Geert Bossuyt applied his cold Belgian logic to this apparent leakage of value from the project. The problem was how to invest surplus cash into a liquid (in other words, readily tradeable) instrument or deposit account on a Sharia-compliant basis. In parallel with their ground-breaking work on the Safa Tower deal, Bossuyt’s crack unit developed an overnight ‘Islamic liquidity product’, an equivalent to cash deposits or money-market products in conventional markets. Now institutions, individuals, corporations and large-scale projects like Safa Tower need not fear the inefficiencies of Islamic finance.
This was all getting a bit convoluted. Surely this was a simple build-operate-transfer development project, just like any other real estate deal? No wonder the Binladins’ finance manager was so vexed.
But the structuring still wasn’t finished. A spaghetti bowl of cross-jurisdictional issues and nebulous tax laws meant that the leasehold interest of the property had to be perfected. As the original leaseholder of the land, the government body owning the land around the Holy Mosque granted the long-term lease to the Binladin Group, who in turn would sublease units in the tower to end customers, the holders of the sukuk. The subleases would be governed by a forward lease and proceeds from these forward leases would fund the construction costs.
Confused? That was just the simplified version of the transaction structure. It had been a herculean effort to resolve the very many tax, jurisdictional, regulatory and Sharia issues to make the deal happen. Millions of dollars of legal and financial fees racked up over two years, but was it all necessary?
As it happened, no. Despite concluding the contractual structure and receiving all relevant regulatory and Sharia approvals, the Binladins lost patience and sold the whole tower in one go to a single buyer. Strangely, it did not matter to Deutsche – such a wealth of goodwill had been generated in the structuring and marketing phases of this unprecedented financial instrument that Islamic investors and the competition were in awe of Deutsche’s boldness and capabilities. A Western investment bank had been allowed into Makkah and imagined possibilities of which others had dared not dream.
Ultra high net worth target clients looking to splash out up to US$27 million on a top-floor suite overlooking the Kaaba were proffered the slickest of marketing tools to accompany the legal documents from their private bankers at Deutsche. Juxtaposed with the typically dry but impressively complex documents were wafer-thin personal computer tablets that took them on a virtual tour of the apartments. The disbursal of these high-tech freebies – several years before Apple’s game-changing iPad – allowed the prospective investor to view an astonishing level of detail, from the fixtures, fittings and views of the real estate units, to the intricate construction of the financial transaction itself. Indeed, no stone had been left unturned, as structuring head Geert Bossuyt had promised, and these same ultra high net worth clients knew that one day, when they had a deal that no one else could solve, they could turn to the only rocket scientists plying their trade in Islamic finance today.
Deutsche Bank’s Islamic finance team was born, though not, it must be said, without the tragic destruction along the way of pieces of Islamic history. Makkah was transformed, the Islamic finance industry had made a quantum leap, and not everyone felt that either change was for the better.
* * *
The Safa Tower deal had created quite a buzz about Deutsche’s capabilities in the Islamic space. So much so that when Deutsche was appointed as sole advisor on another headline-making deal for the Middle East, Bossuyt’s team got the call from their corporate finance colleagues upstairs in London Wall.
It was the autumn of 2005. Fuelled by a boom in commodities prices, real estate, tourism and regional trade activity, the Dubai government had audaciously announced its intention to acquire the British global ports operator, Peninsular and Oriental Steam Navigation Company, or P&O.
The government had stipulated the involvement of its flagship institution, Dubai Islamic Bank, in which it held a stake, and Deutsche’s London-based mergers and acquisitions (M&A) bankers knew that they would need in-house help to make the financing happen. Some of the German bank’s deal specialists thought that this could turn out to be a problem: as a much smaller regional bank, the team from Dubai Islamic Bank (DIB) had not previously worked on a cross-border acquisition of this magnitude before, and Deutsche’s seasoned London-based M&A experts had never come across Sharia structures before. Two worlds were about to collide.
One man knew the immensity of the task ahead. Chairman of DIB’s Sharia board, the same Sheikh Hussain Hamed Hassan who had masterminded the Sharia structure of the Safa Tower transaction, knew that this transaction was uncharted territory for any institution. As the Safa Tower deal approached its conclusion, Sheikh Hussain requested a meeting with what was now becoming internally recognized as an unofficial Islamic team at Deutsche to discuss the new transaction. ‘Bring me all your cash flows, all your financial statements’, he requested in what was now his trademark request. ‘If the doctor is not given all the information, all the symptoms, all the patient history, he cannot find the cure.’ Neither his own bankers from DIB nor the Barclays Capital team – the other investment bank chosen by the government to arrange the financing – were invited. The Sheikh was nominating his favourites for the job, perhaps doubting the ability of anyone other than Deutsche’s structurers for grasping the complexities of the task ahead.
In just a few days’ time, the British financial services regulator would require a statement from the financing banks. This official bid document would tell the regulator that there was a high degree of certainty of providing the financing package to acquire P&O, and Deutsche’s M&A bankers were more than a little nervous. On a conference call attended by bankers in Dubai, London and New York, the talk was of creating a conventional ‘bridge’ financing, that is, one in which debt financing would be put in place for a short time period – to bridge a gap, typically for one to three months – and thereafter refinanced. That would allow the banks more time to work out how to refinance the deal on an Islamic basis. Why jeopardize the deal for the sake of appeasing one awkward bank? Submit a conventionally financed bid and be done with it. Let DIB worry about its portion later.
‘I don’t care about the Shar-eye-ah stuff! Just get me the waiver!’ cried one New York-based acquisition finance banker, as if all one needed to do was sprinkle fairy dust over the loan contract and a scholar would rubber stamp it. The message was clear: just get the deal through the door and let these Dubai Islamic Bank guys worry about their piece later. For the investment bankers for whom careers could be made as a result of this deal, the Islamic element was proving to be an impediment to a year-end bonus bonanza.
But the Deutsche Islamic specialists were undeterred. They knew that if DIB were not brought on board, there would be a gaping billion-dollar hole in the transaction and the Dubai government would not be happy. Keeping their heads down so as not to alarm their conventional colleagues with the complexity of the challenge, they met discreetly with the sheikh in order to craft a financing instrument that would sell on the capital markets like a bond.
The total financing package to raise the money to acquire P&O would not merely be a loan financing involving a syndicate of banks – it would also incorporate a public sukuk issuance raising money from investors across the world, with the proceeds of the sukuk used to part finance the acquisition. It would be a mammoth issuance: the overall financing package would be US$9.6 billion in size, most of it conventional financing from the syndicate of arranging banks, but with the Islamic capital markets element alone needing to raise around $3 billion, an unprecedented size for a Sharia-compliant financing.
To complicate matters further, the cash flows generated by the underlying company would not be sufficient to repay the sukuk within the two-year financing time frame. As a result, the instrument needed to be structured as a ‘convertible’ or ‘exchangeable’ bond, that is one that converts into the equity shares of the underlying company, or exchanges into the equity of a related company. That way, hard cash would not need to be made available to repay investors, a common ruse in acquisitions of this nature, and a way of cheapening the quantum of ongoing repayments during the term of the bond.
The corporate finance bankers suggested to the client that the circumstances of the acquisition lent themselves well to what they termed a ‘pre-IPO exchangeable bond’, that is, an instrument that pays a fixed rate of return to the bond holder, with the principal value repaid when the borrowing company floats its shares, or those of an associated company, on a stock exchange at some point in the future. The shares created in this initial public offering (IPO) would be the currency used to repay bond holders, who would become equity shareholders on maturity of the loan. Indeed the bond could be structured as a ‘zero coupon’, one that pays no interest at all during its life, but instead rolls up the interest cost into the final repayment at maturity. So the investors start out as holders of the company’s debt, on which they earn no cash payments, but eventually become shareholders of a company they hope will become hugely successful.
Not surprisingly, such a sophisticated instrument had never previously been created in Islamic format, let alone sold in such a massive size. A Sharia-compliant pre-IPO zero coupon exchangeable bond. Even the very description strikes fear into the heart of a banker looking for an easy ride to his year-end bonus. For Deutsche’s Anglo-Saxon corporate financiers, it was madness to even try. Perhaps even if it could be structured, there would be no market for it. Sheikh Hussain called his favoured bankers and lawyers to his office and began the structuring process.
‘The transaction is a musharaka’, he declared emphatically, informing us that the underlying Sharia contractual structure would be a type of investment partnership arrangement. ‘The partners are the company performing the acquisition and the sukuk investors. The company shall be the managing partner, responsible for deploying the proceeds from the sukuk according to an agreed business plan: the purchase of P&O.’ With the building blocks of the Sharia structure established, we set to work.
The Dubai government entity responsible for the purchase – the Ports, Customs and Free Zone Corporation (PCFC) – would issue a pre-IPO exchangeable sukuk al musharaka, which would be placed by the three arranging banks. The sukuk would require a fatwa, or legal opinion, in order for it to be accepted by Islamic investors. This judicial pronouncement – typically a short document announcing that a qualified scholar had reviewed the legal and commercial aspects of a transaction and found them to be in compliance with the Sharia – would have to be issued by the Sharia board of DIB, since it was the only Islamic bank of the three, and its investor base was exclusively Sharia compliant. In contrast, Deutsche Bank and Barclays Capital would sell the instrument predominantly to a conventional client base: buyers of convertible and exchangeable bonds from pension funds and hedge funds spread across the world from California to Hong Kong. Those guys weren’t looking for a fatwa, just a solid financial proposition worth investing in.
As the bid deadline loomed, an ebullient Sheikh Hussain was determined to prove to the banks that the Sharia need not be an impediment to the demanding pace of modern finance. ‘For every door that closes in the Sharia, a hundred others open’, he declared in his trademark booming voice at a meeting with the Deutsche structurers and their lawyers. ‘We will find this company a SOLUTION, and we will BEAT their deadline. They will NOT need to refinance.’ He thumped a clenched fist on the table, startling his colleagues as glasses full of water bounced off the table top, spilling their contents onto precious sketches of contractual diagrams and cash flow spreadsheets. The sheikh did not seem to notice. He was just getting into his stride, every critical word emphasized so that people in adjoining offices could hear. ‘We will make this transaction an example for the industry. So everyone can see we [the Islamic banks] do not lack ANYTHING.’ Another thump of the table.
Combative and charismatic at the same time, despite his advancing years Sheikh Hussain’s energy levels were truly remarkable. His working day began at the fajr early morning prayer, his office overlooking the old downtown area of Dubai near the airport, a vista of concrete flyovers and traffic jams. His status as chairman of many Sharia boards, and the outward manifestations of corporate seniority, seemed not to be of huge concern to him. Almost always dressed in a half-sleeved shirt, baggy corduroy trousers and comfortable old shoes, the casual observer might be forgiven for overlooking him in a room full of bespoke-suited corporate drones. Yet the casual observer would soon be put right the moment the scholar opened his mouth, his voice a resonant powerhouse and punctuated with the banging of a pugilist’s fists.
Getting a word in edgeways was a fine art, mastered only by a select few in whom he put his trust. His closest aides seemed to fear and respect him in equal measure, both deferential and submissive, never challenging his authority, and always referring to him as ‘the Doctor’. Their stock response to structuring questions posed to them as gatekeepers to the scholar seemed to be ‘Doctor says no’ as if they had been too timid to ask him the right question or explore possible solutions. In contrast, the small coterie of international bankers and lawyers the scholar seemed to enjoy working with – Samidiites, many of them – were more willing to investigate and robustly debate their commercial position, whilst maintaining a respectful courtesy. Perhaps the charismatic Doctor had simply been waiting to put his keen intellect and knowledge of comparative legal systems to the test, and this new breed of Islamic finance specialist was the conduit. These cross-border, multi-tranche, time sensitive, big ticket deals were finally his chance to show what Islamic finance was truly capable of.
Deutsche’s M&A bankers, unaware of Sheikh Hussain’s efforts behind the scenes and still nervous of the Islamic component to the deal, advised their Islamic colleagues to back off the structuring process. With only a few days remaining until the regulatory deadline, they preferred to leave DIB to its own devices.
It was a large and complex financing, and wherever such transactions involve both conventional and Islamic institutions it is almost always the conventional banks that tend to have the upper hand. Often more sophisticated than their Islamic counterparts, with bigger balance sheets, and usually with stronger and more recognizable brands, they are natural leaders on the biggest deals. But they also tend not to understand Islamic finance well, and naturally fear what they don’t understand. The first instinct of Deutsche’s M&A bankers was to seek waivers so that either the Islamic portion was no longer required or was somehow magically certified so that it would look and feel like the conventional portion. Since the former would have increased the two conventional banks’ exposure to the deal and failed to meet one of the client’s commercial objectives (that of involving one of its flagship financial institutions in the acquisition), and the latter would not have been acceptable to one of the most conservative scholars in the field, the Deutsche Islamic structuring team and their fellow Samadiite lawyers found themselves in a race against time.
As the weekend before the bid deadline approached, I boarded a late-night flight to Jeddah with a colleague and we made our way to the Holy Mosque, the Masjid Al-Haram, in Makkah. Dressed in the traditional pilgrims’ garb known as the ihram, the two pieces of white cloth worn by attendees of the annual Hajj pilgrimage, we circumambulated the Kaaba seven times and travelled between the hills of Safa and Marwa seven times, thus completing our pilgrimage rituals. But we had not come for the sole purpose of making a pilgrimage. At three o’clock in the morning, in the lobby of a small hotel on the fringes of the Holy Mosque, we sat with Sheikh Hussain, still dressed in ihram like the disciples of a Greek philosopher in the Agora. Our return flight to our Dubai base was only four hours away but we were determined to nail this transaction and have the Sharia-compliant transaction documents ready in the hands of our doubting colleagues before they returned to their desks in London on Monday morning. If there was one man who could solve the deadlock, to plug a billion-dollar hole, it was this man, the billion-dollar scholar.
And so in that singular setting, with the commercial terms of the deal set by our conventional colleagues, we worked into the dawn hours to set the seal on the Sharia structure of the PCFC sukuk, which we would convey that same morning to our legal counsel in order to draft up the contracts. The capital markets issuance needed to raise at least US$2.8 billion, and would have a tenor of two years. During this time it would pay no coupon, but accrue a rate of profit. Like the interest rate on any bond being launched in the conventional markets, this accrual rate would be set at the time of launch of the sukuk. It would be in PCFC’s interests to ensure that it floated its underlying companies and allowed sukuk investors access to the stock, otherwise it would have to repay a greater cash amount to sukuk holders.
So that conventional investors would take comfort in this instrument, the sukuk documentation would be drafted according to the standards of conventional eurobond issuances. This would ensure that they would be tradeable and clearable by bond market dealers and clearing houses, and investors would see an instrument on their trading systems that looked and felt like a conventional bond, even though its underlying structure was very different.
As with many sukuk transactions, the notes issued to investors would be ‘limited recourse’ obligations of the issuer. In other words, in the event of a default by PCFC, the note holders would only have recourse to those assets specified in the investment partnership agreement, the musharaka that Sheikh Hussain had declared earlier. The investors would also have the benefit of an undertaking offered by the ‘obligor’, PCFC, who promised to repurchase the units of the musharaka partnership on redemption of the sukuk. This type of undertaking is known as a purchase undertaking and is an often used contract in sukuk transactions in order to give comfort to investors that their bond will be repaid by the obligor at maturity.
As one of the earliest large-scale international sukuk transactions – and indeed the very first exchangeable sukuk deal – Mufti Taqi Usmani’s famous views on sukuk redemptions had not yet been made public. That is, a sukuk based on an investment contract may not be redeemed at its par (or initial) value, and only at its market value at the time of redemption, otherwise it would be in breach of Sharia’s requirement for risk sharing to take place between the financier and the financee. Thus the redemption of investment units in the PCFC sukuk would be at the initial issue value: if the investor bought the bond for $100, he would get $100 worth of shares back at maturity in two years.
No doubt this apparently guaranteed repayment helped to attract conventional bond investors to the deal, though some industry commentators such as Tarek El Diwany subsequently expressed their disappointment that an instrument based on the concept of profit-and-loss sharing was turning into ‘a shallow subterfuge in violation of industry standards’.5 To El Diwany, a supposedly Islamic instrument was guaranteeing its repayment come hell or high water, rather than allowing the investor to share in the underlying company’s profits and losses. Park that thought for now – it is a discussion of critical importance to which we must return because it goes to the heart of what makes Islamic finance ‘Islamic’.
The issuing special purpose vehicle itself was majority owned by PCFC and, at Sheikh Hussain’s suggestion, partly owned by Dubai Islamic Bank. This holding by DIB enabled the bank to act as an independent party, a share agent, for and on behalf of sukuk holders in order to protect their interests. Each of the sukuk notes were in the form of trust certificates representing an undivided beneficial ownership interest in the trust assets, held on trust for the holders by the issuer in its capacity as trustee. This sukuk transaction was not only intended to be ground-breaking, its structure was also intended to be a replicable best practice for the Islamic finance industry.
The trust assets represented the issuer’s rights and interest in the investment partnership itself, and were the crux of the real economy transaction underpinning the financial transaction. Remember, it is that real economy transaction that is of interest to Sharia. The purpose of this partnership was the generation of profit from the application of capital contributions of sukuk holders and PCFC’s in-kind contribution.
So what was this in-kind contribution? PCFC offered to the partnership usufruct rights – the right of ‘usage and enjoyment’ – of fifty-three cranes at the port facility for a period of eleven years,6 in other words a real underlying asset with economic value. These capital contributions would be deployed in accordance with a specified business plan appended to the investment partnership agreement. PCFC’s usufruct rights would generate an ongoing return to sukuk holders, and profits under the agreement would be split between PCFC and the investors (through the issuer). The obligations of PCFC as the managing partner to execute the business plan were set out in a separate management agreement, allowing the managing partner to earn profit over and above a stipulated cap (being the pre-specified yield on the sukuk) as an incentive payment, similar to that of a fund manager. In other words, perform well, and the company would be rewarded.
To complete the contractual circle, PCFC as obligor granted an undertaking – that controversial purchase undertaking we spoke about earlier – in favour of the issuer to purchase the units in the investment partnership on redemption of the sukuk, thus ensuring repayment of the bond in full.
Hang on a moment. We’re talking about the rental of cranes as the basis of a bond instrument. So what happened to the headline purchase of P&O, the acquisition that this deal is all about? Was this not a part of the business plan? The offering circular made numerous references to the impending acquisition,7 though it clearly had no direct link with the monies advanced by sukuk holders. To all intents and purposes, it seemed the sukuk holders were primarily taking income revenue risk on the lease of fifty-three cranes owned by PCFC, and credit risk on the ability of PCFC to redeem its debt in two years’ time. In reality, of course, PCFC would use the sukuk proceeds as part of its war chest in the acquisition of P&O, along with a much bigger tranche of conventional acquisition loan financing provided by the syndicate of banks. However, no doubt the conventional nature of this $6.5 billion tranche of bank debt muddied the waters somewhat for sukuk investors, who consequently needed to find an untainted asset to pin their return to. The cranes happened to fulfil that brief adequately enough and the purchase of P&O was relegated to a mere description of the wider corporate activities of PCFC, which of course were loosely incorporated into the business plan. The other advantage of not linking the business plan explicitly to the acquisition was that the issuance and ongoing status of the sukuk would not be conditional on the acquisition.
So with the structure and documents of the transaction thoroughly vetted and signed off by the various stakeholders in the deal, it fell to the salesmen and -women of the three lead banks to go to work and sell to their investors. Driven by the bid deadline, they called hundreds of their clients, from the world’s largest pension fund managers in markets such as the United States, to specialized convertible bond hedge funds in Hong Kong, to regional financial institutions in the Middle East and South-East Asia, both Islamic and conventional. In the frenzy of transcontinental telecom traffic, one common theme began to emerge. Investors had never seen an instrument like this before. Oh sure, the pension funds and hedge funds were familiar with pre-IPO convertibles and zero coupon bonds, but Sharia? Suddenly a stream of questions needed answers: ‘How do we get our money back if the bond goes belly up? What’s the security? What’s the jurisdiction here? A court of English law? A Sharia court? Let us look into what the risk factors are. We’ll get back to you.’
Whilst DIB’s clients were comfortable with the risk factors related to financial investments complying with Sharia, Barclays’ and Deutsche’s clients were not so sure. They liked the issuing company and its parents. They knew the acquisition plan was commercially attractive though bold. The geographic and industry diversification was appealing. But Islamic? There must have been a catch.
Deutsche’s sales team was getting nervous. In the absence of a dedicated Islamic sales team, the job of selling this sukuk fell to their conventional credit sales desk, and they were struggling. The launch date was approaching and their sales spreadsheets had too few tick marks against investor names in the ‘committed’ column.
‘We believe there’s a 45 per cent probability of selling this sukuk’, stated the London-based head of the MENA sales team on yet another conference call to his structuring colleagues in Dubai. This time it didn’t just seem as if there was a continent separating the two teams, but that the colour of the sky, too, was different in the Islamic and conventional universes. ‘It’s too complex, it’s unprecedented. Investors won’t buy.’ And with that, Deutsche Bank pulled out of the arranging group, leaving a US$1 billion hole in the deal. Deutsche’s Islamic structurers were furious.
A visit by Barclays Capital’s chief Bob Diamond to the region seemed to step up efforts on the Barclays sales desk and before long they plugged the gap. When the deal was finally launched, DIB and Barclays sold the sukuk four times over to their investor base. With a total subscription of $11.4 billion, the issue size was raised from the initial requirement of $2.8 billion to a final issuance of $3.5 billion, and the bankers walked away with a cool $100 million in fees, a premium for cutting-edge work never to be repeated. The Islamic structurers from Deutsche Bank watched from the sidelines, the colour draining from their faces, as Barclays’ bankers were showered with newspaper column inches and industry awards.
It is said that history is written by the victors, and investment banking is no exception. Some years later when I worked at Barclays Capital, the bond specialists maintained their unswerving belief that they had structured the PCFC sukuk; and no better proof of this was their logo attached to the ‘tombstone’ announcing their deal in the press. And yet for some reason I found it remarkably challenging to explain to them the difference between a musharaka and a mudaraba.
PCFC was a watershed for the industry. Subsequent sukuk issuances were measured in the billions instead of the hundreds of millions of dollars. Convertible and exchangeable sukuk became the fashionable method of choice for large corporations and governments to raise capital. Deutsche learnt its lesson and gave in to its structurers’ pleas for dedicated Islamic sales specialists, at least for as long as markets boomed. When the credit crisis hit and sukuk – and indeed Islamic finance in general – came to be regarded as ‘a luxury the bank can’t afford’,8 the bank abandoned the market as abruptly as it had embraced it.