Nakheel likely to resolve issues with $3.5bn bond

Asa Fitch and Bradley Hope

• Last Updated: May 12. 2009 7:53PM UAE / May 12. 2009 3:53PM GMT

ABU DHABI // Nakheel made headlines around the world with its Palm island projects and the planned Hong Kong-sized Waterfront development, while its advertising billboards dotted around Dubai asked “What next?”

What next is the question now being asked by investors as one of the Middle East’s largest property developers contends with a US$3.5 billion (Dh12.85bn) Islamic bond due in December, which helped fund projects that included the world’s biggest man-made islands.

How the sukuk is handled will serve as a key test for the credit ratings of state-controlled companies in the emirate and could affect their ability to raise money on international markets. It is also widely seen as an indicator of how Dubai will cope with its overall debt burden, estimated at $70bn.

“The clock is ticking, so something has to be done,” says Abdul Hussain, the chief executive of Mashreq Capital.

Nakheel issued the three-year sukuk in 2006, when the Dubai property market was still in a fever and the likelihood of a downturn seemed impossibly remote. The bond came with a profit rate – the Sharia-compliant equivalent of an interest rate – of 6.345 per cent per year. To ease its cash flow, however, Nakheel arranged to pay just half of that, or 3.1725 per cent, during the life of the bond. It would pay the rest at maturity, which seemed a sensible strategy given the rapid rise in property prices in Dubai and the healthy profits the company was booking.

As a further teaser, Nakheel added an option for sukuk holders to buy shares of Nakheel at a 5 per cent discount should it stage an initial public offering and become a listed company. It also backed up the sukuk with significant collateral: land and other assets worth more than twice the value of the sukuk.

At first, international investors eagerly snapped up the offering. Initially, just 30 per cent of the shares were sold to investors in the region, according to a source involved in the deal. The rest went to overseas investors.

Almost three years later, the economic climate could hardly be more different and Nakheel, like many other companies in Dubai, is busy working out how to settle its debts amicably while continuing to build and invest. The company recently undertook a round of cost-cutting and is said to be asking its contractors to take discounts on payments due to them. A source at a building contractor in Dubai that has worked on a number of Nakheel projects said all construction companies associated with the company’s Waterfont development had been asked to take discounts ranging between 30 and 40 per cent.

Yet among the many ways in which Nakheel must cope with the changing economic tides, its $3.5bn sukuk probably ranks as the most significant – and most urgent. The uncertainty surrounding the sukuk has caused its price to rise and tumble rapidly. It was recently trading at a heavy discount, with a yield of about 58 per cent. Low prices and high yields mean investors demand to be compensated with a high return for taking an increased risk that their money may not be paid back in full. “The market obviously believes there is a significant risk of some form of restructuring,” Mr Hussain says. “Otherwise you wouldn’t be able to earn a 50 per cent yield. We are now waiting to hear what sorts of strategies are going to be put in place.”

Nakheel has a range of options for the sukuk, analysts say. It may simply pay off investors in full using an injection of funds from the Dubai Government, received as part of the first instalment in a planned $20bn bond programme. Nakheel said recently it was receiving assistance under the programme.

It could also sell part of itself to a private equity firm in order to raise some of the cash. Analysts have suggested that money raised from a possible sale of part of DP World to a private equity firm could be redirected through Dubai World – which owns both DP World and Nakheel – to help pay off the sukuk. Abraaj Capital, a buyout firm managing $6bn in assets, has approached Dubai World about acquiring a “significant minority stake” in DP World, a source with knowledge of the discussions said earlier this week.

Nakheel could also go to banks for loans to refinance part of the sukuk, or it could try to buy back a chunk of the Islamic bond by extending a tender offer to existing owners.

Another option is for Nakheel to partially restructure the sukuk, giving most of investors’ money back and converting the rest of the debt into a new longer-term loan. This route could also involve one or both of Nakheel’s other sukuk, which are smaller and due in 2010 and 2011.

Rumours of such a restructuring began to surface about a month ago, when Nakheel hired a market intelligence firm to identify the owners of its sukuk shares. Many investors saw this as an indication that the company was trying to find out what portion of the sukuk was owned by investors who would be sympathetic to an attempt to restructure.

The possibility of a restructuring led Standard & Poor’s, a major ratings agency, to put numerous Dubai companies on watch for a credit downgrade.

A Nakheel spokeswoman said in a statement that “a number of options” were currently on the table and declined to elaborate. Bankers said that a restructuring that left investors with a loss was probably Nakheel’s least desirable option, aside from a fully fledged default. If Nakheel were to allow many of its investors to take losses, they said, the cost of raising money in the future – for Nakheel and other government-linked companies in the UAE and the broader GCC – might go up.

“Nakheel has a large volume of public debt, much of it held by international investors, so a lot is at stake regarding international credibility of Dubai corporates that will likely at some point seek to borrow again in the global capital markets,” says Khalid Howladar, a vice president and senior credit officer for structured and Islamic finance at Moody’s, another ratings agency.

What seems most likely, investors and observers say, is a combination of some of these options. Nakheel may buy back some of the sukuk shares using subsidy money, for example, offering an above-market price for them. If some investors are unwilling to sell, the company could then try to refinance a portion of the debt with bank loans and sell some of its equity to a private equity firm.

Bobby Sarkar, an analyst at Al Mal Capital in Dubai, believes Nakheel is also considering selling some of its assets, such as its stake in the Atlantis Hotel on the Palm Jumeirah and properties in Discovery Gardens, both in Dubai. “They are looking at a combination of asset sales, some inflow from the Government, some restructuring and a partial sale to Abraaj.”

Whatever options it chooses, a source familiar with the sukuk says, a full default or even a serious restructuring is highly unlikely, given the value of the collateral that Nakheel has provided and the negative message such a move would send to international markets.

Moreover, Dubai’s government-linked companies have so far succeeded in paying off or refinancing large loans and bonds as they come due. In February, for example, Borse Dubai – the company that owns Nasdaq Dubai and the Dubai Financial Market – was able to refinance a $3.4bn bank loan, albeit with major help from local sources of funding.

Last month, the Dubai Electricity and Water Authority refinanced a $2.2bn Islamic loan with 18 international, regional and local banks.

Nasser al Shaikh, the director general of the Dubai Department of Finance, said a week later there was a “shift in the overall mood” in the international credit markets when it came to Dubai’s debt.

* additional reporting by Angela Giuffrida

afitch@thenational.ae
bhope@thenational.ae