The LBO hits Islamic finance – but how?

Asiamoney, March 2008

Headline writers had a field day last year when a consortium buying Aston Martin, every British spy’s car of choice, pledged to finance the purchase through Shariah-compliant means. “The name’s Bond,” said the Financial Times, the pick of the bunch. “Islamic bond.”

Puns apart, the deal signalled the latest branch of conventional finance to make its way into the Islamic world: leveraged buyouts. They’re chiefly a Middle Eastern phenomenon so far, but expect them to appear in Asia before long.

The Aston Martin deal involved the GBP479 million acquisition of the iconic British car company from Ford. The consortium was organised out of London by a British motor racing entrepreneur called Dave Richards, but the key financiers behind the deal were two Kuwaiti financial groups, Investment Dar and Adeem Investment Company. Both invest only in accordance with Islamic principles. Sixty per cent of the deal was financed through equity contributions, and the rest through a GBP225 million loan through West LB, which the backers insisted be arranged Islamically (they used a Murabaha facility (a cost-plus financing; this structure, in which costs and profits are pre-agreed by all parties, is how many mortgages are arranged in the Islamic world). The deal was refinanced in February with a GBP225 million eight-year syndicated loan, again on a Murabaha basis.

To some, the appearance of “leveraged” and “Islamic” in the same sentence rings alarm bells. In fact, there’s nothing in Shariah law against leverage, except for an aversion towards excessive indebtedness. “Shariah does not have problems with leverage as long as it is achieved through Islamic debt,” says Professor Humayon Dar, managing director of Dar Al Istithmar in London, in a recent essay on the subject. “Leverage is not a Shariah concern, rather it is an economic issue.”

There are no hard and fast rules on this – any Shariah transaction is ultimately arbitrated on by boards of scholars – but generally the industry tends to require that the ratio of debt to market capital (some say to total assets) must be less than 33 per cent. So really, it’s an issue of what state the target company is in. In Aston Martin’s case, this wasn’t a problem: it didn’t have any debt. Where companies do have more than that level of leverage, or any conventional interest-bearing debt, scholars will require the buyer to pay off that conventional  debt within a set period of time in order for it to be considered compliant.

Far from being a breach of Shariah principles, some argue that the buy-out – with the target’s cashflows being used to pay off the cost of the purchase – is closer to pure Shariah than regular M&A. “It ties in better with the requirements of Shariah,” says Arul Kandasamy, head of Islamic financing solutions at Barclays Capital in Dubai (he, like many people quoted in this article, was speaking at the Euromoney Islamic Finance Summit in London in February). “In addition to the credit element of the risk you are taking, there is no additional recourse to a third party to provide credit support to the transaction. In the deal itself, the cashflows from it must be sufficient to repay the financing that’s provided.” To his mind, the problem comes with trying to rebadge things to be something they’re not. “In any transaction you will always have an equity piece, possibly a mezzanine piece, and the debt financing piece. What we as an industry need to do is call a spade a spade and say: yes, we are using an ijara or a mudaraba or a musharaka structure, but that piece is a debt piece, not equity. There’s a need for that piece and we will structure it in a compliant manner.” He predicts 2008 “will see a lot more non-recourse type financings, whether for acquisition or project finance or private equity.”

Those who make their living from structuring in the Islamic world are delighted with this new field. “I’m extremely happy with the development of the LBO market,” says Geert Bossuyt, head of structuring for the Middle East at Deutsche Bank, and the man behind the bank’s Shariah product platform. “Personally I’m far more excited about developments in the LBO market than the sukuk market.”

Usman Ahmed, the global head of Citi’s Islamic banking business in Dubai, thinks several things should drive LBO activity. “Firstly, a number of private equity firms that were formed in the Middle East a few years back have demonstrated a successful track record and sold some of their investments at handsome profits; they are seen as contenders in the international M&A scene. Then we have corporates who have become increasingly acquisitive as well, with global ambitions, who are looking to acquire assets outside of the region.

“So there is a real demand for financing structures that look beyond the obvious senior unsecured debt equivalent, and need to be able to push down some of the financing to the level of the assets for which they are being raised.”

There is a sense of some uneasiness, though, about the direction Islamic finance is taking when it embraces structures such as these. The chief executive officer of Qatar Islamic Bank, Salah Jaidah, made a curious and unelaborated remark about Islamic LBOs during a panel discussion at the London conference. “It is not appreciated by a lot of scholars, especially ours, so it is a very sensitive area to explore for Islamic banking,” he said. “But I guess for the time being we’re going to take short cuts and take an advantage.” He didn’t explain what those short cuts were. He had no doubt, though, of the likelihood of further dealflow from the Middle East. “Private equity funds are now on the move. A lot of companies are prepared to be sold, or to grow for further expansion in the region.”

Qudeer Latif, head of Islamic Finance (Middle East) for Clifford Chance, recently advised on another landmark Islamic LBO, when Abraaj Capital, generally considered the leading home-grown private equity business in the Middle East, completed the US$1.41 billion acquisition of Egyptian Fertilizers Company in the largest private equity transaction in the Middle East to date. This LBO is covered in more detail in the case study on page xx.

He, too, expects plenty more out of the Middle East. “There’s a fundamental shift in the mentality from a few years ago,” he says. “Middle East investors are more willing to leverage themselves to acquire assets.” The high liquidity in the Gulf, concentration risks in portfolios, and a general hunger for overseas assets underpin the trend.

From a legal perspective, Latif outlines the issues that have to be thought about before considering doing a buyout on an Islamic basis. “Is the target a Shariah compliant target? Is it a Shariah compliant business? Clearly any acquisition of a brewery or a casino is not going to be financed by Islamic financiers.” Then there’s the financial ratios of the target, as discussed above. “One of the other things to think about is use of proceeds,” he adds. “Clearly the facility on the financing will be used to pay the acquisition price, but there’s issues as to whether you can use the Islamic facility to refinance existing debt, and can you use it to repay the costs and expenses associated with the acquisition?” The answer to that question appears to depend on which Islamic structure is being used, and probably also on the views of the advising Shariah scholars.

Other areas apply equally to a conventional or an Islamic LBO: the structural subordination between mezzanine and senior debt, with the intercreditor issues that follow; upstream security and guarantees, with the target usually providing security for the indebtedness the bidder incurred for the acquisition; and covenant packages in the event of a default. One of the advantages the Islamic world has on this last point is that it isn’t trying to clear up the wreckage of covenant-lite packages that were common in conventional finance ahead of the sub-prime crisis. “In the Islamic LBOs that came to market last year there was a standard acquisition financing and a standard LBO covenant package,” Latif says. “Covenant-lite was never entertained.” Consequently the Islamic world is one of the few places on earth where anyone is talking positively about leveraged finance.

There are some tricky technical matters that come up when trying to finance transactions like this Islamically. Anything in the Shariah world has to be backed by physical assets:  money can’t just turn into more money for its own sake without some link to the physical world. This means the financier will own the asset for a certain period of time, which is not always the case in a conventional LBO, where assets tend to go directly to special purpose vehicles. “The financiers need to think about the issues that arise from that ownership,” says Latif. “Are they going to be liable for any third party liabilities which arise as a result of being owner of that asset? Are they going to be liable for paying taxes as a result of that asset?”

Bossuyt argues that LBOs, raising difficult issues at a local level, can be a useful force to prompt change in regulation. “The fact that there is this underlying asset that needs to move creates all sorts of legal and tax issues that every first Islamic LBO in a country needs to face,” he says. “One of the good aspects about LBOs is it creates a better discussion with the authorities about what needs to be done in specific countries to make sure Islamic finance can grow there. At least then you have concrete transactions to discuss the issues we have.”

Several different Islamic structures lend themselves to LBOs. Aston Martin, for example, used the commodity murabaha approach, which is more usually used as a short term inter-back deposit instrument. The sale and ijarah approach, a lease-to-own method also common in Islamic mortgages, could also apply. And the Abraaj/EFC transaction used another system called bai salam, explained in the case study.

What we haven’t seen yet, though, is the use of sukuk (the Islamic equivalent of bonds). “I suspect as soon as the markets open up we will see the high yield subordinated sukuk,” says Latif. “In the conventional space most acquisitions are effected by senior debt and high yield debt. The high yield debt is normally done in the capital markets. Going forward, we’ll see the development of the high yield sukuk market.”

One curious facet of deals like these is that the people drawn to them are not necessarily Islamic investors. “This is pure Islamic finance: venture capital,” says Hussein Hassan, director and global head of Islamic structuring for the global markets division of Deutsche Bank, who arranged the Abraaj/EFG deal. “We would have expected that Islamic banks would be jumping up and down to get into this deal. But of more than two dozen investors who came into the deal, there were only two Islamic institutions.” It is understood that in a $1.4 billion transaction, less than $50 million came from Islamic institutions.

Why? “A couple of reasons,” says Hassan. “Most Islamic banks obviously need fixed income types of returns, and private equity doesn’t provide that.” Also, this deal involved an Egyptian asset; “banks don’t always have lines to do this in Egypt.”

But it raises an important question. “The question for people who want to finance leveraged buyouts in an Islamic manner is, is there any point? We talk a lot about Islamic finance, and the need to encourage more risk participation and risk sharing contracts. The reality is that Islamic banks are not able to participate in risk-sharing structures such as these.”

But if more and more institutions do as Investment Dar has done and decide they will only finance buyouts through Islamic methods, then it’s not going to matter who comes in to support the deals. The weight of liquidity in the Middle East is going to support this industry for a good while yet. But what about Asia? There is already some evidence of Asian investor support to these transactions: 5% of investors in the Aston Martin deal were from Asia, without that part of the world being particularly targeted. “I don’t see any reason why either of these structures [Aston Martin or Abraaj] couldn’t be successfully sold into the Asian markets,” says Latif. David Testa, CEO of newly informed Islamic finance group Gatehouse Capital, and at WestLB at the time of the Aston Martin deal, adds: “There’s huge and growing interest radiating out of Malaysia… it’s going to have a very healthy future in Asia.”

That’s from the investment perspective. Asian companies, and Malaysians in particular, are also very likely to be targets of Middle Eastern buyout bids. An Investment Dar executive vice president told media in Kuala Lumpur in December that 10 to 12 per cent of the group’s $4 billion in assets would go towards Asia. And then, finally, there’s the prospect of Malaysian buyers wanting to finance their buyouts Islamically. Watch this space.

CASE STUDY: Abraaj/EFG

In June, Abraaj Capital completed the Middle East’s largest ever private equity acquisition: the $1.41 billion purchase of 100% of Egyptian Fertilizers Company.

Abraaj made the acquisition through two of its funds, the Infrastructure and Growth Capital Fund and Abraaj Buyout Fund II. Several prominent co-investors joined it in the deal, among them Dubai Capital Group and the Saudi Arabia-based Rashed Al Rashed & Sons Group.

Deutsche Bank and Clifford Chance were among the advisors, and many of the challenges they faced were unique to Egypt. Chief among them was the fact that Egyptian takeover requirements gave only a very limited period of time to complete the deal. Consequently – and this may prove increasingly common in Islamic LBOs – the bidder and advisors got special dispensation from their Shariah committee to finance the deal conventionally, with a commitment to refinance it again Islamically after the acquisition went through. The scholars agreed. Another problem is that the ijarah structure, which would have been the obvious way to do the deal, was not possible under Egyptian law.

The structure they came up with instead is called bai salam. This is a forward sale agreement, and is one of the few exceptions in Islamic financing where the delivery of an asset can be delayed to a future date. The financier pays on day one; they get the asset on some future specified date.

This proved a handy arrangement for EFC, a manufacturer of urea. There is a forward sale contract in which the purchase price for the urea is made on day one, with the urea then obliged to be delivered on specified dates in the future. Once that cash comes in, it is used to repay the conventional debt.

There was also a mezzanine piece using the musharaka method (musharaka means partnership, and a sharing of risk and reward; capital between investors is put together, with profits shared on a pre-agreed ratio, and losses must be proportionate to the amount invested). This too was used to refinance the conventional bridge financing.