HSBC Saudi Arabia's team: (top row, l-r): Rajiv Shukla, Fahad Al-Saif, Mohammed Albensaleh, Muhammad Farhan, (bottom row, l-r) Asma Alghofailey and Lama Al-Saleh

With its seven-year maturity making it the longest for any sukuk drawn up by a Saudi corporate, the $1.9bn capital raising put together for the Saudi Electric Company marks a huge achievement for the HSBC Saudi Arabia team that assembled it. Writer Edward Russell-Walling

As Saudi Arabia's relatively new debt capital markets start to build up a head of steam, one international bank is leading the way. It is, of course, HSBC, which has been so active in other Gulf states. In Saudi Arabia it has been enjoying growing success with the sharia-compliant vehicle, the sukuk.

HSBC punctuated that success with the recent SR7bn ($1.9bn) sukuk from the Saudi Electricity Company - the company's third in three years. With an effective tenor of seven years, the longest for any Saudi corporate, it was the biggest transaction of its kind from any Gulf Co-operation Council utility.

The sukuk has had its ups and downs of late, with a number of recent defaults or threats thereof. But HSBC detects a particular appetite for this form of financing and investment in Saudi Arabia, where sharia compliance is especially valued by issuers and investors, and where sovereign issuance is on the wane.

Established presence

HSBC has had an investment banking presence on the ground in Saudi since 2003, even before new legislation was introduced to regulate - indeed, create - capital markets, opening the doors to foreign players. HSBC Saudi Arabia was granted a licence in 2006 and today has more than 250 people working across a wide range of investment banking activities, in equity and debt markets, corporate finance, asset management and research. It remains the largest investment bank, domestic or foreign, in the country.

It led the first Eurobond issue out of Saudi Arabia in 2005, for its local associate, Saudi British Bank, in which it has a 40% stake. And it was joint lead on the country's first international lower Tier 2 deal, for Arab National Bank. These were the beginnings of a traded market in corporate debt in a country in which the only bond issuers had been the central bank and the ministry of finance. And all their debt was held within Saudi Arabia - there was no external debt.

"The challenge of kick-starting a domestic debt capital market was even more difficult because the sovereign had taken the decision to pay down its debt and sterilise the proceeds from sales of oil," says Rajiv Shukla, HSBC Saudi Arabia's head of global capital financing. In chicken-and-egg fashion, another hurdle was the absence of any appropriate local benchmarks, which made new issues tricky to price, though Sibor - which tends to track Libor - was one form of reference.

A new challenge

Given the nature of the market, the sukuk was an obvious way of diversifying funding for companies that have traditionally relied upon bank loans. But this raised one of the grittiest challenges of all, which was how to create a structure that would pass muster with the strict Saudi sharia scholars.

Elsewhere in the Gulf and in markets such as Malaysia, the most common form of sukuk is al-ijara. Since sharia law prohibits the paying or receiving of interest, al-ijara creates a form of lease, where investors acquire an underlying tangible asset and lease it back to the sukuk issuer. The lease payments become the investors' return on investment.

Saudi Arabia, though, is the birthplace of Islam. Its scholars set the bar very high and they had concerns with parts of the al-ijara. What they did eventually accept was al-istithmar (an investment sukuk) in which the investors acquire the rights to a business activity rather than a tangible asset. "The rights are sold to the sukuk-holders, who then allow the company to use those rights to carry out a certain business," says Muhammad Farhan, head of Islamic finance at HSBC Saudi Arabia. "It could be the marketing rights for a particular product, for example."

Sukuk success

The first of these Saudi sukuk was issued in mid-2006 by Sabic, the giant Saudi petrochemical company. With HSBC as sole lead manager, it was a roaring success, raising SR3bn. Next up was the Saudi Electricity Company (SEC). Created from a merger of all the country's electricity companies, SEC was floated on the Tadawul in 2000, with the government retaining an 81% stake. It is responsible for all electricity distribution in the country and most of its generation.

HSBC had been working with SEC, encouraging it to diversify its funding sources and advising on its obtaining a credit rating - a sovereign-level AA- from Standard & Poor's. In July 2007 it acted as sole lead manager and sole bookrunner for SEC's debut sukuk, which raised SAR5bn. For the sake of sharia compliance, the structure was a 20-year-put-five (like the Sabic deal), giving it an effective tenor of five years. The underlying 'asset', in this case, was SEC's meter-reading business and the pricing was a keen 45 basis points (bps) over Sibor.

"In a very short space of time, the company had gone from bilateral facilities through syndicated facilities to the debt capital markets," says Mr Shukla. "To get financing at 45bps - its loans were well in excess of 100bps - was a considerable achievement."

HSBC continued to work with the company, advising on ratings maintenance and financing, before orchestrating a follow-on sukuk issue in July 2009. By then, the atmosphere in financial markets had changed somewhat.

For the follow-on, protocol demanded that HSBC work alongside a local bank, and it was joined by Samba Capital as joint lead manager and bookrunner. While Saudi Arabia was relatively immune to the wider financial crisis, spreads had widened and there was a shortage of liquidity, and the team worked hard to position the credit as closely aligned to the sovereign. The result was the biggest order book ever seen for a Saudi bond or sukuk, at more than SR20bn. The size of the five-year deal was capped at SR7bn, priced at 160bps over Sibor, rather wider than its predecessor but well within the market at that time, and tighter than Qatari and Abu Dhabi sovereigns.

"It was very well received and it set the stage for the third issue," Mr Shukla says.

There had been no strict timetable for the third issue but, as 2010 progressed, the company decided to bring forward the construction of certain power plants and needed additional finance with some urgency. It was decided to use a template similar to issue number two, with the connection services business once again as the underlying asset.

Already, the shape of SEC's financing had changed radically. Before 2006, it had been 100% bank financed. By the end of 2009, bank lending accounted for only one quarter of its financing, with sukuk finance - much cheaper and pushing out the tenors - making up 49%. The balance was made up of export credit agency and government funding.

High demand

For the May 2010 issue, the tenor was pushed out to seven years with a 20-put-seven transaction. Once again, HSBC and Samba Capital emphasised SEC's proximity to sovereign risk and once again orders hit a new high - at SR27bn. "The ministry of finance was not issuing more debt," points out Fahad Al Saif, HSBC Saudi Arabia's head of debt capital markets. "Government bonds and Treasury bills were maturing substantially and so there was much liquidity in the Saudi market. Bad news in international markets is good news for Saudi issuers because it drives investors into local assets."

Low interest rates and volatility in local equity markets played to the advantage of sukuk returns and their stability, and the result was an influx of new investors. "There was more demand from mutual funds," says Mr Al Saif. Banks took 55% of the issue while fund managers took 18%, compared with less than 10% for the previous SEC issue. Insurance companies and pension funds took 12%, government entities 8% and corporate institutions 7%.

Pricing was at the tight end of the 95bps to 105bps guidance range, at 95bps over three-month Sibor. There was 'some international participation', but take-up was largely driven by locals, flush with liquidity.

More competition would help the market, as even HSBC acknowledges, to drive innovation and spread the word. "But Islamic finance increasingly has a reputation as a very viable, market-based source of funding," insists Mr Farhan. "And it provides a market-based alternative for those with money to invest."

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