Islamic Finance: Sukuk – The Next Growth Market? Securities & Investment Institute CPD Seminars Thursday, 14th February 2008

Contents The Islamic Market International Sukuk Universe Sukuk Issuer Demographics Sukuk Investor Demographics Islamic Financial Structures Islamic Financing Techniques Drivers For Secondary Market Liquidity Islamic Finance In The UK Conclusion

Source: Standard & Poor’s and Bloomberg The Islamic Market The Islamic market in terms of invested assets is estimated to be worth circa US$750 billion globally, and is growing at 10% to 15% p.a. There are approximately 1.5 billion Muslims worldwide, accounting for 20% of the world’s population, of which 80% live outside the Middle East. Forecasts predict that the global Muslim population will grow to 2.5 billion people over the next 20 years, representing 30% of the world’s population. Current personal wealth in the Middle East is estimated to be US$1.5 trillion, and is the fastest growing sector in wealth management. Sukuk (“Islamic bonds”) issuance is estimated to total in excess of US$98 billion globally (including Malaysia). Source: Standard & Poor’s and Bloomberg

International Sukuk Universe Currency Denomination International Sukuk Universe Profit Rate Profile Source: Bloomberg

Sukuk Issuer Demographics Source: Bloomberg

Sukuk Investor Demographics Islamic investors: Islamic banks HNWIs GCC institutional investors Conventional investors: Specialist convertible houses Hedge funds Investors demographics in selected Sukuk issues Nakheel ($3.52bn) : European (40%) Middle Eastern (38%) Rest of the world (22%) Aldar Properties ($2.53bn): International (70%) Middle Eastern (30%)

Islamic Financial Structures It is acceptable for investors to make a financial return from: Owning physical assets (e.g. commodities, real estate and manufactured goods) Leasing or renting physical assets Sharing of risk in a commercial venture Principles to be kept in mind when determining the Islamic acceptability of financing techniques: Speculation Unjust enrichment/ exploitation Interest Uncertainty

Islamic Financing Techniques Murabaha – The sale of goods with an agreed-upon mark-up on the cost (cost plus finance). Tawarruq – The purchase of goods for deferred payment and their subsequent sale for cash to a buyer other than the original seller at a lower price for the purpose of raising cash. Ijara – Islamic finance equivalent of leasing. Hybrid between conventional operating and finance lease. Istisna – A contract of sale of specified goods to be manufactured (construction financing). Salam – A contract for the purchase of a commodity for deferred delivery in exchange for immediate payment (financier pays in advance for the purchase of fungible assets). Musharaka – Joint venture, partnership whereby each party contributes capital in equal or varying degrees to establish a new project or to share in an existing one. Mudaraba – A partnership in profit between capital and work in which one partner contributes money and the other expertise, time and effort.

Sukuk Al Ijara An ijara is a Sharia'a compliant lease. In an ijara Sukuk, the obligor (originator) sells certain physical assets to the issuer, funded by cash raised from the issue of Sukuk certificates. The issuer leases the asset to a third party, often the obligor itself, and enters into a management agreement with the obligor to manage those assets on its behalf. The obligor pays lease rentals to the issuer, which in turn uses this cashflow to pay the profit on the Sukuk certificates. The obligor gives a Purchase Undertaking to the issuer under which it promises to purchase the assets of the Sukuk at maturity in order for the Sukuk certificates to be redeemed. The cash raised by the obligor from the sale of the asset can be used for general corporate purposes.

Purchase Undertaking @ $100m Sukuk Al Ijara (cont.) 4 Purchase Undertaking @ $100m 2 1 Obligor $100m $100m Issuer Sukuk holders Sale of Asset $100m Certificates 3 Lease Agreement and Management Agreement 1. Paying Agent 2. Investment Management

Ijara vs. Finance Lease Ijara Finance Lease The lessor is responsible for major maintenance and insuring the asset. (The lessee may be appointed as Servicing Agent with responsibility for insuring the asset.) The lessee is responsible for insuring the asset The lessor bears primary responsibility for taxes. The lessee is often responsible for taxes. On destruction of the asset the lease terminates. On destruction of the asset, the lease continues. The lessee is responsible for any harm caused to the asset due to the lessee’s misuse or negligence. The asset may be transferred at maturity for a fixed price.

Sukuk Al Musharaka Musharaka, also known as a joint venture or partnership. Two distinct types of Musharaka arrangements:- Sharikat al-aqd is an agreement between two or more parties to combine their assets, labour or liabilities for the purpose of making profits. Sharikat al-milk arises when two parties pool their resources to jointly acquire/ own an asset. Unlike the sharikat al-aqd, a partner in a sharikat al-milk can give a binding promise to buy all the assets (i.e. the other partners’ share of the asset (s)) at a fixed price (which may be the face value).

Sukuk Al Musharaka (sharikat al-aqd) Purpose is to generate profits 6 Profit Distribution Musharaka 6 Profit Distribution 3 Management Agreement 2 2 $100m $100m Issuer 4 Musharaka Management Agreement Partner 5 Purchase Undertaking [???] $100m 1 Sukuk Sukuk holders

Sukuk Al Mudaraba Mudaraba is a partnership in profit whereby one party, the rab al-maal, provides capital and the other party, the mudarib, provides labour. The parties agree on a profit share. The profit is distributed according to the profit share agreement. Final distribution should be made on the selling price of the assets after accounting for losses.

Sukuk Al Mudaraba Mudarib Rab al-maal Mudaraba Profit share agreement Expertise Funds

Drivers For Secondary Market Liquidity Sharia’a jurisprudence Environmental Structural Market dynamics Price discovery

Islamic Finance In The UK Finance Act 2003: SDLT applicable to individuals. Finance Act 2005: Alternative finance arrangements - recognising mudaraba, and murabaha. Finance Act 2006: Alternative finance arrangements - diminishing musharaka and wakala. SDLT on companies. Finance Act 2007: Sukuk. 2008: ???

Conclusion A nascent market with significant growth potential. Developments over the past year have been extremely positive. Key to enhancing liquidity will be to embrace international best practice without compromising Sharia’a integrity. Attract a wide range of investors (Islamic and non-Islamic). Innovative liquidity management tools and structured alternative assets. Develop uniform and standardised products and documentation. Increase use of sukuk.

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