Outlook for Saudi capital markets and mortgage market

Interview with Hani O. Baothman, Managing Director & CEO of Al Murjan Holding

Global Islamic bond issuance is expected to reach $175 billion in 2015, up from $110 in 2014, and is projected to hit $250 billion by 2020, according to a recent study.

The Islamic finance industry has evolved in the direction of complying with the conventional system. Islamic finance industry has to rethink its philosophy. The latest trend in the industry is the emergence of innovations from Islamic institutions that are derived from the principals of the Islamic finance philosophy, not from the motive of providing solutions or mimicking the conventional finance systems.

Out of the $24 billion of bonds issued within the GCC region in 2014, $5 billion was from organisations in Saudi Arabia. Companies issuing Sukuk included National Commercial Bank, Saudi Telecom Co. and Saudi Electricity Co.

An institution in Bahrain that is following the sukuk issuance has published a report which showed that Saudi issuance represented only 5% of the global issuances, a number which is lower than this number you mention.

This figure could be more accurate because Saudi blue chips still have access to funds from Saudi banks and they don’t have the motive to go into secondary markets or debt markets to issue sukuk.

The companies issuing sukuk had their limits closed with these banks and this is why they are now going into the debt markets. With the development of the mortgage industry, we are going to see a huge issuance of sukuk because banks cannot take 30 or 20-year loans on their balance sheets.

It is common sense for them to go to the sukuk market and this is what will drive a huge demand for Saudi sukuk issuance.

You mentioned 5%, what is your estimate for this percentage in the future vis-a-vis global issuance?

Currently only the mortgage market represents about 4% of Saudi GDP. The normal level for a country like Saudi Arabia would be 20% of GDP. That will take it to something like a trillion Saudi riyals of issuance.

Part of this will be financed by sukuks. These are big figures and the timeline for this development is short because it is a necessity. The mortgage industry cannot be launched without an active debt market.

Has the investment behaviour of your investors changed with the current global investment climate?

Following the financial crisis we saw lots of investors either going for very secure assets or sometimes cash bases in terms of asset allocation and in terms of geographical allocation we saw a lot of interest in staying in Saudi; not exporting capital to international markets. Nowadays the picture is changing and we are seeing more interest in risky assets, especially alternative assets such as real estate and private equity. This trend is still continuing.

Do you think that the main reasons that caused the global financial meltdown in 2008 were fully resolved or do you think something similar might occur in the future?

The global economy is still dealing with the consequences of the crisis but I don’t think any new major surprises will come. One of the major consequences of the crisis are the economic problems in Europe. The US seems to be recovering and the Middle East is also still recovering but we all still have to deal with the consequences of the crisis.

You are known to structure investment vehicles that are exotic and new; call it financial innovation if you will. Can you tell us more about your funds and how you differentiate from other Islamic investment companies, locally and globally?

Our asset management strategy and our products are truly different from what is offered by the big Saudi banks. That strategy directed us to alternative assets and in turn we found ourselves playing active roles in real estate development and income generating funds in the UK and in Europe in addition to the trade finance funds in West Africa which was a pleasant surprise for a lot of investors given the returns that they enjoyed from such funds.

What made you come up with your investment vehicles?

Our partner who started this strategy, originally came from the commodity trading finance industry and that gave us access to good companies that were involved in commodity trading in West Africa. We don’t deal on a mass basis; we don’t extend finance to hundreds of companies.

We only deal with a few companies that need short term finance either pre-export or post-export and normally we would have an international off-taker for the commodities that are under finance and we would have collateral managers in well-established ports.

This kind of structure gave us the opportunity to function in a very profitable way in West African countries.

The Saudi market is soon going to open up to international investors. It is believed they are thinking about major funds and perhaps insurance companies. In your opinion, what is the outlook for the Saudi capital market?

I don’t think we shall see a huge jump in liquidity in trading because the investors and asset managers who are now allowed to enter the Saudi markets and who qualify as financial investors are big asset managers who are looking for yields or medium to short term returns and are not looking for daily trading.

However, we will see an increase in liquidity in the first stages of their entrance into the Saudi market, when they start taking positions in the Saudi market. Thus I don’t subscribe to the opinion that we shall see a huge jump in liquidity with the entrance of foreign asset managers.

However, one of the main benefits for the Saudi market in addition to increasing transparency is the shift in mentality of the Saudi publicly listed management companies. As of today, most of these companies are owned by one or two public or semi-public entities; because of their patience these funds are not asking for exits; they are not very keen about the share of the prices.
I don’t think this will apply to the foreign investors, who if they enter want to see some sort of increase in price shares. I think this will redirect the compass of a lot of management in Saudi public companies.

Which asset classes in your opinion are undervalued in Saudi Arabia?

Sectors like banking will benefit a lot from the market opening because this sector has always been a low traded segment given it is Shariah compliant. The Saudi market is dominated to some extent by retail investors who mainly seek Shariah compliant investments; that has resulted in lower prices of major Saudi conventional banks.

Banking sector is one of the sectors that will benefit from the entrance of foreign investors. In addition, the telecommunications and petrochemical sectors will benefit.

The real estate market has been protected for a long time from foreign investment. Is that something that could potentially yield some returns in the future?

It is not open and won’t be open to foreign investors. Given the excess liquidity in Saudi Arabia I think sectors like real estate lack foreign know-how more than foreign capital i.e. how to develop real estate projects, housing projects, how to market them etc. these are the kind of inputs that the Saudi economy needs from foreign investors: knowledge rather than capital.

How would you define your biggest challenge associated with the performance of your own funds?

Our funds are performing very well but we are still a small company that was recently established. The main challenge is branding; to put our name out there in the market and share our track record with investors. That is a challenge that we need to address.

Can you tell us a bit about the performance of your funds and what is the expected return on investment for your clients?

They vary historically; we have income generating funds that gave a double digit IRR. We have real estate development funds that gave 19 to 20% IRR and then we have the funds that are more of a short term liquidity fund that give 7 to 9% per annum.

According to the research, today we have the largest Islamic trade finance fund in the world. The strategy is to keep increasing the size of the fund.

What is an Islamic trade fund? How special is it?

You have a lot of commodity trade finance funds but most of them are conventional and big in size but as far as Islamic trade finance funds, I think ours is the largest because we only have a few competitors in the market.

What makes the difference between Islamic and conventional?

It is mainly the Shariah structure and how the deals are conducted because they have to be cleared by Shariah committee.

And this gives more assurance to investors?

Two ethical commissions are in subcontracts for the investment. Shariah principals add another layer to our investors.

Can you describe the key challenges and opportunities associated with investing during the current economic cycle globally?

Coming back to the change in perception of investors, we are seeing big opportunities in alternative riskier assets. Investors are now willing to take higher risk in private equity and in real estate. We are seeing this also from Saudi investors; they are looking for some sort of non-conventional asset classes, different from what they were used to, particularly public equity bonds. This is the trend right now.

In terms of your assets under management, it is 400 million dollars. What is the outlook? What is your strategy for assets under management?

The current assets under management is quite low and it will be easy for us to double or triple it in a very short period of time. The challenge will be to keep on the same growth rate. That will be the serious challenge for the medium and long term.

What is the growth rate that you would like to maintain?

20% per annum.

In the low interest rate environment, how do you look for yield?

By going into riskier assets. These assets are still giving these kinds of yields but if you go into the public equity market or bonds, we are now experiencing negative yields in some of these asset classes.

Do you intend to make any changes to your current portfolio? For example how your funds are structured or the geographical distribution?

We are focusing more on West Africa. We are expanding further in Africa. We started our funds as purely trade finance and now we are moving into private equity investment. Again the fund gave us the opportunity to work with companies for 6 or 7 years, so we know them inside out and when it was time to invest in these companies, it was much easier for us than for anyone else who was not familiar with them. That is our approach. Geographically, we are expanding in Africa and we are taking higher risks in that continent.

Out of your portfolio what proportion of your assets are allocated in Saudi?

I would say 50:50.

Out of that 50% abroad, how much is allocated in the UK—

The majority is in the UK and about 15 to 20% is in West Africa.

Do you still see significant opportunities in the UK?

Yes. Given the results of the latest elections, I think investors are coming back with a bigger appetite for UK investment.

Sidra Capital and Al Murjan Holding is part of a large conglomerate owned by the Bin Mahfouz family. What is your overall positioning within the group?

Al Murjan is a holding company that has investments within Saudi and abroad. The role of Sidra Capital is to act as the investment banking arm of the group. It mainly manages our overseas investments and some of the Saudi real estate and private equity investments. The shareholders are completely different.

What is the outlook for the economy?

The economy will keep on growing. Most of the big public projects that are currently being executed had their funds allocated in the past few years.

For example, Jeddah airport and some hospitals are in their final stages, so I do not think there will be a huge public expenditure burden on the economy for the next 5 years.

The only threat to the continuous growth of the economy in my opinion would come from the geopolitical conditions but not from anything internal.

Looking at the real estate sector in particular, we interviewed various players in building materials and they said that there was a significant slowdown in the beginning of 2015. Yet the real estate developers are very optimistic because 50% of the population is under 18 years of age. With an annual population growth of 1.9% growth, there is an intractable nationwide housing shortage. The overall homeownership rate among the Saudi population is about 35 percent, or a little more than half what it is in the United States. According to several studies by banks, real estate companies, and financial journals, Saudi Arabia is already short at least 1 million housing units, whether owned or rented, and will need at least 200,000 new units every year for the next decade. The population density per household is 6.4 people. In India, it’s 5.5. There is a huge deficit of housing in the country. What is the outlook for the real estate market?

The main driver for the demand on construction material in the past was public projects. Now, this demand will increase again by the reactivation of the housing sector in Saudi. As we know, the housing sector is suffering from a slowdown due to the restrictions that SAMA put on financing homes; SAMA requires Saudi households to put 30% of the capital needed to purchase a home.

I think this is a temporary measure, I think it was put in place to not see the market over heat following the approval of the mortgage laws. Shortly, we shall see solutions to this problem.

How do you see this legislation that is putting fees on the white lands?

It is too early to tell. We don’t know what is going to be the outcome or what the definition of white lands is. We have lots of land in Saudi that does not have the infrastructure required to develop it.

How do you attract these investors? Is it your track record? Do you go to speak to them?

Basically we attract investors with our track record and our ability to seed funds. Given the fact that Sidra is backed by Murjan group, it allows the company to cede funds from its shareholders. It also gives credibility to the funds that we are sharing with other investors.

We also interviewed KAMCO, Gulf Investment House and others. You have a lot of competition in the GCC, is it difficult to compete in this particular sector in the GCC?

In the sector of asset management it is difficult. The markets are also open to international asset managers. It is a difficult market to operate in; there are well established regional players in addition to having the market open to international players.

Any of the large asset managers can come in and approach an institution, investors or the big families and offer them investment products. Thus your product has to be as good or better in order to convince the local investors to subscribe to your funds.

When you have individual investors knock on your door, what is their main worry? How do you respond?

First of all we don’t do retail investment; we only do the category that is for high net worth individuals. This category is looking for advice of how to exit an investment or how to create an investment portfolio etc.

Some of them are looking for real growth, others are looking for capital growth and this is where our role starts as advisors.

Not in all cases do we end up with them investing in our funds. We may direct them to other funds provided by other asset managers but which comply with their investment strategy or requirements.

Since we are not operating in investment fund schemes, our investors are not institutions that are looking for specific IRRs in specific periods. We tend to have more patient capital so we can tolerate the dates to some extent. It is not a major issue in our case.