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  1. 1. Sukuk & Capital Market November 2012 Features Chapters Islamic PE & VC: Still Misunderstood? Secondary Markets Stalemate? Eastspring Al-Wara’ Investments The KLRCA: Dispute Resolution PP17808/06/2013(032740)
  2. 2. November 2012 1 editor’s note Supplements Nazneen Halim Editor Features Editor & Lauren Mcaughtry Copy Editor Senior Publishing Sasikala Thiagaraja Manager Copy Editor Roshan Kaur Sandhu News Editor Ellina Badri Journalist Lidiana Rosli Production Hasnani Aspari Manager Production Norzabidi Abdullah Editor Graphic Eumir Shazwan Kamal Bahrin Designer Senior Production Mohamad Rozman Besiri Designer Web Designer Aieda Zakaria Business Steve Stubbs Development Manager Direct Line: +603 2162 7800 ext 55 Subscriptions Musfaizal Mustafa Director Tel: +603 2162 7800 x 24 Subscriptions Adzli Arizal Ahmad Executives Tel: +603 2162 7800 x 63 Kughashinee Dewarajan Kughashinee.Dewarajan@REDmoney Tel: +603 2162 7800 x 23 Ratna Sari Ya’acob Tel: +603 2162 7800 x 38 Sivaranjani Sukumaran Tel: +603 2162 7800 x 41 Admin & Support Nurazwa Rabuni Executive Tel: +603 2162 7800 x 68 Deputy Publisher Geraldine Chan & Director Managing Director Andrew Tebbutt Managing Director Andrew Morgan & Publisher Published By: 21/F, Menara Park, 12, Jalan Yap Kwan Seng 50450 Kuala Lumpur, Malaysia Tel: +603 2162 7800 Fax: +603 2162 7810 DISCLAIMER All rights reserved. No part of this publication may be reproduced, duplicated or copied by any means without the prior consent of the holder of the copyright, requests for which should be addressed to the publisher. While every care is taken in the preparation of this publication, no responsibility can be accepted for any errors, however caused. The last year has seen unprecedented growth in the Gulf Sukuk market, with major issuances spurring its primary Sukuk market, and new entrants such as Turkey creating diversity in the issuance space. Although Malaysia currently dominates the global issuance table, making up 60% of global Islamic issuances, the challenge to attract cross-border investments and Middle East issuers still remains a hurdle in the country’s bid to create a dynamic and internationally attractive capital market. For any capital market to be successful, clear laws and precedence are important elements in attracting foreign issuers and creating a sustainable market. Past defaults and the current global economic environment has further pushed the need for transparency, proper regulations and clear-cut tax laws in order to attract major issuers and to create investor confidence in the market. Diversity amongst investors is also fundamental in avoiding too much concentration in one single geographical area to mitigate risk from an issuer’s perspective. Analysts have projected a continued rise in demand for Sukuk particularly in the infrastructure and project finance space; in the GCC, Arab Spring countries and Asia moving forward. Tapping the Sukuk market could help improve the capital structure and liquidity profiles of GCC and Asian companies, particularly those operating in capital-intensive industries such as infrastructure. It could also provide such companies the longer-term funding they need via a different funding source. This is expected to create more depth and substance in the Sukuk and capital market space, and also ties in with the need to tether Islamic finance to the real economy. In this issue of Islamic Finance news Supplements, we take a comprehensive look at the current Islamic capital market landscape; its issues and challenges, as well as the meteoric rise in capital market issuances. We also examine the secondary markets, which has seen development over the years, but still requires much more attention in order to create more depth and sustainability. The private equity and venture capital sector also take center stage in this issue; in which we question the habits and intentions of Islamic investors who are eager to reap the rewards but still shy away from risk. We hope you will find this issue an informative and enjoyable read. consulting Market resurgence Nazneen Halim, Editor
  3. 3. 2 November 2012 feature 25 The Islamic Fund Management Industry – Back to Basics The Islamic fund management sector is still grappling with fundamental challenges that could prove to be crippling to this nascent industry. chapters 13 A Bright Path Ahead The outlook is favorable for Sukuk issuance in Malaysia this year and in the future, as issuance is expected to continue to grow exponentially. 18 Sukuk Investing: Diversification for Resilient Performance The 2009 Dubai debt crisis erroneously gave the global investment community a poor impression of Sukuk (Shariah-compliant fixed income) investing. 22 Dispute Resolution: The Final Piece of the Puzzle With an eye on the growing complexity and internationalization of the Islamic finance market, The Kuala Lumpur Regional Arbitration Center (KLRCA) has become the first organization in the world to launch its i-Arbitration Rules; a dispute resolution mechanism specifically formulated for Shariah compliant transactions. 27 Diverging Models Shape The Growth Prospects for Takaful The growing need for insurance that complies with Shariah law means that the global Takaful sector is becoming an increasingly significant niche within the wider insurance industry. COVER STORY 4 Sukuk and the Islamic Capital Markets: Moving Forward As the Islamic capital market space sees new entrants and Sukuk issuances gain momentum in the Middle East and in emerging markets such as Turkey and Hong Kong, Islamic finance players look forward and seek to create a sustainable and credible Islamic capital market to capitalize on the influx of business. interview 8 Addressing Relevance Afaq Khan, CEO of Standard Chartered Saadiq shares his views with Islamic Finance news on the global Islamic capital market, and prioritizing for the future. featureS 11 Islamic Private Equity and Venture Capital: Still Misunderstood? Until issuers and investors alike accept risk sharing as a fundamental aspect of Islamic finance, the Islamic private equity and venture capital space will continue to struggle. 15 Secondary Markets Stalemate? Liquidity and the secondary market, or the lack thereof, in the world of Islamic finance, has been an issue of much debate for many years among industry professionals. contentscontents
  4. 4. 4 November 2012 Cover story Sukuk and the Islamic Capital Markets: Moving Forward As the Islamic capital market space sees new entrants and Sukuk issuances gain momentum in the Middle East and in emerging markets such as Turkey and Hong Kong, Islamic finance players seek to create a sustainable and credible Islamic capital market to capitalize on the influx of business. NAZNEEN HALIM explores the current issues in the market and challenges moving forward. Although Sukuk remains the buzzword particularly in Asia and the GCC, industry players have begun to place more emphasis on products and structures beyond the traditional debt capital market instruments, looking to incorporate Islamic finance into the real economy via project and infrastructure financing structures, increasing trade finance and syndication activity, and most importantly realizing the need to underpin Islamic finance transactions to real and tangible assets. For the last ten years, Sukuk has been one of the main drivers in the industry. However, industry players have been urged to take a macro perspective on the Islamic finance industry and help it find place in the global economy. As a result, the Arab Spring countries have taken center stage in the bid to venture into new, untapped markets with an opportunity to directly link infrastructure building and development to Islamic finance. UsmanAhmed, the head of corporate and investment banking at Citibank in the Philippines, believes that an important driver of sustainability in the market is the integration of Islamic finance within existing markets and the development of new products. The global financial crisis has also served as a wake-up call at the very least to the Islamic finance industry as a whole, creating further need for regulatory supervision, transparency in documentation and structures, as well as sound capitalization in the banking and financial system. As an instrument that allows medium-term capital raising, the popularity of Sukuk amongst capital market players—both Islamic and conventional— has become more prevalent. The growing desire for jurisdictions to issue sovereign Sukuk to diversify their investor pool and attract liquidity from the Islamic world is constantly reflected by the entry of new markets; with the most recent being Turkey, which had issued its debut US$500 million Sukuk, attracting over five times its initial issuance target. Malaysia leads the way Malaysia is currently touted as the most favored destination for issuers in the Sukuk market dominating 60% of the global share worth US$100 billion. This is primarily due to its deep and broad market with comprehensive regulations that ease Sukuk issuances, a favorable tax regime, a sophisticated investor base as well as support from all issuers, regulators and investors. However, the lack of an available platform in the Islamic capital markets outside of Malaysia and Saudi Arabia, as well as cross-border transactions involving swapping the ringgit to the currency of the issuer still remain a concern in the market. Cover story
  5. 5. November 2012 5 Cover story From a foreign issuer’s perspective, Sabri Ulus, the head of treasury at Bank Islam Brunei Darussalam, is full of praise for the Malaysian Sukuk market, particularly due to its government and regulatory support, as well as its “very sophisticated” investor base. He added: “There are also many Islamic financial institutions, regulatory organizations and standard-setting bodies. GCC entities come to Malaysia and issue ringgit Sukuk mostly due to the premium on cross-currency swaps, thus reducing their costs if they issue in Malaysia. The tax regime and regulatory environment is also very encouraging to foreign companies to issue in the ringgit market.” Afaq Khan (caricature below), CEO of Standard Chartered Saadiq believes that clear laws and precedence are key to the success of any capital market in attracting cross-border issuances; a feat Malaysia has achieved over a decade of fine-tuning its Islamic capital market laws. “It is always a big concern for issuers when they want to come to a new market to issue paper. Malaysia’s regulations make it easy for the Middle East issuers to come to a new legal jurisdiction, and the ringgit market remains the most liquid in the Sukuk industry, so Middle East issuers are confident they can meet their issue size requirements by coming to the ringgit market as opposed to going to any other regional currency.” However, he adds that the main drawback of the ringgit market is its failure to meet the requirements of most international issuers in terms of currency. “The need of the issuer isn’t exactly in the ringgit currency, and it has to be swapped back into the currency which the issuer can use in their day to day business. Sometimes you will see Sukuk issuances in the ringgit market go up, or some taper off. At the back of this there really is no concern. It is simple economics; once they (the issuer) swap into a currency they can use, can it still be considered a competitive financing for them? That is what drives the issuances from the Middle East to the ringgit market; when it is viable for them to competitively tap this liquid and growing market.” Another fundamental to Malaysia’s popularity as an up and coming jurisdiction for cross-border deals involving Middle East entities is its legal system, which is based on Common law. Saad Rahman, the executive director for global Islamic banking at Credit Agricole explains: “Most cross-border deals are based on English, New York or Texas law. As an issuer, you are looking for transparency of contracts, proper enforcement, and to seek satisfaction under the enforcement; and you get that under English law more than civil law. There is a precedence which exists in more codified forms of law. As an investor and issuer you want robustness of the contract and a legal jurisdiction that gives you comfort on both sides when it comes to a cross- border deal.” Badlisyah Abdul Ghani (caricature right), CEO of CIMB Islamic believes that it is imperative for the industry to take a step back and evaluate its position in the market. “Outside of Malaysia, the Islamic capital markets in other jurisdictions need to be aware of the need to chart greater growth in the future, and to create a platform that will ensure success. In my opinion, the infrastructure in the global Islamic capital markets is already there: with RegS and 144A regulations in place, however, from a jurisdictional perspective, it is unstable to rely on the global market at all times.” He added: “The framework is available and the liquidity is there. But as a nation, you do not have control over the global market, which creates instability. What we want as a player is to be able to go into a particular jurisdiction and to do transactions in the local currency. Because in the long-run, that would be more stable for issuers in terms of ability to tap the currency that they require in a particular jurisdiction. As CIMB Islamic try and facilitate issuers and issue Sukuk globally, we always advise the issuer to do it in their local currency first, then in US dollars. Outside of Malaysia and Saudi Arabia however, there is currently no local currency market.” Change in mindset It has been said time and again that Islamic investors are incredibly risk-averse, which in reality goes against the main tenets of Islamic finance which promotes the sharing of risk. This has proven to be a major drawback for the Islamic capital markets, especially in its bid to create a more equity-based issuance and investment environment. According to Usman, innovation and growth can only be achieved if the industry moves beyond fixed-income instruments and embodies the true spirit of Shariah financing; which involves the willingness to take up equity-type risk. “In the capital markets we have only just scratched the surface by relatively integrating Islamic finance with fixed-income instruments. However, we haven’t even explored truly asset- backed securities, infrastructure financing and equity-linked issuances. It is important to understand first what differentiates Riba from profit. It is the risk related to ownership; and therefore we have to take real risk, relate to ownership of assets. “We are still very far from the true spirit of Islamic finance, and that is exactly what is holding us back in terms of the development of new instruments. The whole world will open up to us if we are willing to take equity-type risk. Fixed-income Sukuk should just be seen as a means to an end. Issuers should be encouraged to do Sukuk issuances because then their equity will become Shariah compliant, and if they do a
  6. 6. 6 November 2012 Cover story debt on a Shariah compliant basis, they will be able to tap into a much bigger equity investor base that will come from the Islamic finance market. Islamic investments have to be coupled with risk-taking appetite.” Market challenges and moving forward The all-time low yields currently being experienced by Middle East issuers is seen as a catch-22 amongst some industry players. Although it has attracted an unprecedented number of issuers to the market, some worry that the market will become hollow once this low-yield run ends. Sabri notes that: “As a treasurer, it is important to keep in mind that although the cost of funding is very low today, it might not stay the same for the next five to ten years. This is worrying if you are tapping into the market with low-yield Sukuk. At present, most conventional issuers are shortening their borrowing from the market, because they can’t find investors, and even if they can, the price of the conventional bond is very high. For instance, Spain’s sovereign bond saw a pricing of 3% compared to Turkey’s debut sovereign Sukuk; which was below investment grade paper, but priced at 2.8%. On the other hand, it is encouraging to see the Sukuk investor base evolve to almost a 50-50 share between conventional and Islamic investors. We are seeing conventional pension funds and banks subscribe to Islamic paper mainly because for issuers, from a credit-rating and cash flow perspective, Sukuk is more reliable than the conventional or European issuances at present.” Although the recent impact from Dana Gas’ inability to meet its Sukuk repayment deadline on the 31st October for its US$1 billion issuance has yet to be thoroughly explored, industry players are clearly divided. On one hand, many believe that Dana Gas’ standstill with its creditors is just a mere hiccup in the Islamic finance capital market space, and on the other, some worry that this might have a spillover effect into the UAE Islamic issuance market and deflate any ambition of a market resurgence in the Middle East. Khalid Howladar, vice president/ senior credit officer at Moody’s believes that the market was already primed on the Dana Gas situation and a possibility of a default, in the several months leading up to the standstill; thus eliminating the shock factor which is usually the main reason for panic in the market. He said: “Dana Gas has been in trouble for a while, so it’s not really a shock. The market was already aware of the situation, unlike the Dubai World/Nakheel Sukuk— which was a bit of a surprise at that time. Broadly, the UAE market is recovering, and the economy is much better. So this is just a small piece of bad news in what is overall a much improved credit environment. So, I don’t think it is that significant. In terms of the Sukuk market, it’s not so much a negative signal about Sukuk, and it’s more about the company, so I don’t think it would affect the Sukuk market that much.” In terms of its effects on the credibility of the UAE credit market, Khalid believes that there are more pressing issues at the moment, including Dubai Holdings’ current financial woes: “There are still bigger problems outstanding such as the companies of Dubai Holdings that are under restructuring. It has been a year but there is still no resolution on that. That’s a much bigger story and in terms of exposure in the market, that will have more of an impact. This (Dana Gas) is relatively small at US$920 million and the banking system is well capitalized and liquid.” The lessons to be taken from this nail-biting experience, Khalid believes, are aplenty: “From an issuer’s perspective, companies need to look at their capital structure and take on debt based on solid cash flow projections. I think they need to take a more conservative approach to future cash flow forecasting to ensure that they can pay back all the debt borrowed and not be carried away by the boom times. Investors on the other hand need to study the company, their cash flows and the ratings they get, and make sure they understand the risks in the bond… such as, will the company be able to pay me back in bad times as well as good times? People need to do their due diligence in these investments to make sure that the company is in a strong position to pay back the money that they borrow.” As the market evolves and the industry becomes clearer of its goals and objectives, market players are becoming more perceptive of what investors want and what motivates bankers to become part of the growing global Islamic finance movement. “From an issuer’s perspective, their primary objective is to tap liquidity, build a profile with investors they haven’t really explored before, and ensure diversity of their funding base. At the heart of every Islamic capital market issuance is the desire to get core Islamic demand from issuing an Islamic finance transaction. Sustainability has to be driven by the ability and the increased participation of Islamic banks to anchor a transaction that is issued in a Shariah compliant manner,” said Usman. He added: “Transactions are substantially driven by demand from non-Islamic banks and conventional investors, and that should encourage more issuers to look at the Islamic market. It is primarily a case of investor demand driving sustainability.” According to Saad, it is important to bear in mind that the Islamic capital markets is far from isolated from the conventional space, and that Islamic finance exists in a greater credit model of global liquidity. “We are still working in a very much conventional environment and issues in this market have a direct impact on the Islamic finance industry. For instance, in terms of Sukuk, many times it is the conventional investor who drives the pricing down, and although this is to the benefit of issuer, it does not necessarily bode well for the Islamic investor looking to come into the deal. Islamic finance cannot be a standalone industry.” consulting Cover story
  7. 7. ASEAN RAtiNg ScAlE UNlEAShEd: locAl PERSPEctivE. gAiNEd:ExtENSivEANdPowERfUliNSightS. The ASEAN rating scale gives you a powerful perspective on the region’s financial markets. We’ve enhanced transparency, enabling you to compare credit quality, elevate your knowledge, and form your own opinions about risk and return. For over 150 years we’ve been providing powerful benchmarks to the global financial markets. Now we’ve taken this deep experience and focused it on the future – the future of integrated ASEAN markets. The analyses, including ratings, of Standard & Poor’s and its affiliates are opinions and not statements of fact or recommendations to purchase, hold, or sell securities. They do not address the suitability of any security, and should not be relied on in making any investment decision. Standard & Poor’s does not act as a fiduciary or an investment advisor except where registered as such.
  8. 8. 8 November 2012 interview Addressing Relevance Afaq Khan, CEO of Standard Chartered Saadiq shares his views with Islamic Finance news on the global Islamic capital market, and prioritizing for the future. Standard Chartered Saadiq, ever since its inception in 2004, has come leaps and bounds in the global Islamic banking and finance space. The bank, which has successfully remained on track in terms of fulfilling its clients’ needs and providing them with a complete suite of Islamic products for end-to-end solutions is also a major player in the Islamic capital markets space; having been involved in landmark Sukuk deals this year, including the Qatar Government’s US$4 billion issuance and Abu Dhabi National Energy’s RM650 million (US$213.07 million) innovative cross-border transaction. “This year we have had two significant milestones: we launched a global private banking business recently, and also launched the Islamic Euro Clearing Account in Turkey in September this year. This has been very well-received in the market, and we are constantly looking to expand by products, businesses and geographies. Overall, the journey has been very rewarding. We have a very cohesive, client- centric mandate to serve our clients, to offer a complete Islamic banking alternative product suite to meet the end-to-end requirements of our clients,” Afaq said. However, despite the bank’s many successes in arranging major Islamic capital market deals throughout the year, and a healthy deal pipeline moving forward, Afaq insists that the bank’s priorities extend beyond Sukuk. “Although Sukuk is a good proxy for the health of the industry, we should be very careful. It is not the only proxy. Islamic banking is an alternative to the entire conventional banking space. In the conventional banking space, nobody says that if the capital markets are down, then the entire banking system is down. The same applies to Islamic banking. Trade finance and syndication are also growing sectors.” “Sukuk in itself is an instrument that allows medium-term capital raising. As and when the clients need medium-term capital, they currently have three options: to do bilateral financing, go to the syndications market, or go to the Sukuk market. But that is only a small part of it, clients are constantly doing treasury activities, buying products, using Islamic banks, doing trade finance and cash management activities too,” he added. Afaq also warns that most of the Islamic capital market activity moving forward hinges on the global economy, and to an extent, the outcome of the Eurozone crisis. He said: “I am optimistic for next year’s issuances, but a lot depends on what happens to the global economy. This is because medium-term capital is raised for expansion or new projects, for restructuring and lowering cost of capital. And if everyone has refinanced and lowered their cost of capital, then there is no need for them to keep coming to the market.” Although Sukuk is a good proxy for the health of the industry, we should be very careful. It is not the only proxy interview
  9. 9. November 2012 9 interview What the market needs, Afaq says, are more players issuing paper in order to expand the current issuer base: “The market needs more players to issue paper. We were very excited that the government of Turkey had recently issued a sovereign, and I believe that Malaysia and Indonesia should become repeat issuers in the market, and new counterparts should also look to enter the Sukuk market. This is because banks have regulatory limits on how much exposure they can have to each client as a proportion of their capital. Therefore we need the issuer base to expand.” Islamic treasury: Area of focus Based on the current issuer and investor trend, particularly in the GCC and Malaysia, it is evident that there is ample liquidity to be tapped in the market, and there is still much Shariah compliant liquidity looking for Islamic assets to invest in. However, this can only be engaged effectively with the proper deployment of Islamic treasury products, including risk management. Afaq explained: “We are very focused on risk management, because I believe it is very important to manage risk as the industry grows in size and scale. In the real economy, Islamic banking is exposed to these risks, and it is important to keep in mind that derivatives are not for speculative purposes, and are essentially restricted to hedging purposes. Risk management is a very important catalyst to the growth of Islamic finance as the product suite grows and the gap between conventional and Islamic finance is breached. Innovation and product development will remain a key growth driver for the next decade for Islamic banking. For us to become relevant to the needs of society and the economy, we must meet the needs of society and the economy.” According to Afaq, there are currently two types of treasury products in the market; one is for the money-market, in which Malaysia has taken the lead in terms of having a complete product suite, and was generally a pioneer in this area with support from Bank Negara Malaysia. “The progress is good in this area, as a lot of other countries such as the UAE and Pakistan have now started issuing money-market products, and the International Islamic Liquidity Management Corporation (IILM) has also begun work in this area. These are all important initiatives.” “Because we operate in the real economy, we are exposed to the risks in the real economy whether it is exchange rate risk, yield curve risk, etc.- these are facts of the economy. And this is true from the perspective of the bank’s balance sheet and our clients’ viewpoint; because our clients are also exposed to these risks and need to hedge them. We currently have a comprehensive product suite covering currencies, rates and commodities hedging solutions. I believe these are important for the corporates, because we are offering them end-to-end solutions, and for Islamic banks, because they are growing in size, and becoming material to the banking system in the country. Therefore, they must have risk management tools to manage the risk. For instance, Malaysia’s Islamic banking sector currently stands at 20%, and there are aspirations to double this figure. However, this cannot be done without risk management tools. We are very focused on this, and it is essential to the growth of the Islamic market, where we have balanced growth, with business and risk going hand in hand,” he added. Industry initiatives Afaq believes that the industry is currently already committed to grow Islamic treasury and risk management products, with the International Islamic Financial Market (IIFM) actively involved in drafting standardized commodity Murabahah, and profit-rate swap documents. “Standard Chartered was on the working committee for these standards, and as the market grows, these standards will start as best practice, and then the market will use them as the base document and either adopt them or tweak them based on local norms and local regulations. It is a very good start. We believe that this whole area needs more attention and more exposure.” New frontiers In terms of new markets, Standard Chartered has revealed its aspirations to tap into the African Islamic banking space in the medium-term. “The market is growing, and we are excited about the market there. There has to be a change in regulations in some markets, and we are currently studying the prospects there. To successfully launch in the country, you need a regulatory and legal framework in place. We are currently talking to different stakeholders in Africa, and as Standard Chartered is very client-centric, we will choose which products to launch based on the feedback we receive from the clients.” Afaq also believes that there is much potential amongst the Arab Spring countries such as Egypt and Libya. There is a great opportunity for these countries to rebuild, and Islamic banking is looking for new markets. Therefore, it appears to be a perfect match. What timeframe the regulations will be passed and how welcoming they will be in terms of giving licenses remains to be seen; but clearly there are opportunities due to their proximity to the Middle East and a common language.” consulting Afaq Khan Chief executive officer Standard Chartered Saadiq Building One, DIFC Gate Precinct Dubai International Financial Centre Dubai, UAE Email: Web: I believe it is very important to manage risk as the industry grows in size and scale saadiq
  10. 10. Leaders in Financial, Technical and Product Training for the Islamic Financial Services Industry. For more details, contact us: Tel: +603 2162 7800 Fax: +603 2162 7810
  11. 11. November 2012 11 feature Islamic Private Equity and Venture Capital: Still Misunderstood? Until issuers and investors alike accept risk sharing as a fundamental aspect of Islamic finance, the Islamic private equity and venture capital space will continue to struggle. NAZNEEN HALIM studies the prospects of this virtually non-existent sector and its potential contribution to the Islamic finance industry as a whole. At present, industry experts unanimously agree that investments in private equity and venture capital in the Shariah compliant universe are almost zero. Despite the myriad of family-owned businesses and start-ups in Islamic finance strongholds in the Middle East and Asia, investments in Islamic private equity have been dismal to say the least. Opportunities in this sector also extend beyond these two regions, into countries such as Germany where SME businesses and start-ups are well-regulated and a common phenomenon. Considering the continuous calls for Islamic liquidity and investments to be channelled into real economic activity, and for the sharing of risk and rewards in a Shariah compliant transaction, it is ironic that this sector remains dormant as private equity and venture capital investments are the perfect fit for the Shariah compliant investment universe. Amongst the most common structures prescribed for investing in Islamic private equity and venture capital are Mudarabah, Musharakah and Wakalah. These structures involve profit sharing (Mudarabah), partnership between two parties (Musharakah) and the use of an agent to act on behalf of the principal (Wakalah). In a Mudarabah arrangement, a contract is made between two parties to finance a business venture. The parties are a Rab al maal (investor) who solely provides feature
  12. 12. 12 November 2012 feature the capital and Mudarib (entrepreneur) who solely manages the project. Ahmad LutfiAbdul Mutallip, a partner of global financial services and Islamic banking at Azmi & Associates, wrote: “This is akin to a conventional PE/VC, where there exists a relationship between the capital provider and the entrepreneur. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. In the event of a business loss, it should be borne solely by the capital provider, to the extent of the capital contribution while the entrepreneur will lose his time and effort. The key to a Mudarabah structure is the fact that the entrepreneur cannot be placed at risk to bear losses, unless proven negligent.” In Malaysia, the Securities Commission issued guidelines and best practices for Islamic venture Capital in March 2008, solidifying the regulator’s support for the sector. The guidelines specify the core requirements for establishing an Islamic venture capital corporation or an Islamic venture capital management corporation, and set out the best practices intended to assist such corporations in carrying out Islamic venture capital activities. According to the guidelines’ core requirements, the corporation must first be registered under the Guidelines for the Registration of Venture Capital Corporations and Venture Capital Management Corporations issued by the Securities Commission. In addition, all activities of the VCC and VCMC must be Shariah compliant, and an independent Shariah advisor must be appointed to ensure adherence to the Shariah. The Shariah advisor is also expected to disclose, on an annual basis, and declare to the board of directors of the Islamic private equity/ venture capital fund company that the Islamic private equity/ venture capital fund company is managed according to Shariah principles. The Shariah advisor is also expected to endorse any investment decision and to ensure that the activities of the investee companies remain Shariah compliant right to the point of full divestment. According to Lutfi, the four key considerations involving the investment into Islamic private equity/ venture capital companies include Shariah compliant documentation, financing and investment structures; Shariah compliant underlying assets and investments; legal documentation, which includes the powers of the Shariah advisor; and an express provision and understanding between the parties involved that any profit of the Islamic private equity/ venture capital fund company shall be based on returns from investment of the fund, with no guaranteed profit return and there should also be a provision for reinvestment of profits into the Islamic private equity/ venture capital fund company. What is needed now to create some sort of momentum in the Islamic private equity and venture capital space – apart from a change of mindset amongst Islamic investors – is regulatory support; particularly in ensuring transparency and proper regulation of these companies, the creation of attractive and innovative structures to encourage investments, the establishment of legal and regulatory frameworks, as well as guidelines specific to this sector across the board. consulting The key to a Mudarabah structure is the fact that the entrepreneur cannot be placed at risk to bear losses, unless proven negligent IFN has 1,768 active mobile users. Are you one of them?
  13. 13. November 2012 13 chapter Malaysia maintained its pole position with 71% of Sukuk issued, followed by Saudi Arabia with 15% . In addition, global Sukuk issuance in the first quarter of 2012 reached US$43.5 billion, up by an impressive 55% from the corresponding period last year. According to Zulkifli Ishak, CEO of Eastspring Al-Wara’ Investments (formerly known as Prudential Al-Wara’ Asset Management), Malaysia will continue to lead the market as the world’s largest Sukuk center. The latest issue of Malaysia’s sovereign Sukuk earned a strong response and was oversubscribed by almost five times. At the same time, there has been a marginal downside to Sukuk in that there are default cases in Malaysia and other countries. But these isolated cases are not likely to dampen sentiment for Sukuk in future. Elaborating on this, Zulkifli says: “Standing true to Islamic principles, Sukuk are perceived to be ethically protected from turning bad. However, when Sukuk defaults were scrutinized by the practitioners and academicians, concerns were raised on the reliability of their structures and Shariah supervision. This has created the perception that Sukuk may not be any safer than conventional bonds in terms of investor protection and the treatment of defaults.” On a brighter note, unlike the high profile default and near- default cases in the Middle East, Malaysia’s Sukuk defaults have received less criticism and scrutiny from global industry players. Some reasons for this are Malaysia’s robust supervisory structure, established governance and disclosure standards; and the highly developed legal framework and court system which provide the necessary protection and comfort to investors. A Bright Path Ahead The outlook is favorable for Sukuk issuance in Malaysia this year and in the future, as issuance is expected to continue to grow exponentially. External economic shocks such as the Eurozone crisis are not likely to affect the domestic Sukuk market due to ample liquidity, but will have an impact on the international capital markets. chapter
  14. 14. 14 November 2012 chapter A default occurs due to the breach of binding obligations under the original terms of the agreement between the issuer and the Sukukholders. Both contractual parties must fulfill their obligations under the contract or agreement. The level of investor protection provided by a Sukuk structure is a factor in credit assessment, but from a rating perspective, assessing the issuer’s inherent credit strength is fundamental to the final rating outcome. In other words, the financial and operating outlook of the Sukuk issuer highly affects the final rating on the Sukuk itself. The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) guidelines emphasize the difference between Sukuk and conventional bonds. These guidelines show that Sukuk does not represent a debt owed to the certificateholder by the issuer, so that the owners share the returns and the losses. De-mystifying Sukuk The most common Sukuk issued in Malaysia are Sukuk Musharakah and Sukuk BBA. Sukuk BBA were the Sukuk most issued in Malaysia in 2004, before the Malaysian Sukuk market got dominated by Sukuk Musharakah beginning 2006. Sukuk are not similar to bonds because the latter represents a debt obligation of the issuer. It is created to service the need for working capital or to re-finance existing debt, normally to be used in the transportation sector, especially in the shipping and aircraft sectors, real estate, construction, and also for petrochemical projects. Despite the wide variance in ratings, the default rate for Malaysian Sukuk in 2009 was relatively low at 0.46% . Between 1997-2010, there were 24 cases of Sukuk default. Most were mainly structured based on Murabahah and BBA contracts – 12 on Murabahah, 11 BBA, and only one on Ijarah. Industry experts maintain that Sukuk defaults in Malaysia will not pose a significant threat to the local capital market; however, they may have a slight impact on the overall reputation of Malaysia as the hub for global Islamic finance. “We are optimistic about the performance of Sukuk in Malaysia and the rest of the world. And we will highlight the positive points of diversification to our investors,” concluded Zulkifli. According to Securities Commission Malaysia, total outstanding global Sukuk amounted to US$243 billion as at June 2012, with Malaysia continuing to be in the forefront of the market. consulting Zulkifli Ishak Chief executive officer Eastspring Al-Wara’ Investments Berhad (formerly known as Prudential Al-Wara’ Asset Management Berhad) Level 12, Menara Prudential, Jalan Sultan Ismail, 50250 Kuala Lumpur, Malaysia Tel: +603 2072 8808 Web: chapter
  15. 15. November 2012 15 feature Secondary Markets Stalemate? Liquidity and the secondary market, or the lack thereof, in the Islamic finance industry, has been hot on the lips of industry players since the inceptionoftheIslamiccapitalmarkets.Alacklustersecondarymarket has had an effect on the overall growth of the industry, particularly in the long-term, NAZNEEN HALIM discovers. The Islamic investor is known for his penchant to buy-to-hold papers to maturity, which is perhaps one of the main reasons for the current tepid movement in the secondary markets. Driven by the mechanics of supply and demand, pricing in the Islamic secondary market has also been relatively disappointing as the buy-to-hold mentality and a limited diversity of Sukuk investors have inhibited efficient price discovery. Despite efforts from central banks such as the Central Bank of Bahrain and Bank Negara Malaysia to drive secondary market growth – through the issuance of short-term paper and the establishment of the International Islamic Liquidity Management center, which is meant to facilitate more efficient and effective global liquidity management solutions for Islamic financial institutions and to create greater cross-border investments; the money market has yet to truly yield the results of these efforts. In a paper by the IMF entitled: “Islamic bond issuance – what sovereign debt managers need to know” it was suggested that the development of a liquid secondary market will depend on Shariah compliant short-term liquidity facilities and Sukuk as an interbank money market instruments. It said: “Given the current short-term nature of bank liabilities, the creation of money market instruments, and asset securitization with shorter maturities should help to encourage a secondary market for Sukuk. Although Islamic banks are currently one of the largest buyers of Shariah compliant products (with long maturities), they would benefit most from issues at shorter tenors. feature
  16. 16. 16 November 2012 feature Short-term Sukuk could serve as money market instruments for liquidity management purposes. Malaysia and Bahrain are the only Muslim countries that have developed an active interbank market. Since 2001, the Central Bank of Bahrain has issued short-term Sukuk of either three- or six-month maturities (in addition to medium- and long-term notes). In the GCC, 20% over-subscription for these Sukuk indicates the substantial demand for a Shariah compliant interbank market. In Malaysia, similar considerations apply to Government Investment Issues (GII) and Bank Negara Malaysia Negotiable Notes (BNNN). Alternatively, banks can resort to asset securitization in order to transform the proceeds from Islamic contracts into customized capital market securities with variable maturities. One such transaction was completed in July 2005 by Cagamas, the National Mortgage Corporation of Malaysia, when it issued the first Islamic mortgage-based securities as Mudarabah bonds with varying returns and maturities, ranging from three to 20 years.” A silver lining to have emerged this year is the increased utilization of Sukuk for the funding of project finance and infrastructure development in Asia and the Arab world. Issuers are also beginning to look into new, previously untapped markets to access Islamic liquidity and plug the demand gap for more Shariah compliant paper linked to the real economy. An industry player based in Dubai revealed that at present, there is simply not enough Shariah compliant paper in the market to fulfil investor appetite, and that issuances from highly-rated issuers and sovereigns are still few and far between. “The outcome of this is that Islamic investors are unable to purchase enough Sukuk, and this supply and demand imbalance has caused Sukuk-holders to feel unwilling to trade out of a position for fear of not finding another Sukuk of similar credentials to invest in,” he said. A difference in opinion amongst scholars with regards to the Shariah compliance of Islamic paper and their acceptability has also been a reason for the lack of cross-border trading across jurisdictions, causing a lack of diversity amongst investors and creating a homogenous and largely domestic trading environment. Dominic Harvey, project finance partner at Vinson & Elkins, and Barry Cosgrave, finance associate at the same firm wrote in a paper: “Barriers to secondary market trading are not the result of a lack of effective valuation alone; there are also other considerations relating to differences of opinion among scholars as to the acceptability or not of certain structures. It is possible that certain investors shy away from secondary market trading because of a lack of clarity as to the acceptability or not of the transaction structure employed. Were a scholar to rule against a particular structure, and a secondary market trade to be sought to be unwound, it would cause huge complications both on a practical level and from the point of view of market reaction.” A lack of mark to market (MTM) valuations for Sukuk, which became apparent over the last few years as a result of the restructuring activities in the Middle East has also impacted the Islamic secondary market. Harvey and Cosgrave wrote: “As balance sheets became distressed over the past few years and options to restructure were being explored, one of the factors that caught a number of restructuring advisors from conventional markets off guard was this lack of MTM valuation. This led to difficult conversations with certain creditors when ‘hair cuts’ were being discussed. A lack of MTM valuation also impacts secondary markets as it does not establish any sort of profit-making opportunity for traders. Without effective valuation of Sukuk there is no way to establish a market and as a result trading does not happen.” The growth of the Islamic secondary market requires a collective effort amongst all the stakeholders of the Islamic finance industry; from central banks propagating high-quality short-term paper and encouraging the growth of the inter-bank money market, bourses working to encourage trading through Shariah compliant trading platforms, standardization and agreement amongst scholars to create universally accepted papers to increase investor diversity on a global scale, and the creation of effective risk management tools to engage the otherwise risk-averse Islamic investor. consulting feature
  17. 17. IFN FORUMS 2013 • IFN Indonesia Forum 15th & 16th April • IFN Europe Forum 21st & 22nd May • IFN Africa Forum 27th & 28th June • IFN Asia Forum 21st & 22nd October • IFN Saudi Arabia Forum 18th & 19th November The most recognized brand in the Islamic finance events sector, the IFN Forum, returns in 2013 with an extended agenda. In addition to the 8th IFN Asia, the 3rd IFN Europe, the 2nd IFN Indonesia, and the 2nd IFN Saudi Arabia – in 2013 we will host the inaugural IFN Africa Forum. The renowned ‘Issuers & Investors’ format will again feature at all IFN Forums ensuring both buy-side and sell-side are fully incorporated in these two day events. With complimentary delegate passes for all issuers, investors, regulators and other senior and relevant key practitioners, the IFN Forum series provides you with opportunities no other events can. Through a series of exclusive regulatory and country presentations, practitioner-led round- table discussions, non-debatable power presentations, original case studies and sector focused side sessions; the IFN Forums in 2013 will again be the key, must-attend industry events for issuers, investors, regulators and all financial intermediaries involved in the Islamic financial markets with any interest in tapping the Islamic markets.
  18. 18. 18 November 2012 chapter Sukuk Investing: Diversification for Resilient Performance The 2009 Dubai debt crisis erroneously gave the global investment community a poor impression of Sukuk (Shariah-compliant fixed income) investing. Having fully recovered from this, the Sukuk market performance has proved resilient for the past two years. Sukuk investing not only enhances potential returns relative to conventional fixed income investing but also reduces portfolio volatility. This article will shed light on how Sukuk investing offers diversification benefits by examining the investment universe, sector weightings and country spread. It will conclude with a case study of how investors who have limited themselves to investing in the conventional fixed income asset class can definitively add value to their portfolios by allocating a portion to the Sukuk investment universe. The Dow Jones Sukuk Index (DJSI), designed to measure the performance of global Sukuk, comprised merely seven constituents when it was first introduced in October 2005. At that time, the index lacked breadth and depth in comparison to the conventional bond index, the World Broad Investment Grade Bond Index (WBIG). The 2008 global financial crisis and 2009 Dubai debt crisis were the first real tests for Sukuk. The combined headwinds proved damaging to the nascent Sukuk market and several issuances slumped to their lowest level during these crises. However, in spite of the challenges, or because of them, the Sukuk investment universe has staged a strong comeback since 2009, and has reestablished itself as a vibrant and attractive new asset class today. The DJSI has not only improved from the unimpressive performance of its five and seven-year returns, but it also went on to produce superior returns by outperforming the conventional index over a two-year time period as at the end of September 2012. Table 1: Annualized returns of DJSI and WBIG Annualised Returns 2-year 5-year 7-year Dow Jones Sukuk Index 6.27% 4.87% 4.63% World Broad Investment Grade (WBIG) Bond Index 4.52% 5.55% 5.17% Source: Bloomberg and CIMB-Principal Islamic Asset Management as at end-September 2012. Repeat of the Dubai debt crisis unlikely With Dubai and state-controlled Dubai corporates being early entrants as issuers in the Sukuk market, Dubai’s 2009 crisis reverberated forcefully into the Sukuk space. With the onset of the global financial crisis that adversely affected economies everywhere, Dubai’s real estate market declined after a six- year boom. On the 24th November 2009, state-controlled Dubai World rattled financial markets by announcing that it was seeking to delay payments on US$59 billion of debt1 . The collapse of the real estate market in Dubai severely affected the mortgage sector and hence, the broader Dubai economy. Uncertainties surrounding how the Sukuk securities would fare, caused many global investors to flock to what they viewed as the comparative safety of conventional fixed income. However, investor fears in the 2009 Sukuk market proved to be unfounded. Dubai did not actually default on its public debt. In fact, Dubai received financial assistance from Abu Dhabi, the ‘patriarch’ of the UAE. In similar fashion to what investors had seen related to the global banking firms a year earlier, Abu Dhabi stepped in to support Dubai with a US$20 billion bailout2 . Following the extension of financial support to Dubai from Abu Dhabi, the Government of Dubai made concerted efforts to strengthen its banking system by implementing a scoring system to evaluate individual borrowers’ creditworthiness. In addition, the Gulf Cooperation Council (GCC) banks have made a variety of efforts to strengthen their balance sheets to protect against declines in loan recovery rates and asset prices. The banks’ tier 1 capital adequacy ratios have steadily increased over the last four years and were in the region of 15% at end-2011. More importantly, equity forms the bulk of the banks’ capital base, and their equity-to-assets ratios are high, ranging from 10% in Bahrain to 16% in Qatar3 . 250 200 150 100 50 0 9/30/2005 9/30/2006 9/30/2007 9/30/2008 9/30/2009 9/30/2010 9/30/2011 9/30/2012 Source: Bloomberg Chart 1: Sept 2005 — Sept 2012 (7 years) DJSI WBIG Dubai crisis
  19. 19. November 2012 19 chapter Global Sukuk makes a high quality recovery The DJSI has recovered completely from the crisis. The index has matured with respect to both the quality and quantity of its constituents. This has led to markedly lower volatility given the higher creditworthiness of the investment universe. The returns volatility of the DJSI has fallen significantly to 2.08% for the two-year period compared to the five and seven-year periods of 10.13% and 8.58% respectively. At 2.08% the return volatility in the Sukuk space is less than half of that in the conventional space over the same period, which registered at 5.16% for the WBIG. This lower volatility is coupled with a tripling of the number of constituents in the index, meaning that a severe fluctuation of any one constituent has less singular effect on the overall index. Table 2: Returns volatility of DJSI and WBIG Returns Volatility 2-year 5-year 7-year Dow Jones Sukuk Index 2.08% 10.13% 8.58% World Broad Investment Grade (WBIG) Bond Index 5.16% 6.29% 5.99% Source: Bloomberg and CIMB-Principal Islamic Asset Management as at end-September 2012 A further examination of the DJSI’s returns reveals a significant increase in the Sharpe Ratio, a measure commonly used to better analyze performance by taking risk into consideration. A portfolio with a higher Sharpe Ratio is considered to have exhibited better performance as the Sharpe Ratio measures how well the return of an asset compensates the investor for the risk taken. The Sharpe Ratio for the DJSI is 2.96 over the most recent two year period, versus 0.47 and 0.53 over the five and seven-year periods respectively. In contrast, the Sharpe Ratio of the WBIG remained similar over the two, five and seven-year periods at average of 0.86. Therefore in examining the quality of the Sukuk index performance while considering both return and risk, we find that its superior performance is further enhanced with lower volatility and a higher Sharpe Ratio. Table 3: Sharpe ratios of DJSI and WBIG Sharpe Ratio 2-year 5-year 7-year Dow Jones Sukuk Index 2.96 0.47 0.53 World Broad Investment Grade (WBIG) Bond Index 0.87 0.87 0.85 Source: Bloomberg and CIMB-Principal Islamic Asset Management as at end-September 2012 Sukuk investing offers an enlarged investment universe Unlike Shariah compliant equity investing, which is a subset of global equity, Sukuk is a unique investment space that enlarges the existing conventional fixed income investment universe to grant conservative investors attractive opportunities in a completely separate class of fixed income assets. The number of constituents in the DJSI has tripled in two years, largely due to active participation by governments and corporations that have facilitated numerous Sukuk offerings. The number of constituents in DJSI has increased from 13 (in June 2010) to 36 (as at the end of September 2012)4 . In addition, the constituents of the DJSI have similar ratings to those of the WBIG. Both indices require a minimum quality of ‘BBB-‘ or ‘Baa3’ by the rating agencies5 . Moving forward, we anticipate that more issuers will participate in the Sukuk market. Today Sukuk investors are seeing several first time issuers come to issue in their market. For instance, the Republic of Turkey issued a US$750 million benchmark issuance in September with Citigroup and HSBC included as bookrunners. Further, following on the sovereign issuance, Turkey’s Sukuk market is gathering even more momentum as companies from the national airline to the biggest telephone operator plan Sukuk offerings6 . Sukuk investing offers strong international diversification The performance of the DJSI has remained resilient despite political unrest in pockets of the Middle East. The stability of the index is a reflection of the geographical diversification it offers. The sovereign representation of Sukuk issuers in the DJSI leads with Malaysia, and is followed by Saudi Arabia, Qatar and Indonesia. Table 4: Percentages of sovereign debt in Dow Jones Sukuk Index Country Percentages Malaysia 17.08% Saudi Arabia 16.21% Qatar 13.60% Indonesia 6.04% Dubai 5.53% Abu Dhabi 3.60% Total 62.06% Source: Bloomberg and CIMB-Principal Islamic Asset Management In addition to the benefits of diversification, these jurisdictions have strong macroeconomic fundamentals and offer exposure to oil and gas-related revenue streams which offer deep reserves support to issuers. In addition, more than 60% of the investment universe of DJSI is comprised of investment grade Sukuk from countries which may not register significantly, if at all, inside the conventional index. Sukuk investing offers Shariah compliant exposure to financials Investment exposure to the financial sector is considered a proxy for the growth of an economy since banking prospers with an economic expansion. However the Shariah compliant equity portfolio will typically filter out the financial sector, as they tend to be conventional banking and financial services entities. Shariah-sensitive investors who want exposure to the financial sector can still access the sector through the Sukuk asset class. Below are the sector weightings of both indices:
  20. 20. 20 November 2012 chapter Table 5: WBIG and DJSI Sector Weightings Weightings (%) Sector Dow Jones Sukuk Index World Broad Investment Grade (WBIG) Bond Index Government and governments sponsored 53.47 68 Financials 29.42 5.33 Utilities 6.30 2.31 Industrial 5.53 6.35 Energy 5.28 1.00 Collaterised (MBS and Covered Bonds) 0 17 Source: Bloomberg and CIMB-Principal Islamic Asset Management as at end-September 2012 As shown in table 5, financials constitute the second-largest sector of about 30% in the DJSI. This is also an investment opportunity for conventional investors who want to diversify the quality of their overall portfolio’s exposure to the financial sector as they can gain exposure to Islamic banks such as QIB Sukuk Funding (Qatar), IDB Trust SVCS (Saudi Arabia) and Abu Dhabi Islamic Bank (UAE). Case study: Sukuk investing as a diversification strategy The benefits of diversification with Sukuk securities is not just theoretical, it is demonstrable. For example, one can examine the results of the following two scenarios to determine if investing in Sukuk serves as a good diversification strategy without compromising investment returns: 1. One portfolio which tracks the conventional index com- pletely, and 2. A second portfolio which is split, whereby 20% tracks the DJSI and 80% tracks the conventional index For the two-year period ending the 28th September 2012, the annualized returns of the second portfolio resulted in a slight enhanced return of 4.88%, versus 4.52% in the first portfolio. In addition, the second portfolio’s Sharpe Ratio was increased significantly to 1.14 versus 0.87. Table 6: Two-year returns and Sharpe ratios improved with 20% Sukuk allocation Annualized returns Sharpe Ratio Portfolio 1: 100% tracking the World Broad Investment Grade Bond Index 4.52% 0.87 Portfolio 2: 20% tracking the Dow Jones Sukuk Index and 80% tracking the World Broad Investment Grade Bond Index 4.88% 1.14 Source: Bloomberg and CIMB-Principal Islamic Asset Management as at end-September 2012 Given low yield markets worldwide, a 36 basis points differential in and of itself is not an insignificant improvement. Equally as important, the improvement in the Sharpe Ratio shows that the strategy can generate alpha or additional returns that better compensate for risk. Conclusion As one can see, investment exposure to Sukuk can offer diversification benefits. In addition, prices of Sukuk generally hold up well by virtue that they are often treated as a ‘buy and hold’ investment. This grants an additional layer of insulation against volatility relative to conventional fixed incomes. With additional information and enhanced knowledge, investors are becoming more comfortable with Sukuk investing. One of the most convenient and easiest ways to access the Sukuk asset class is via a fund which invests in diversified portfolio of global investment grade Sukuk such as the Al Hilal Global Sukuk Fund. Launched in early 2012, the Al Hilal Global Sukuk Fund has delivered a strong performance of 4.3% in only six months since its March debut. The fund invests in a diversified portfolio of Shariah compliant Sukuk issued by sovereign, quasi-sovereign and corporations and aims to generate regular income as well as capital appreciation. There are clear signs that the Sukuk market is maturing and spurring a growing interest in gaining investment exposure to the asset class. Over the two-year period, we found similar investment results with lower volatility compared to the conventional fixed incomes. These similar investment results also showed a clear improvement in the Sharpe Ratio over the conventional index. Closer examination of the Sukuk investment space revealed further diversification benefits for investors who have until now only invested in the traditional fixed income space. From its ability to enlarge the total fixed income investment universe to offering international diversification with credit quality and Shariah compliant financial sector exposure, there is evidence which shows that diversifying a portion of one’s overall investment portfolio to Sukuk investments away from traditional fixed income will show an improvement in the Sharpe Ratio without diminishing investment returns. consulting Endnotes: 1 Source: Dubai World Seeks to Delay Debt Payments as Default Risk Soars 2 Source: After Crisis, Dubai Keeps Building, but Soberly from the NY Times on the 29th September 2010 3 Source: Middle East Credit Compendium 2012 by Standard Chartered Bank dated 2nd May 2012 4 & 5 Source: Bloomberg 6 Source: Sukuk Taking Flight as Airline Readies Debut Sale: Turkey Credit by Bloomberg dated 3rd October 2012 CIMB-Principal Islamic Asset Management Level 5, Menara Milenium, 8, Jalan Damanlela, Bukit Damansara 50490 Kuala Lumpur, Malaysia
  21. 21. November 2012 21 chapter Ramlie Kamsari Deputy Chief Executive CIMB-Principal Islamic Asset Management Email: Michael S. Zorich, CFA Chief Investment Officer CIMB-Principal Islamic Asset Management Email: CIMB-Principal Islamic Asset Management (CIMB-Principal Islamic) is a dedicated Islamic global institutional asset management house, combining the strength of 2 credible shareholders. The joint venture between CIMB Group and Principal Global Investors allows CIMB- Principal Islamic to leverage on the compelling global Islamic credentials of CIMB Group (via CIMB Islamic) while Principal Global Investor’s lends its expertise in global asset management. CIMB-Principal Islamic won Best Overall Islamic Asset Management Provider of the Year 2012, Best Islamic Asset Management Company in Asia, and Best Institutional Solutions Provider of the Year 2012 by Islamic Finance News Awards - Islamic Investor Poll 2012. At the International Takaful Awards 2012 (London), the company was awarded The Best Asset Management House in Asia for the third year in a row and also earned the Islamic Asset Management House of the Year by The Asset’s Triple A Islamic Finance Awards 2012. Headquartered in Kuala Lumpur, Malaysia, the firm is strategically located in the world’s first country with a complete Islamic financial system operating in parallel to the conventional banking system. This allows the firm to leverage on Malaysia’s comprehensive Islamic financial infrastructure and its adopted global regulatory, legal and Shariah best practices. Ramlie Kamsari, Deputy Chief Executive Tel: +603 2084 2289 E-Mail: CIMB-Principal Islamic Asset Management Level 5, Menara Milenium, 8, Jalan Damanlela, Bukit Damansara 50490 Kuala Lumpur, Malaysia Michael Zorich is the chief investment officer of CIMB-Principal Islamic Asset Management (CIMB-Principal Islamic). He is responsible for establishing and implementing investment strategies for the firm’s clients and overseeing the performance of both global Islamic equity and global sukuk portfolios. A seasoned fixed income professional with a strong credit background, Zorich has worked in tandem with portfolio managers in the management of multi-sector portfolios. Previously, he was managing director, special assets, for Principal Global Investors (PGI) Fixed Income. As the head of special assets group, he was responsible for negotiations with distressed companies and the oversight of the analysis, valuation and restructuring of all distressed debt in PGI’s fixed income portfolios. Zorich joined PGI in 2001. Prior to that, he was a senior associate at PrimeSolutions Capital Corporation. Zorich is a Chartered Financial Analyst (CFA) and a member of the CFA Institute. He obtained his Masters in Business Administration (MBA) from Carnegie Mellon University and his Juris Doctor (JD) from the University of Pittsburgh, School of Law. He is a member of the Pennsylvania Bar and has a Bachelor’s Degree in Business and Communications from the University of Pittsburgh. Ramlie Kamsari is the deputy chief executive of CIMB-Principal Islamic Asset Management (CIMB-Principal Islamic). As the head of global sales & marketing, he also drives and oversees the global institutional sales of CIMB-Principal Islamic’s full range of Islamic funds to institutional investors in Europe, Middle East and Asia. His responsibilities include implementing successful sales efforts which targets relevant institutions and third parties, as well as identifying new business opportunities and driving transactions through to the close. Since joining CIMB Group in 2004, he has held several senior positions, including CEO and head, institutional sales of CIMB Futures and CEO and director of CIMB Insurance Brokers. He was also director and head, Islamic equity markets & derivatives of CIMB Investment Bank. Ramlie has extensive experience in the global financial industry, spanning over 18 years across major financial markets and covering the areas of global sales, advisory services and deal executions of capital market products, derivatives products, risk transfer solutions, and most recently, Shariah investment products. In Singapore, his previous stints include Barings Futures, Daiwa Co. and Refco Investment Services. Prior to joining CIMB Group, he was vice president and head of global services at FIMAT, the global derivatives trading division of Societe Generale. He holds a Bachelor of Commerce from the University of Western Sydney and a Graduate Diploma in Financial Management from the Singapore Institute of Management. Profile
  22. 22. 22 November 2012 chapter Dispute Resolution: The Final Piece of the Puzzle With an eye on the growing complexity and internationalization of the Islamicfinancemarket,TheKualaLumpurRegionalArbitrationCenter (KLRCA) has become the first organization in the world to launch its i-Arbitration Rules; a dispute resolution mechanism specifically formulated for Shariah compliant transactions. Islamic Finance news speaks to Sundra Rajoo, director of the KLRCA on this cutting-edge idea and its role in pushing the industry to new heights. The Islamic finance industry is fast attaining a globalized status; taking a more international approach in the structuring of products and contracts, and through the proliferation of cross- border transactions amongst issuers and investors. Although Malaysia is considered to be one of the most sophisticated jurisdictions in terms of regulations and resolving contractual disputes for Shariah compliant transactions, based on Bank Negara Malaysia’ Shariah Advisory Council’s rules established by the Central Bank Act 2009 and the Shariah council established by the Securities Commission under the Securities Commission Act 1993, the country’s dispute resolution capabilities can still be considered insular, as the judgment of the courts are only enforceable in Malaysia. Although the practice of alternative dispute resolutions for Islamic finance contracts are becoming more common in civil and common law courts, the system is far from impervious to further dispute. Issues with ambiguity concerning the language used in the contract, and in some cases the constitutional limitations imposed on judges to interpret laws derived from religious sources have all become prevalent issues in the legal decision making process. chapter
  23. 23. November 2012 23 chapter In a bid to create an effective and internationally enforceable set of rules for Islamic commercial transactions, and to increase the fluidity of cross-border transactions, the KLRCA’s i-Arbitration rules were launched as a set of procedural rules which cover all aspects of the arbitration process, allowing for the resolution of disputes from any contract or agreement containing Shariah issues. The rules, which are the first in the world to adopt the United Nations Commission on International Trade Law (UNCITRAL) Arbitration Rules, ensures international recognition, while taking into account Shariah principles. Essentially, it is the first set of arbitration rules that cater to both conventional and Shariah compliant transactions and contracts. The rules are also based on the 1958 United Nations Convention on the Recognition and Enforcement of Arbitral Awards, or the New York convention – the defining element within the i-Arbitration rules, according to Sundra. “The New York convention is a convention in which countries enter into and they agree to enforce foreign arbitral awards. This makes arbitration different from litigation, where the foreign court ruling of one country cannot be enforced in another country. It is so far the most successful convention in the history of mankind, and on the last count, involved 146 participating nations. Basically, if you are a serious business nation, you are already part of it. Our main challenge in structuring the rules was how to make it compliant with the New York convention to ensure its enforceability on a global level.” “The most elegant ideas are usually the most simple,” Sundra revealed; referring to the additional component- Rule 8, which is activated in the event of a dispute involving a Shariah compliant transaction. “The approach that the center has taken is that we have to provide an avenue when an item of such significance comes along, and see how it will be resolved in the arbitration. Rule 8 comes into effect when there is a Shariah dispute. The Shariah component is submitted to a Shariah Advisory Council or expert for an opinion, and when the opinion comes back, it is applied. For example, in a dispute involving Islamic financial instruments, parties and the arbitral tribunal may agree to refer the matter to Bank Negara Malaysia’s Shariah Advisory Council or the Malaysian Securities Commission’s Capital Markets Act- whichever is deemed relevant. In the instance of a situation involving a Shii’te dispute for example, the parties and the tribunal can appoint their own Shariah expert, as provided in the UNCITRAL Rule, under article 26. Therefore, parties will always be able to choose which Islamic school of thought (madhab) to apply to their dispute. ” Long-term view It is the internationalization of the Islamic finance market which spurred Sundra and his team at the KLRCA to formulate a dispute resolution mechanism based on international laws and acceptability before incorporating the Shariah element. “It is a cutting-edge product. It took us two years to come up with this, to deal with expert opinion and how it all ties together. A lot of people will start with Shariah as a base, but we decided to work from the New York convention and then incorporate the Shariah element.” “These rules can be used even when there is no Shariah component involved. Rule 8 only gets activated when a Shariah component comes into play. In Item 6 of Rule 8, it states that the ruling of the relevant council or the Shariah expert may only relate to the issue or question so submitted by the arbitral tribunal; and the relevant council or Shariah expert shall not have any jurisdiction in making discovery of facts or applying the ruling or formulating the decision relating to any fact of the matter which is solely for the arbitral tribunal to decide. Therefore, they (the Shariah council) can only decide on the Shariah component. It is the arbitral tribunal, not the Shariah Advisory Council or expert, who is the final determinant on the matter as the tribunal cannot delegate its powers to make decisions.” he added. “In the recent International Bar Association (IBA) Conference in Dublin, the question of how people are dealing with Shariah issues was raised, and to be honest, there is no experience outside of Malaysia except in limited pockets such as Dubai and Bahrain. The Malaysian system is so far the most comprehensive,” Sundra explained. Sundra believes that the best way to resolve disputes, particularly from a business point of view is through arbitration: “From my understanding, what is not forbidden is allowed in Shariah. Most of these Shariah compliant products are the ones that are allowed and not forbidden. And when you have those products, you are marketing to the world at large and therefore, there needs to be a dispute resolution mechanism because people will have disagreements. And for business people, resolution of those disagreements or disputes is best done through arbitration.” “For the first time, there is a viable dispute resolution mechanism for Shariah-compliant products. The Islamic world has not really explored international commercial arbitration, and after a certain point, there is a dichotomy between a religious and secular dispute system. In all honesty, business people do not want to go to the Shariah court, and prefer a legal secular system. A great deal of thought and care would have gone into putting together the complex and sophisticated Shariah- compliant deals and products, but if a business dispute arose, they would have to go to conventional arbitration. With the KLRCA i-Arbitration Rules, there is now an option for a dispute resolution mechanism that is Shariah-compliant, thereby putting the last block in place for a complete Shariah compliant transaction,” he concluded. consulting Sundra Rajoo Director Kuala Lumpur Regional Centre for Arbitration No.12, Jalan Conlay, 50450 Kuala Lumpur Tel: +603 2142 0103 Email: Web:
  24. 24. November 2012 25 feature The Islamic Fund Management Industry – Back to Basics The Islamic fund management sector is still grappling with fundamen- tal challenges that could prove to be crippling to this nascent industry. NAZNEEN HALIM explores. Although there are no current definitive figures, the size of global Islamic assets is estimated at around US$1.2 trillion, and is expected to grow at a rate of 10-15% in the next three years, according to industry forecasts. Despite standing at only 0.5% of conventional assets, Islamic assets are still looking to be managed and marketed effectively in order to mobilize the sector and to create an efficient global Islamic fund management industry. According to the 2011 Ernst & Young report on Islamic Funds and Investments, Islamic funds’ assets under management grew by 7.6% from 2010 to US$58 billion in 2011; with Sukuk, commodities and capital protected funds featuring as the investment modes of choice for the Islamic investor. However, it is hard to ignore the gap between total Islamic assets and total assets under management, particularly in high growth areas such as Asia and the Middle East. According to Raja Teh Maimunah, the managing director at Hong Leong Islamic Bank, Malaysia and Saudi Arabia still remain the top jurisdictions for the Islamic fund management industry, particularly due to regulatory efforts in providing screening services, especially in Malaysia. “Only Malaysia has a list of screened equities - and apart from Malaysia and Saudi Arabia, the Islamic fund management industry is still small and insignificant,” she said. “There are Shariah compliant equities in the Middle East which you simply do not have access to. And it becomes expensive to buy equities outside of Malaysia. From my experience in the Middle East, we had to hire experts to screen the stock; thus adding to the cost of the fund by 25 to 50 basis points (bps). We had to hire screening consultants to seek equities for us to invest in. Additionally, the channels for asset management are still difficult to access outside of equities. In the fixed income arena for example, the Sukuk market is still very much concentrated in Malaysia. Apart from the ringgit market, there is some activity in the MENA region. Investors are currently focused on equities and fixed-income products, whilst most of them post-crisis have moved to cash,” said Raja Teh. A recent comparison done between the asset allocation for the feature
  25. 25. 26 November 2012 feature conventional and Islamic markets by AmIslamic showed an almost identical breakdown in terms of investment preferences amongst conventional and Islamic investors - 25% in emerging market equities, 35% in global equities, 15% in global bonds, 20% in emerging market bonds, and 5% in alternative assets. The difference between the Islamic and conventional market lies in the need for investments in Shariah compliant alternatives, and the Islamic fund management industry will continue to struggle as long as there is a lack of Shariah compliant solutions in the market. In the equities space for instance, the report by AmIslamic said: “It is not possible to have an Islamic version available for every conventional (non Islamic) investment product/ strategy out there. For example, a typical equity asset allocation includes an allocation to Smart Beta and when it comes to the Islamic space, there are almost no Islamic Smart Beta funds available.” On the fixed income side, the report commented: “A global Sukuk fund will have significant exposure to emerging markets and minimal exposure to developed markets as there are hardly any Sukuk issues from developed markets. Therefore, it is not possible to get a global Bond fund’s geographical allocation with a global Sukuk fund. One of the solutions is to seek other alternatives that replicate the payoff of a Sukuk (periodic return and lower risk). We have developed an equity-based solution that exhibits lower volatility and yields periodic income (high dividend) to replicate the payoff profile of a Sukuk fund. This solution supplements the allocation to global Sukuk and addresses the geographical coverage/diversification issue.” Monem Salam, the president of Saturna Capital, highlighted the challenges currently facing the Islamic asset management industry: including limited opportunities in the cross-border space, higher fees and lack of competitiveness with the conventional markets: “Most Islamic funds are currently domiciled in Malaysia, and there is very limited opportunity for cross-border distribution of funds. The Malaysian Securities Commission is working hard to facilitate this with Dubai and Hong Kong, but there are many other markets fund managers are interested in. The opening up of other markets has to be done on a regulatory level. Second, fees tend to be much higher across the board in Asia compared to those in the west; particularly the US and Europe. If you can access an Asian fund in Europe which you can buy at less than a 1% expense ratio, then why would you come to Asia to buy the same product at 1.5 – 2%? We have to be competitive on a global level in terms of fees. Although the cost of running funds is a lot cheaper in Asia, expenses are lower in US and Europe.” In terms of Islamic exchange-traded funds, education still remains a key issue, says Mahazir Othman, CEO at i-VCAP. “The Islamic ETF market is still underdeveloped, and education is still a main concern. There also needs to be more understanding on how investors actually use Islamic ETFs in their portfolio to enable them to meet their investment objectives. The current mentality in Asia is: ‘Why do we need to go beta when we can do our own stock-picking?’ and most Asian investors are stock-pickers. Another challenge is product depth. There are currently not enough Islamic ETFs in the market for investors to asset allocate their portfolios using this instrument. It is important to get managers to roll out more products to address this challenge.” The ongoing debate on the use of derivatives to hedge risk in the Islamic finance space has also brought about challenges in the Islamic fund management industry; with the divide between the proponents of derivatives and those who disagree becoming more apparent. From a fund manager’s perspective, Monem believes that it is possible to avoid the use of derivatives all together, simply by picking the best stocks to invest in. “It depends on the mandate of the portfolio. When we look at the fundamentals of derivatives and their purpose, it is essentially to transfer the risk from you to someone else. Islamic finance is about sharing risk, whilst derivatives are about transferring risk. In Islamic finance, the gains and losses are shared. “The way you can fundamentally do that is by going back to the fundamentals of investments – i.e. plain vanilla structures. We have managed to provide our clients with high returns and low volatility investment products without derivatives, simply by buying companies that pay you back in dividends so you can utilize the gains in your portfolio, and by holding cash if you don’t like a certain investment. If you stick to the fundamentals, you will realise that the use of derivatives simply add cost to your portfolio and lower your returns - and that doesn’t really help. In the conventional space for instance, normal indexes actually outperform hedge fund indexes, so what is the point of doing that (derivatives) except for someone lining their pockets with money?” he added. It is absolutely vital for the Islamic industry to develop effective products with competitive returns to enable the efficient management of Islamic liquidity, in order to create a robust investment environment and attract more investors to ensure the health and sustainability of the Islamic capital markets. consulting Investment preferences amongst conventional and Islamic investors Emerging market equities 25% Global equities 35% Global bonds 15% Emerging market bonds 20% Alternative assets 5% There are Shariah compliant equities in the Middle East which you simply do not have access to
  26. 26. November 2012 27 chapter What’s fueling the growth of Takaful globally? Global Takaful growth was about 20% in 2011, although actual rates varied widely between regions. Sharp spikes in growth in countries such as Saudi Arabia were triggered by regulatory action to expand compulsory insurance covers, particularly medical insurance. For Asia, the family sector was boosted by the customers’ needs and growth of agents and bank channels distribution. Is such growth sustainable? We expect to see generally strong growth over the long-term, however, we don’t anticipate that the sector will sustain 20% growth over the next few years, given the stuttering global economy and the relative maturity of some of the larger Takaful markets. Nevertheless, Takaful has developed most fully in countries that have relatively high economic growth rates, and where the state follows Islamic principles. Economic growth can support greater personal wealth, leading to an increase in insurable asset risk. In addition, if sufficient wealth is created, we expect the longer-term family (life) insurance sector will also expand, especially in the GCC region. How does the Takaful market in Asia compare to that in the Middle East? Takaful has developed most in the Gulf Cooperation Council (GCC) region and Southeast Asia, but individual countries in each region have taken different routes to develop the sector. Malaysia is the most well-established Takaful market, which is reflected in its size and relative sophistication. It contributes over 17% to global contributions and has grown five-fold over the past decade. In Malaysia’s Takaful market, family business was about 63% of total contributions - the remainder comprised general business. Most family business is linked to mortgage lending (about 47% of total family contributions in 2011), which perhaps reflects linkages between Takaful companies and banks. For general business, mirroring the conventional market, motor is the dominant business line, accounting for 55% of total general contributions in 2011. The market in Saudi Arabia is larger but less seasoned. All insurers have to operate to a cooperative model broadly comparable with the various Takaful models used elsewhere. While the country has seen very high growth recently, the main source of growth over the past five years has been regulatory action to introduce compulsory medical and motor insurance. As a result, over 50% of global Takaful sector contributions derive from Saudi Arabia. We do not expect the industry to maintain the growth levels it saw after these changes, but it is likely to remain high relative to global levels. Is the investment approach similar between Asian and Middle East Takaful companies? Afundamental requirement ofTakaful companies is to provide a fully Shariah compliant service to both fund members (policyholders) and investors. Southeast Asia makes greater use of Sukuk for Islamic finance than the GCC region. Its more developed market provides meaningful volumes for the Takaful sector to invest in. In Malaysia, more than half of Takaful insurers’ portfolios are invested in Sukuk, with the remainder invested in cash & equivalent, equities and other assets. In contrast, a shortage of Shariah compliant rated instruments in the GCC region means that Takaful companies tend to invest in equities and real estate at a higher portfolio than in Malaysia. Such investments can carry high levels of value volatility and illiquidity and can drag on Takaful companies’ balance sheets. However, the Sukuk portfolio for GCC Takaful operators is increasing, reflecting the increase in Sukuk issuance in recent years. Many Takaful companies, particularly in the GCC region, were set up during the boom years of the early 2000s. The historically high investment valuations that operated when they purchased their assets subsequently resulted in realized losses. The current low investment yields strain bottom-line results further. In our analysis, we consider the limited range of acceptable instruments in which Takaful companies can invest Diverging Models Shape The Growth Prospects For Takaful The growing need for insurance that complies with Shariah law means that the global Takaful sector is becoming an increasingly significant niche within the wider insurance industry. In the following Q&A, Standard & Poor’s Ratings Services (S&P) compares the Takaful markets in the Middle East and Asia, and discusses the outlook for the sector amid the global economic slowdown. Connie
  27. 27. 28 November 2012 chapter of the companies involved will sustain their profitability over the longer term, particularly in the GCC region. However, developments in Malaysia - the largest Takaful market in Southeast Asia - appear much more healthy and sustainable. They are supported by more sophisticated regulatory oversight and the stronger investment profile of the industry. How is the global economic slowdown affecting the growth of Takaful? The worldwide slowdown in economic activity will ultimately depress growth in economies that provide resources for manufacturing; this happens to include many of the resource- rich countries where Takaful is developing. For insurers, this constrains growth, partly by reducing demand for insurance, but also by limiting investment yields. Globally, the current low investment yields have hurt insurance providers and markets. Insurance, Takaful included, is an asset-rich business. Fierce competition in the economies where Takaful is developing is putting underwriting margins under pressure, especially in the high-volume, low-margin retail lines that form the bulk of Takaful business. Meanwhile, yields on Shariah compliant instruments and investments are increasingly depressed. Providers will therefore need to maintain their underwriting profitability to succeed. What are the growth prospects of Takaful versus conventional insurance? Over the next 12-18 months, S&P expects Takaful company contributions in the GCC region to significantly outgrow premiums in the local conventional insurance industry, as well as the global insurance industry. Global insurance premium growth is expected to be little more than 2% in 2012; by contrast, in its World Takaful Report, Ernst & Young estimates that gross Takaful contribution for 2012 will grow to US$12 billion, a year-on-year increase of 24%. In Southeast Asia, we anticipate that tightening regulatory requirements in Malaysia could depress the strong growth momentum the industry has built up over the short-to-medium term. That said, tighter solvency calculations are likely to strengthen the financial profiles of Takaful operators and operators will also benefit from revised risk management practices in the long term. consulting Connie Wong, Managing Director and Analytical Manager for Insurance Ratings, Asia-Pacific, Standard & Poor’s Kevin Willis, Director, Insurance Ratings, Standard & Poor’s to be a constraint that places downward pressure on their risk- based capital position. Is there potential for cross-border Takaful activity? To date, the primary Takaful sector in Southeast Asia and the GCC region has tended to comprise local operators that rarely engage in cross-border activity. This reflects the relatively small operational scale of the sector and its still-developing status. However re-Takaful companies, which provide protection to the primary Takaful sector, are operating in increasingly diverse geographical areas. We see Southeast Asian-based re-Takaful companies competing and working with GCC-based re- Takaful companies to develop and service the growing capacity needs of the primary sector in Africa, Southeast Asia, and the GCC region. As local companies become increasingly mature and financially robust, we expect cross-border activity in the primary sector to grow. We also expect to see some consolidation in the more over- populated insurance markets. What is S&P’s key concern for the Takaful market? We remain concerned by widespread use of high-risk investment strategies by Takaful providers, and by the sector’s lack of global standards in areas such as accounting standards and Shariah compliance. In our view, it is unclear how many chapter Willis
  28. 28. July 2012 Features ChapterThe Size Issue Decree 57: A Much Needed Innovation Market Games Resolving Disputes The Civil Law Chokehold GUIDE February 2012 May 2012 Features Chapters On the Horizon Effective Engagement The Global IslamicDebt Market: Has itreached a plateau? Takaful and Waqf: An idealpartnership? The Takaful andre-Takaful industry Deals of the Year Handbook Deals of the Year Handbook Case studies SATORP Sukuk Salik One syndication Danga Capital Yuan Sukuk First Sukuk in Jordan March 2012 To receive the latest developments on the global Islamic capital markets Read exclusive research reports from industry practitioners every week Read exclusive articles and case studies in our annual guides and supplements sent to you in hard copy Get to know the leaders in your industry Keep abreast of latest deal flows and funds performances Exclusive online access to Contact Musfaizal for a FREE Trial subscription | Tel: +603 2162 7800 ext 24 | Email: