Islamic Finance Attracts Both Islamic Law and Conventional Investors

 
By Nana Phiri and Ebrahim Moolla, Rand Merchant Bank 

 

The Islamic finance sector is the largest component of the halal economy. The halal economy comprises industries that conduct themselves in compliance with Shari’ah (Islamic law) requirements and is estimated to have been worth US$4tr in 2015, as published by Reuters Zawya in its annual report of the state of the halal economy.  Islamic finance makes up $2tr (50%) of this market, and is expected to grow at a CAGR of 9% to reach $3.5tr in 2021.

 
Financial institutions have a great opportunity to participate in this market and some have responded to meet the demand for Islamic finance by diversifying their service offering and, at the same time, include a population of 1.6 billion Muslims into the financial system. Islamic finance comprises the following sectors, with banking leading the way:

What is Islamic finance?

Islamic finance has the same underlying purpose as conventional banking but operates in accordance with the rules of Islamic law (Shari’ah). The basic principle of Islamic finance is the prohibition of riba (interest). Although Islamic finance evolved to provide a Shari’ah-compliant alternative to conventional financing, it has now become the fastest growing segment in financial markets across Asia, Africa and Europe. (Islamic banking is not restricted to members of the Islamic faith: it is open to any person who wishes to choose this form of banking.)

In prescribing the form of economic activities under Shari’ah, the key principles are outlined as follows.

• Trade is encouraged whilst interest is prohibited. Islamic finance has developed mechanisms to earn income from productive sources, such as returns from profit generating investment activities and operations. These include profits from trading in tangible assets and cash flows from the transfer of usufruct (the right to use an asset), for example rental income.
  
  
• Islam encourages and promotes the right of individuals to pursue personal economic wellbeing, but makes a clear distinction between what commercial activities are allowed and what are forbidden. The Islamic economic model is based on a risk and profit-sharing (and loss-bearing) philosophy.
  
  
• Fulfilment of contractual rights and obligations is an integral element of social conduct within an Islamic society.  Islamic commercial jurisprudence consists of principles and rules that must be observed for transactions to be acceptable in Islam; the Islamic Law of Contracts is at the heart of this. One important requirement is for certainty in the contractual obligations of the parties involved.

 
The key differences between the conventional finance model and the Islamic finance model are summarised in Table 1.

 

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Who should consider Islamic financing?

Islamic financing is open to any borrower as long as the borrower meets the principles of Islamic law.  There are typically two types of borrowers who would consider Islamic financing:

• Borrowers who follow Islamic law
  - These borrowers naturally prefer Islamic financing and would look for financing structures that assist them in achieving this; and
  
  
• Borrowers who are looking to tap into a new investor base for diversification.

What type of investor considers Islamic financing?

Any investor can look at investing in Islamic finance facilities.  

• There are investors who specifically have mandates to look at purely Islamic finance facilities and are not permitted by their mandates to look at conventional finance facilities.  These investors are typically always looking out for new transactions in which they can invest.  
  
  
• In the international debt markets, there are numerous Middle East and Gulf investors who are cash-flush and have mandates for only Islamic finance transactions.  An international issuer who ordinarily issues conventional finance instruments will be unlikely to tap into these types of investors and may look at Islamic finance instruments to attract this diverse type of investors into their investor pool.
  
  
• Conventional investors typically do not have mandates restricting them to invest in Shari’ah compliant transactions.  As such, they are often seen purchasing Islamic law compliant transactions to meet their investment objectives such as diversification and/or returns.

These investor dynamics mean there is potentially a larger number of investors that Islamic financing is able to attract - both Islamic law and conventional investors.  This may result in higher demand than in conventional financing and therefore result in pricing benefits for an issuer/borrower.

 

Deal case study: Africa Finance Corporation Rand Merchant Bank (RMB), as joint lead manager and book runner assisted Africa Finance Corporation (AFC) to successfully issue its maiden Sukuk. The deal received strong interest from high quality global investors, resulting in the transaction being upsized from $100m to $150m, as well as the transaction being priced at the tight end of price guidance, of 6mLibor+200 to 210bps. The deal was the supranational’s first Sukuk, enabling it to successfully meet its objective of diversifying its funding source.  Aside from this being AFC’s first Islamic bond, RMB assisted AFC to raise its global profile with this transaction being the: First Sukuk transaction of 2017; and Highest rated US$ Sukuk issuance by an African entity. This transaction met and surpassed the issuer’s objectives of pricing, size and diversification of funding sources.

Types of structure in Islamic financing

A borrower can utilise various Islamic financing structures to meet its funding needs. Four of the more popular structures are as folows. 

1. Sukuk (similar to a bond)

Sukuk are Islamic bonds that are structured to generate returns to investors without infringing Islamic law (that prohibits riba or interest). The issuer raising funds first creates a special purpose vehicle (SPV). The SPV issues trust certificates to qualified investors and channels the proceeds of the investments to the funding of an asset, as per the agreement with the issuer. In return, investors earn a portion of the profits generated from the asset.

In 2014, South Africa successfully concluded its debut $500m 5.75-year Sukuk (Islamic) bond issuance in the international capital markets. The Sukuk, based on an Ijara structure, was priced at a coupon rate of 3.90%. The transaction was more than four times oversubscribed. The bond was listed on the Luxembourg Stock Exchange. 

The decision to issue an Islamic bond has been informed by a drive to broaden the investor base and to set a benchmark for state-owned companies seeking diversified sources of funding for infrastructure development.

 

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2. Murabahah (cost plus mark-up)

This concept refers to the sale of goods at a price that is set on a ‘cost + mark-up’ principle. The purchase and selling price, other costs and the profit margin must be clearly stated at the time of the sale agreement. The bank is compensated for the time value of its money in the form of the profit margin. This is a fixed-income financing arrangement for the purchase of a real asset (such as real estate or a vehicle).

The contract can be structured to look similar to that of conventional loans. The mark-up can be fixed or floating in nature, provided that if it is floating, the benchmark rate (LIBOR or JIBAR) must be agreed upfront.

3. Ijara (lease and rental agreement)

Ijara means lease. Generally, the Ijara concept refers to selling the benefit of use or service for a fixed price or wage. Under this concept, the bank makes available to the customer the usufruct of assets/equipment such as plant, or a motor vehicle for a fixed period and remuneration The Ijara contract is essentially of the same design as an instalment leasing agreement. 

4. Mudarabah (form of partnership)

This is a contractual partnership where one party provides the capital investment and the other party provides specialised knowledge to invest the capital and manage the investment project. Profits generated are shared between the parties per a pre-agreed ratio. If there is a loss, the first partner with capital invested (rabb-ul-mal) will lose capital, and the other party (mudarib) will lose the time and effort invested in the project. The profit is usually shared according to an agreed profit sharing ratio.   

  

 

Nana Phiri Nana Phiri holds a Business Science Finance and Economics degree from the University of Cape Town and a Masters in Finance from University of London. Nana has over 10 years of investment banking experience in corporate finance, leveraged finance and loan markets, having worked for institutions such as Merrill Lynch (now Bank of America Merrill Lynch), Libfin (a division of Liberty Group), and Rand Merchant Bank (RMB). Nana is a senior transactor at RMB in the Loans Solution team responsible for loans origination and structuring in the SADC region.

 

Ebrahim Moolla Ebrahim Moolla has 10 years’ banking experience. He began his career at Deloitte auditing major South African and international banks. In 2011, he joined FirstRand Bank working in various roles within FirstRand Group Treasury.  He has assisted in setting up and implementing the group treasury functions for Islamic banking.   Ebrahim is a CA (SA) and has a CIMA qualification in Islamic Finance.