I am not too surprised by the Arcapita bankruptcy (the NY Times has a copy of the bankruptcy filing on their Deal Book blog, their other filings are available here). Their portfolio of investments was mainly from pre-financial crisis, with the lone exception being J. Jill. They had $1.1 billion in a syndicated murabaha financing coming due at the end of the month, and reported only $19 million in cash as of September 30, 2011 despite many asset sales earlier in 2011.
I have written quite a bit about the troubles with J. Jill (which saw its debt ratings downgraded repeatedly) for The Islamic Globe, including in late February 2012. However, the problems with Arcapita were far deeper than just the troubles of J. Jill (the debt of the two is separate and one does not directly affect the others, apart from the potential cash infusion that would be required from Arcapita to stave off default by J. Jill if that happens).
The biggest problem for Arcapita is that it was unable to continue its business model (leveraged buy-outs and sales of its holdings at a profit) after the credit crisis hit. In the immediate wake of the credit crisis, potential buyers of its portfolio were likely unable to get their own debt financing. As the crisis dragged on, the holdings remaining on the Arcapita balance sheet (most of the holdings were in part sold off to their investors when deals were completed) were worth far less than they were purchased for.
Leverage works both ways. Arcapita (and other private equity companies) relied upon their holdings appreciating so that they could be sold off for more than they paid to buy, with the returns amplified by the leverage they employed, both on a portfolio company level and the holding company level (the more debt they had to support their balance sheet, the higher the returns to their equity holders. However, their business model imploded along with the business model of many private equity companies. It is impossible to speculate about whether they were disproportionately hurt compared to their rivals. Their headquarters building sitting alone on the location of a development at Bahrain Bay they began in 2005 which has still not been completed says more than any analysis of their balance sheet can.
The real question for creditors is whether the extend-and-pretend will succeed. If they extend the murabaha they are hoping that Arcapita's holdings can be sold for prices high enough to repay the company-level debt and return enough cash to Arcapita's coffers to repay the murabaha, so long as it is not turned into a fire sale. The situation is complicated by distressed debt funds owning between 15% and 25% of the murabaha by my best estimates (with the remainder split between around 60% original syndicate members and 20% who likely invested directly in the syndicated murabaha in 2007).
Arcapita blamed this minority as precipitating the bankruptcy filing, but perhaps these investors put a fair value on Arcapita's holdings, and they would not be able to repay the murabaha and continue on as a going concern afterwards, even if they were given additional time. The concept of bankruptcy and Islamic finance is not well established and one of the few relatively successful bankruptcies of an Islamic debt instrument was East Cameron. It was solved through a relatively ad hoc solution in a US bankruptcy court that saw some conventional funds work with Islamic investors to create a solution that allowed for the Islamic investors to potentially recover some of their investment, while remaining within their Shari'ah mandate.
From what I could see in the East Cameron filings and a post mortem from people I spoke with, the solution wasn't pretty (i.e. it wasn't solved along the exact lines drawn up in the contracts), but instead relied upon the focus of US bankruptcy courts of finding an equitable solution. Perhaps a similar resolution of the Arcapita bankruptcy through US courts could make the US a more recognized jurisdiction for Islamic finance. That, more than anything, would encourage more Islamic finance in the US.
A post script: I wasn't able to fit into the blog post the connection between current discussion of presidential candidate Mitt Romney's involvement in private equity with Bain Capital and the Arcapita bankruptcy, but they do have a strange overlap. Bain Capital has been heavily criticized for leading American Pad & Paper into bankruptcy in 2000. Three years later, the firm was bought by Arcapita.
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There is one more element to the Arcapita bankruptcy that should be considered.
Remember, when Arcapita bought assets it often applied a whopping "premium" to the deal, making investors pay substantially more than the deal acquisition cost. This premium was the primary source of Arcapita revenue for many years. But, it substantially inflated the carrying value of the assets.
For example, if Arcapita bought into a deal at $10 then it would sell the deal to investors through an SPV at $12 or even more. The extra 20% is the premium paid to Arcapita. This is the same mechanism used by other Bahrain investment banks, such as Gulf Finance House. It works as long as investors agree to paying what is in effect a success fee in advance.
But, when you try to sell an asset you have an already inflated value. You are booking the value of the asset at $12, not at the acquisition price of $10. In the meantime liquidity has dried up, transactions volumes have plumetted, trade sales disappear, and real-world valuations could be 30% to 50% lower than your stated carrying value.
This is the hard part about Arcapita: what is the true value of those assets? It appears the hedge funds have looked and discovered something we don't know. Valuations could be much less than are shown on audited financial statements.
This would not be surprising as we know that private equity investments worldwide suffered enormous losses when the bubble burst, in particular assets that were acquired during the bubble when credit was abundant and cheap (thus overly high asset values).
When I last looked a couple years ago Arcapita had made deals they valued at around $22 billion from inception to that date. But, they had only exited 15% of the capital allocated. That means 85% of the money Arcapita raised from investors and deployed into private equity investments was still out there. Since most of that was purchased during the bubble, and presumably all of it had the infamous "premium" attached, then one could easily conclude that real-world valuations are far less than declared values.
We shall see how this all works out. What is especially puzzling is that Arcapita's management must have known there was a problem way back four years ago, in early 2008, when the bubble was bursting everywhere. They have had four years to reorganize their business, four years to find business lines with recurring rather than erratic revenue, but still it appears Arcapita is focused only on private equity.
The world changes. Nothing stays the same. Clearly the overreliance on private equity by nearly all Islamic finance institutions has cost them dearly. None of them created a "third leg" on which to stand, most importantly no one created true asset management businesses with replicable, stable revenues. Perhaps Islamic bankers were seduced by the high commissions available in private equity, not realizing that investment banking is a very unstable and highly volative (meaning: risky) business.
Banks like JPMorgan and Morgan Stanley also suffered terrible losses in their investment banking units when the bubble burst. One can calculate that they almost achieved negative enterprise value at the worst of the crisis. What saved them? Ignoring their commercial or retail banking businesses, it is clear that only their asset management units kept enterprise value above zero.
This means that plain-and-boring asset management, which is almost totally absent from the Islamic banking industry, is ultimately the savior of many big global banks. Investment banking (including private equity) destroyed a lot of capital.
I, for one, put my money on asset management. It's a stable and "normal" business. Maybe Arcapita should change its business model and focus instead on more stable businesses.
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