Several years ago, around 2008, the writer was asked by industry commentators whether the classic Sukuk structures common in the market would finally evolve from ‘asset-based’ structures to ‘asset-backed’ structures that were true securitisations and thus limited in recourse solely to the performance of the assets underpinning them. At the time, this writer thought that such progress was inevitable, particularly given that the move to asset-backed would follow more closely the concepts that were promulgated by the scholars when structuring Shariah compliant issues. Flash-forward to 2015, the industry has not moved on very much from the asset-based structures still dominating the market and asset-backed structures are very few and far between. This raises the fundamental question why such asset-backed structures are still very much a minority and also why the industry has not evolved notwithstanding the continued pressure from scholars to do so. Debashis Dey feels that the answer is a simple one: the investor base is simply not ready to do so and the issuers in the market are not ready either.
Market participants in the Sukuk market over the last two decades know that the term ‘asset-based’ refers to the overriding reliance of investors on the credit strength of the obligor (or sponsor) of the transaction rather than the assets that are used as the reference for a Sukuk. Similarly, for a sponsor, the term asset-based means that the sponsor can simplify its reporting and segregation in relation to the assets as the sponsor knows that the investors are really relying on the sponsor’s credit strength.
For example, in an Ijarah transaction, where there is a sale by the sponsor of the transaction of an underlying asset that will then be leased, a typical asset-based structure will not fully analyse the sale value of the asset in question or the potential value of the lease if leased to third parties. Instead, the investors will rely largely on the credit strength of the sponsor as sole or principal lessee of the asset in question.
In other words, the investors will investigate the strength of the balance sheet of the lessee (who is typically also the sponsor of the transaction and the seller of the asset) to quantify the credit strength as sufficient to pay the lease rentals (and thus ultimately return capital and generate income for the Sukuk certificates). This is even more acute where the structure involves a purchase undertaking obligation extended by the sponsor (the obligor) to repurchase the asset in case of financial default or where the Sukuk has reached the date capital is scheduled to be fully returned. In both circumstances investors will, through the actions of the special purpose issuer holding the assets for the investors, ‘put’ the asset to the sponsor, thus crystallising the debt claim against the sponsor for the capital amount equal to the outstanding Sukuk capital.
What the investors will not do is truly review the assets on an independent basis as if they were genuinely acquiring the assets as owners and then assessing what rental income could be derived from the open market or what could be obtained from selling the asset on the open market. On that basis, the Sukuk transactions are typically asset-based and dependent on the credit of the sponsor.
In a genuine securitisation, where the profit return and return of capital are limited in recourse to the assets themselves, investors will genuinely try to assess the value of the assets in a number of situations: where the assets are being exploited by the sponsor, where the assets are being exploited by third parties in the open market, and where the assets need to be liquidated in an urgent bankruptcy of the lessee. Thus for example, if the aforementioned Ijarah structure was used in a genuine securitisation, the investors would only be assessing the credit strength of the sponsor if the sponsor was to be a lessee of the asset. However, the investors would be more focused on the asset value of both the asset itself and the value of any lease that could be genuinely obtained in the open market.
Given that the investors’ recourse would be limited only to the asset and the value of any lease, there would have to be a critical analysis of the asset and most likely a discounting of such value to provide some cushion in case there are unforeseen market events that affect future value. Certainly, investors would not solely rely on the balance sheet of the sponsor (if it is the lessee).
So why hasn’t it happened more often?
TOther than some notable exceptions such as the recent announcement by CIMB of a ‘collateralised Sukuk’, the vast majority of Sukuk are asset-based in today’s market. The question is why, and the answers, in the writer’s view fall into two broad simple concepts.
Investors are not ready for the product
In order for the product to evolve into an asset-backed structure, there needs to be sufficient investors with sufficient appetite to invest in such structures. However at the moment, the majority of Shariah compliant institutional investors who purchase Sukuk do not appear to wish to invest in the resources necessary to assess asset values in the fashion described earlier in this article, where such investment is asset-backed. Such resources are necessary because as all investors in assets know, the assessment of an asset at the time of purchase requires dedicated knowledge of the industry in question, the market generally and the ability to compare such asset value to other similar asset purchases historically. When looking at the transaction in this light, one realises that for the investor, an assessment solely of the credit strength of the sponsor can seem quite straightforward in comparison.
There is also the additional factor that many of the Shariah compliant investors driving the market are actually financial institutions (rather than private equity or funds), which gives the added complication that such investors have capital constraints from their bank regulators that favour a balance sheet assessment of the sponsor over the limited recourse investment in assets. This again pushes the product towards asset-based rather than asset-backed.
Sponsors are not ready for the product
In addition to investor appetite for the product, sponsors of Sukuk must also be willing to participate in transactions that are securitisations rather than corporate balance sheet Sukuk. However, for many sponsors, the concept of an asset sale that leads to recourse against the assets in a default is beyond their appetite for funding, particularly if they are comparing their funding options against a conventional bond or loan. The idea that the Sukuk investors can sell the assets to third parties in a securitization structure will often severely limit the assets the sponsor wishes to make available for the Sukuk.
In addition, true securitisations require frequent reporting on the asset performance and typically certain step-in rights for the investors to take over management of the assets should the asset performance be below certain pre-agreed levels. This is often well beyond what a sponsor is willing to do in the context of a fundraising and thus the sponsor’s reluctance to allow for this prevents the securitization structure being applied.
Debashis Dey is a partner at White & Case.
This article first appeared in Islamic Finance News (29 July 2015, Volume 12, Issue 30, Page 21-22). For more information, please visit the website at www.islamicfinancenews.com.