Islamic Finance: Sukuk – The Next Growth Market?

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

2. 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

3. 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

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

5. Sukuk Issuer Demographics Source: Bloomberg

6. 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%) Sukuk Investor Demographics

7. 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

8. 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.

9. 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.

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

11. Ijara vs. Finance Lease

12. 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).

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

14. 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.

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

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

17. 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: ???

18. 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.

19. Disclaimer European Islamic Investment Bank plc (“EIIB”) reserves all propriety rights to the contents of this Presentation. No part of this Presentation may be used or reproduced in any form without EIIB’s prior written permission. This Presentation is provided merely to facilitate discussion. No representation, warranty or assurance of any kind, expressed or implied, is made as to the accuracy or completeness of the information contained herein. EIIB accepts no obligation to any recipient to update or correct any such information. This presentation should be read in conjunction with any subsequent or other marketing materials prepared by EIIB in relation to the products and transactions discussed herein. All such marketing materials, including this presentation, shall be subject to amendment without notice and shall in any case be read in conjunction with and qualified in their entirety by the final terms and conditions of the products described herein. Copies of such documentation can be obtained from EIIB.