This article appeared in Middle East Legal Insights - June 2012
This article previously appeared in Islamic Finance News: Volume 9, Issue 6 on 15-Feb-2012.
As traditional lines of credit dry up and the crisis in Europe and elsewhere deepens, many corporates and investment institutions are increasingly turning to alternative modes of finance in order to fund acquisitions. The low yields offered by Sukuk financing in particular have attracted notice with several institutions favoring Sukuk over their traditional capital markets funding lines. Recent Sukuk issuances in the U.S. and elsewhere may herald a new phase in Islamic financing as the drivers behind the choice to go Islamic move away from matters of traditional Shari'a compliance and instead become driven by the need to diversify sources of funding to satisfy liquidity needs. This could be a boon for the Islamic finance industry but care will need to be taken to ensure that the principles of Shari'a are adhered to in a manner that is acceptable to the broadest group of scholars possible. The drivers behind Shari'acompliant acquisition finance and conventional acquisition finance in the context of an M&A transaction are economically comparable but it should be noted that the former must comply with strict Shari'a screening criteria. It is clear that by abiding by Shari'a principles, a buyer's investment opportunities are more limited; although it could also be argued that such a buyer can enjoy a larger pool from which to raise money as Islamic funds tend to attract both Islamic and conventional investors. There is also a common misconception that Islamic finance — and the precepts of Shari'a that guide it — is something that is available to Muslim investors only. However, as further discussed below under Shari'a screening criteria, many of the prohibitions on investment that guide Islamic finance overlap with the principles that guide ethical investments in the conventional sphere: such as a prohibition on investing in casinos and arms production.
Shari'a screening criteria
Any M&A transaction will only be considered an Islamic M&A transaction if it satisfies specific Shari'a criteria. These range from the nature of the financing instrument itself to the nature of the target's business. The business of the target is obviously particularly relevant in the context of an M&A transaction owing to the fact that the use of proceeds for any acquisition facility associated with it will be narrowly defined and that the end result of such transaction will be the integration of the target or its assets into the business of the purchaser. As each M&A transaction presents a different fact pattern, it is not possible to produce an exhaustive list of the requirements of Shari'a. However, there are certain key principles that will always need to be considered when a target is selected and the failure to satisfy one or more of these criteria will be a 'red flag' issue. The criteria exclude any proposed investment in a company based on the following two key principles: (i) the nature of the business conducted by the target company and (ii) the financial viability of the target company.
Business activity screens
In order to qualify as a Shari'a-compliant investment, at least 95% of a company's gross revenues must be generated from business activities not excluded under the Shari'a principles. Any business activity involving alcohol, tobacco, pork-related products, pornography and conventional financial services is an excluded activity under the Shari'a principles. While on the surface these restrictions might seem to be clear (an M&A transaction involving a casino or an alcoholic drinks manufacturer would obviously be prohibited), there are more far-reaching implications. For instance, were an M&A transaction to involve a retail business that owned a number of shopping malls, consideration would need to be given as to whether those shopping malls contained cinemas, alcoholic drinks outlets or any pork butchers. In the event that they do, it is common for scholars to request that such aspects of the business are carved out of the deal or that they are not material; with the materiality threshold being revenues that do not exceed 5% of the target's revenues.
Financial ratio screens
A company must meet certain financial ratio criteria in order to qualify as a Shari'a-compliant investment. The relevant financial benchmarks used differ slightly and are dependant on the Shari'a school of jurisprudence adopted by the scholar advising on the relevant investment as well as the investment itself. It is generally accepted that the company's total debt should be less than 33% of the equity; accounts receivables should be less than 49% of total assets; and interest income from cash and interest-bearing securities should not be more than 5% of the total income. This becomes particularly relevant in the context of an acquisition financing and consideration will need to be given to the balance sheet of the target both before and after the completion of any acquisition.
It should be noted that although there are certain restrictions which apply to Islamic finance, there is nothing that states that it is not possible for Islamic investors and institutions to profit from business activity. In line with this thinking, scholars are prepared to take a pragmatic approach to the implementation of the above guidelines in the form of granting a post-completion grace period during which the purchaser must 'clean up' the business of the target so as to ensure that it complies with the principles of Shari'a. Such 'clean up' or 'Islamization' of the relevant target's operations can be achieved through paying off the target's conventional debt and/or replacing it with Shari'a-compliant financing instruments. Further, an ongoing dialogue with the scholars is to be encouraged from the outset of any proposed transaction so as to provide clarity to both sides and allow for collaborative solutions to any issues that may arise.
Common structures used for financing M&A transactions
Innovative products are, of course, common in the still-burgeoning Islamic finance industry and this innovation may increasingly be turned on the world of M&A. A number of transactions in the past have employed Islamic acquisition financing.
Most notable among these is The Investment Dar (TID)'s acquisition of its stake in Aston Martin in 2007. TID is a fully Shari'a-compliant company and, as such, conventional methods of finance were not available to it. Instead, TID used a commodity Murabahah financing to raise the funds required to purchase its stake. TID also had to satisfy itself and its Shari'a Board that the Aston Martin Lagonda group was a company suitable for investment from an 'activity' standpoint. Being a car manufacturer this was a relatively straightforward process but consideration should be given to certain car manufacturers that, for instance, have fighter jets manufacturing divisions or a consumer finance arm. In such circumstances the structure of the deal becomes important as it will determine at what level the investment or acquisition is made. The implication of this is that a corporate reorganization may be required in order for a company to be deemed eligible for an acquisition or investment by another in compliance with the principles of Shari'a irrespective of any financing structure that may be utilized.
Although the Bai Salam structure has traditionally been used to provide working capital, it has recently also been used as a form of acquisition financing. The acquisition by the Infrastructure and Growth Capital Fund and Abraaj Buy Out Fund II of the Egyptian Urea Petrochemicals Company was partially refinanced by a syndicate of financiers (led by Deutsche Bank) using the principles of the Bai Salam structure, whereby the purchase of a future supply of urea by the financiers was agreed with Egyptian Urea Petrochemicals Company being appointed by the financiers to sell the supplies of urea on their behalf. This was a U.S. dollar refinancing and the return on the financing was benchmarked to Libor plus a fixed margin. What is interesting about the Bai Salam structure employed here is the difference between it and a financing that relies solely on the balance sheet of the obligor to make payments of, for example, the Murabahah purchase price. A structured repayment profile similar to the one outlined above may also appeal to the risk appetite of a private equity fund and, given the opportunity for sharing in the losses as well as the profits of the target, would also appeal to one of the central principles of Shari'a.
However, it is Sukuk financing that is currently catching the eye of the M&A market, owing to the current low yields and the relative ease with which offerings are being brought to market. Much of this is a result of the dearth of Islamic assets classes in which funds can invest. Sukuk would be a popular choice for many Shari'a-compliant investment funds and as such their popularity is high. Sukuk funding was successfully utilized by DP World in connection with its acquisition of a stake in P&O.
DP World used a Musharakah structure under which it invested (through its subsidiary Ports, Customs & Free Zone Corporation (PCFC)) a US$1.5 billion contribution in kind in the Musharakah. The Sukuk holders invested US$3.5 billion in the Musharakah through PCFC Development FZCO which, together with PCFC's investment, provided the capital necessary to meet the purchase price for the target: P&O. The Musharakah partners then appointed PCFC as manager of the Musharakah capital and instructed it to complete the purchase of P&O. The challenge for industry professionals will be to augment the typical Sukuk structures with more sophisticated structured returns to satisfy the needs of financial investors. A structured return profile or alternative exits can take many forms, but one of the more obvious is that of a convertible Sukuk, as seen with Nakheel's issuance in 2008, the Tabreed Mandatory convertible Sukuk issued in 2008, as well as the PCFC example above.
The Nakheel convertible Sukuk offered investors the opportunity to exchange the amounts payable to them at redemption under the purchase undertaking for the right to participate in any qualifying public offering on preferential terms. This sort of structure would lend itself well to financial investors seeking to participate in the upside following the restructuring of a target. Similarly, a mandatory convertible could be employed to lock investors into a participation in the future of the target.
The Musharakah structure is one which also lends itself to the world of private equity as it is a partnership structure in which the parties agree to share in any losses of the business/project in proportion to their initial investment but may agree on a profitsharing mechanism in any manner they wish.
In structuring a Musharakah where shares of a target are the underlying assets, careful consideration will need to be given to AAOIFI's ruling in 2008 regarding the valuation of the assets subject to the purchase undertaking. AAOIFI ruled that assets should be valued at their fair market value immediately prior to their purchase by the obligor at maturity/exit (as opposed to fixing the price in reference to the face value of the outstanding Sukuk). Where shares are involved this means that the concept of principal protection that was seen in many pre-2008 Musharakah structures cannot be used. For example, in the case of the P&O transaction, the underlying assets of the Musharakah were the shares in P&O (and certain other Shari'a-compliant investments). In order to return the principal amount invested to Sukukholders at maturity, DP World is required to purchase the interest held by the Sukukholders' in the P&O shares under the Musharakah. It should be noted that a right was also included (and was exercised) for Sukukholders to convert a portion of the cash purchase price for the Musharakah assets held by them for shares in DP World in the event of an IPO of DP World. The DP World transaction pre-dated the 2008 AAOIFI ruling and as such there are doubts as to whether such a structure would work were it to be proposed today. It is instead more likely that the scholars would insist on a market valuation of the P&O shares prior to the exercise of rights under the purchase undertaking. Whilst this risk profile may appeal to certain classes of investors, consideration will also need to be given to the impact such a structure may have on pricing and/or the ratio in which profits are shared when a Musharakah structure is utilized.
Under the Mudarabah structure the financier commits capital to a project and the Mudarib (who is seeking the capital injection) commits their expertise. The financier takes a risk on the business/ project and the ability of the Mudarib to deliver on its business plan, but this sort of risk has appeal to certain investors especially if the proposed venture has the opportunity of making a healthy profit. Therefore, it could usefully be used in the venture capital and, to a lesser extent, private equity space to provide structured, equity-style returns which are off set against the risk of the business/project failing.
Other variations to the Mudarabah structure include the utilization of a Wakalah (investment agency) arrangement by which the obligor acts as an agent to the investor, hence lending its investment management expertise within the framework of a pre-determined set of investment guidelines and restrictions. These include both general investment criteria (e.g., concentration, industry and geography) and Shari'a investment criteria. Wakalah arrangements are commonly used in the context of private equity and real estate investment funds. Conclusion While specific M&A activity involving Islamic finance is currently limited, there are clearly wide-ranging opportunities for financiers, funds and acquisitive companies to explore and exploit. The challenge for industry professionals as always will be to provide innovative products to meet these requirements and to attract investments by both Islamic and conventional investors into industries that are 'ethical' and unduly burdened by debt. This can only be achieved through an alliance of creativity and an understanding of the key precepts of the Shari'a through a process that engages scholars at an early stage and maintains dialogue throughout. As events in Europe continue to unfold, sources of funding will become ever more diverse and new solutions need to be found. Islamic finance structures represent an opportunity to provide creative solutions to these evolving problems.
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