© Islamic Development Bank, 2016
           King Fahd National Library Cataloging-in-Publication Data

Islamic Development Bank
Financial development through partnership./ Islamic

Development Bank – Jeddah, 2016

ISBN: 9960-32-322-6

1-Development    2-Partnership    3-Islamic finance              l-Title
332.042 dc                       1437/7791

L.D. no. 1437/7791

ISBN: 9960-32-322-6

All rights reserved. No part of this publication may be reproduced or distributed in any form or by
any means, or stored in a database or retrieval system, without the prior written permission of the
Islamic Development Bank.

This Report was prepared by SHAPE Financial Corp., upon the request of the Financial Product
Development Center. The views in this report do not necessarily reflect the views of the Islamic
Development Bank Group.

Executive Summary
The Islamic Development Bank (“IDB”) has been financing development in its Member
Countries (MC) mainly by relying on its balance sheet. Since 2002, IDB has been a leading
issuer of sukuk. Yet, sukuk leverage the balance sheet, and IDB faces constraints from the
continuous growth of its balance sheet, including challenges to maintain its “AAA” credit
rating. Therefore, the goal of this study is to look at how IDB can leverage its knowledge of the
needs of its member countries ,in order to develop alternative financial methods to deliver
rightly priced financial solutions. Taking the cue from the Member Country Partnership
Strategy (MCPS), this study examines the role of partnership in serving IDB’s goals.

Because IDB is a development institution, the return on financing to MC is not in line
with market expectations. The cost of financing is usually way below the risk of financed
projects. To obtain external financing, IDB has usually relied on its balance sheet’s strength
to reduce the risk to investors in its sukuk. Given the limits of this approach, IDB should find
a mechanism to obtain off-balance sheet financing that strives for a low cost of funding to
MCs, and seeks to compensate investors for the associated risks. This study seeks to address
this challenge.

The study focuses on practical partnership solutions, notably fund structures. These do not
stress IDB’s credit rating by adding more debt. The existing suite of funds and off-balance
sheet vehicles at IDB helps to demonstrate that crafting a more expansive strategy can fulfill
key objectives: meeting funding needs with situation specific financing; expanding funding
without creating pressure on the balance sheet; reaching out to various classes of investors;
and achieving properly priced financing.

In order to create a context for this study the first chapter discusses IDB’s partnership
approach in the concept of IDB’s Vision 1440. The chapter examines the aspirations of
multi-lateral development funds and asks whether or not a natural partnership exists in the
capacity of IDB to serve specific high growth emerging markets and guide investment into
weaker, but promising economies among the member states.

In the second chapter, the study evaluates sukuk. Sukuk are critical for the direct funding
of IDB’s operations. IDB’s AAA-rated sukuk will also prove critical for Islamic banks to meet
Basel III liquidity obligations. Yet, sukuk necessarily grow the balance sheet as most of IDB’s
risk exposures cannot be securitized. As a result, sukuk have certain limits and therefore
need to be complemented with off-balance sheet instruments. The chapter also includes a
review of retail bond and Sukuk issuance trend in selected markets. Whereever relevant, the
review also highlights the trend of infrastructure bonds and Sukuk issuances. This review is
relevant for IDB to take an intermediate approach before pursuing a full equity infrastructure
fund strategy.

The third chapter analyzes and compares various development funds. Multilateral
development financial institutions (MDFI) like IDB are engaged in a dynamic transformation.
Funds, direct investment, capacity building through funds and direct investment vehicles are
allowing MDFIs to serve broader markets in more unique ways. The study evaluates MDFI
and IDB experiences, and then looks at the strength of the Islamic funds market. A key reality
is that for IDB to be successful in the delivery of development funds, IDB must reach out

III

beyond the Islamic market space and attract new investors to the member countries under
IDB’s mantle. Funds have significant capacity to meet IDB’s goals in managing costs, relieving
pressure on balance sheet, and reaching out to prospectively broader group of investors.

Funds, however, need the correct infrastructure. In the fourth chapter, the study delivers
a SWOT analysis of 13 jurisdictions. The goal is to find out which domiciles are best suited
to draw investors of different types, and to facilitate IDB’s delivery of a master umbrella
fund. IDB members like Bahrain and Malaysia perform well in the review. Some other global
jurisdictions also show well. Therefore, IDB’s opportunity lies in considering a blended
approach to jurisdictions. Besides jurisdiction analysis, the chapter also reviews fund market
development trend, and detailed discussion on target investors and their expectations.

The fifth chapter reveals a master-umbrella-feeder structure. The chapter takes into account
how the master fund may benefit from a pooled investment in infrastructure projects, trade
finance, and participation in IDB’s existing portfolio. It also discusses how IDB may benefit
from other member countries’ experience with socially oriented funds.

IDB will not find a “one size fits all” solution to off-balance sheet financing. Although some
tools for funding may facilitate low cost financing, funds will typically be more equity-
oriented in their risk profiles. The proposed IDB master feeder fund structure is meant to give
IDB a strategic and tactical flexibility in the delivery of funding to member countries. These
could be specialized funds by type, business style, investment method, and even country or
region. The proposed method is also meant to help with the construction of investment and
investor capacity within member countries.

The master fund strategy achieves the following results:

The strategy requires IDB seed money, without a major impact on the balance sheet;•
The strategy allows IDB to leverage its skills and relationships. This should be protective •
of IDB’s AAA rating;
The strategy allows sub funds to deliver targeted, right priced investment to member •
countries; and,
The strategy also supports the development of domestic capital market capacity in •
member states.

We also conducted a simple market survey with selected industry players to gauge the market
acceptance of IDB’s funds strategy. A number of industry players still prefer that IDB pursue
the Sukuk strategy, instead of a fund strategy. As such, the final chapter also summarizes
how IDB may benefit from the retail Sukuk market experience to finance infrastructure.

IV

Contents

Executive Summary ...................................................................................................  III

Chapter 1 - Resource Mobilization for Development through Partnerships ...............  1

1.1  Introduction to IDB 1440H Vision ............................................................................  1
1.2  MDFIs Dynamic Role and Sources of Funds .............................................................  3
1.3  Evaluation Criteria for Alternative Resource Mobilization Solutions .......................  7
1.4  Conclusion ................................................................................................................  9

Chapter 2 - Evaluation of Sukuk as Resource Mobilization Tool ..............................  11

2.1  Introduction to Main Sukuk Types ...........................................................................  11
2.2  IDB’s Experience in the Sukuk market .....................................................................  15
2.3  Recent Innovation in Sukuk Structures ....................................................................  22
2.4  Common Operational Issues in the Sukuk Market ..................................................  24
2.5  Retail Bond and Sukuk Market .................................................................................  25
2.6  Evaluation of Sukuk against the Research Objectives: .............................................  38

Chapter 3 - Development Funds as Source of Funding for MDFIs .............................  41

3.1  Experience of other MDFIs in using development funds .........................................  41
3.2  The IDB Experience ..................................................................................................  50
3.3  Islamic Funds Market ...............................................................................................  55
3.4  Evaluation of Funds against Research Objectives ....................................................  60

Chapter 4 - Structuring Considerations - Domicile ....................................................  64

4.1  Market Development and Investors ......................................................................... 64
4.2  Investors’ expectations ............................................................................................  78
4.3  Domicile Selection ...................................................................................................  92
4.4  SWOT Analysis of Individual Jurisdictions ................................................................  97
4.5  Evaluation of Different Jurisdictions ........................................................................  110

Chapter 5 - Proposed Fund Concept .........................................................................  116

5.1  Proposed Structure ..................................................................................................  116
5.2  Murabaha Funds & Market Feedback .....................................................................  123

Chapter 6 - Conclusion .............................................................................................  129

Appendix I: Top 10 investors in Unlisted Infrastructure Funds ..................................  139

Appendix II: Top 5 investors in Private Equity Funds ................................................  140

Appendix III: Indian Committee Report on Development Infrastructure Fund ..........  144

Appendix IV:  SEBI Regulation on Mutual (Infrastructure debt fund) .......................  146

Appendix V: SEBI Regulation on Alternative Investment Funds (AIF) .......................  148

Appendix VI: Dana Infra Retail Sukuk Distribution Channels ..................................  150

- Resource Mobilization for Development Chapter 1
through Partnerships

“The Mission of IDB is to promote comprehensive human development, with a focus on
the priority areas of alleviating poverty, improving health, promoting education, improving
governance and prospering the people.”

Introduction to IDB 1440H Vision1.1
IDB has developed a clear vision for 1440H which is geared to achieving development through
partnership. This is characterized as the Member Country Partnership Strategy (MCPS),
developed in 1431H. The nature of partnership creates multiple avenues for investment in
the emerging markets, which constitute IDB’s MCs. The MCPS is designed for the IDB Group
to seek the optimal avenues for intervention in MC and to initiate suitable programs for
economic development.1 The “Vision 1440H: A vision for human dignity” is derived from an
institutional desire for “introspection and reform”. The nature of partnership is to make all
parties to a relationship equal in status, even if they are not equal in contributing factors like
money or technology: therefore, it brings dignity to the seemingly weaker or less illustrious
members of a partnership. A well thought out process of development should help in the
process of “mainstreaming … the integration of Member Countries’ economies into the
global economy.”2 The mainstreaming would also create the opportunity to showcase IDB’s
values, improving lives with dignity.

The operating principles that flow from IDB’s mission include reaching out to governments,
community needs, stakeholder feedback and collaboration, and participation. Among IDB’s
strategic thrusts, the relevant elements for our purpose are the second: Alleviate poverty; the
third: Promote health; the fifth: Prosper the people; and, the eighth in particular: Facilitate
integration of IDB Member Country economies among themselves and with the world. In our
approach to partnership, we will examine how poverty alleviation, health, and prosperity,
socio-economic development3, have become investment targets to a growing universe of
global investors. As IDB member states represent some of the states in the greatest need of
assistance, IDB should become a partner of choice in leading efforts to channel commercial
funds to MCs.

As a result, partnership tools are important means to meet IDB’s challenges, which include
achieving “Strong and Sustainable Economic Growth” in the context of “Promoting Good
Governance” whilst “Restoring the Image of the Muslim World”. These important challenges

1  Islamic Development Bank Group in Brief, April 2012.
2  Vision 1440H: A Vision for Human Dignity, Islamic Development Bank, Safar 1427 / March 2006; and, Report: IDB

1440H Vision Regional Workshop for ECO plus Albania (2 August 2005, Almaty, Kazakhstan) Prepared by Technical
Experts Team “IDB 1440H Vision” Strategic Planning Office Islamic Development Bank; both accessed at www.
isdb.org.

3  Vision 1440H: A Vision for Human Dignity, Islamic Development Bank, Safar 1427 / March 2006; and, Report: IDB
1440H Vision Regional Workshop for ECO plus Albania (2 August 2005, Almaty, Kazakhstan) Prepared by Technical
Experts Team “IDB 1440H Vision” Strategic Planning Office Islamic Development Bank; both accessed at www.
isdb.org.

1

http://www.isdb.org

http://www.isdb.org

http://www.isdb.org

http://www.isdb.org

are among those which may be pursued in a global fund partnership strategy. Leading this
challenge, IDB follows the reminder of Quranic advice given by Tun Dr. Mahatir Mohamad
who stated, “Muslims have to decide, and remember that Allah Subhaanahu wa Ta’ala will
not change our destiny unless we put in the efforts to change it ourselves.”4

The role of IDB is to assist the evolution of markets. Part of this process may cause public
goods to turn into business opportunities. The areas of investment include agriculture,
infrastructure, water, energy, health, and transport. Some of these are traditionally under
the purview of government. And, some are left to local authorities or subsistence farmers
and small businesses to manage on their own. But, the dynamic goals of investors and
the changing basis of business mean that improving the quality of life in poorer countries
can be achieved by global economic integration. IDB may accomplish these outcomes by
encouraging lateral investment and trade amongst emerging market nations; and engaging
global investors to mobilize resources through investment partnerships.

The blend of private and public sector development with the objective of poverty reduction
and eradication has proven as an attractive opportunity to global institutional investors. Yet,
investing in such assets also involves new types of investment vehicles and risk (or pension
funds, among other institutional investors) to manage. These include exposures to leverage,
legal and ownership issues, environmental risks as well as regulatory and political challenges.5
Some of these issues are assuaged and overcome by the role of strategic partners like IDB
and other MDFIs. The right partnership approach leads to the expansion and encouragement
of foreign direct investment (“FDI”) in new ways.

Why are the emerging markets, which present both alternative investment characteristics
and socially responsible opportunities, and their most basic investment needs, attractive to
global institutional investors? First and foremost, many of these are believed to have low
correlations to investments in the developed countries, especially listed equities and bonds.
The lack of correlation is enhanced by the potential for exceptional, sustained and long-term
growth in the emerging markets. The challenges for investors include a blend addressing
social needs in emerging markets as well as finding the best investment vehicle: primary
or secondary market tools; debt or equity; listed or private; or direct compared to indirect
investment. Since data is often a major challenge, the role of MDFIs is fundamentally critical
in helping institutional investors to overcome challenges in their risk analysis.6 An area which
is less in the direct skill set of IDB, but within the purview of some MDFIs is the provision of
political risk insurance.

IDB has long sponsored studies about the use of musharakah, mudarabah or wakalah
(“MMW”) for the finance of development. But these approaches are typically limited to a
focus on MMW in a way that does not integrate into the global capital markets, and fails
to support the evolution of domestic capital markets. Some of these studies like Hennawi
(1986) are very limited in their perspective and basic. Yet Hennawi’s type of study certainly

4  Ibid.
5  OECD paper on Pension Fund Investment in Infrastructure (Inderst, 2009)
6  Key thoughts derived from OECD paper on pension investing in infrastructure.

2

inspired the Unit Investment Fund (UIF) and the mudarabah deposits placed with IDB.7

This report aims to discuss resource mobilization for the development member countries
(“MCs”) with funds sourced by the Islamic Development Bank (IDB) via capital market
approaches. The next section will review the role of multilateral development finance
institutions (“MDFI”). This will provide a clear context of MDFI operations, and how, over
time, their role and focus has been shifting due to changes in the market. This shift has also
affected how the MDFIs fund themselves.

Multilateral Development Finance Institution – Dynamic 1.2
Role and Sources of Funds

The five main MDFIs are the World Bank, the Inter-American Development Bank (IADB), the
African Development Bank (AfDB), the Asian Development Bank (ADB), and the European
Bank for Reconstruction and Development (EBRD). These account 85% of MDFI lending. The
World Bank accounts for 60% of the total MDFI lending.8

Over the past twenty-five years, MDFIs have made a significant shift in their operational
profile, providing more market-oriented financing and investment. The main MDFIs were
established as part of the reconstruction of war-torn Europe and Asia in the late 1940’s. The
formal name of the World Bank is the International Bank for Reconstruction and Development.
Only as its mandate expanded did the World Bank change its corporate identity. As Europe
and Japan recovered, new MDFIs were created mostly by western powers to address the
needs of emerging markets in the context of the Cold War. The focus was on using western
aid to staunch the flow of communism.

The basic function of any MDFI was to transfer some of the surplus of developed countries
to developing countries. The primary tool for an MDFI was to borrow in the form of bond
issuances, and to lend to their relevant MCs. MDFIs were generally less active in the main
emerging markets (in fact, commercial banks were often the lead lender until the Latin
American loan crisis of the early 1980s). Three reasons framed the anemic MDFI lending to
developing countries until the 1990s:

Crowding out by Europe and Japan: Until the mid-1970s, Europe and Japan were the 1.
main focus of the World Bank and Asian Development Bank;
Lending Conditions: Until the 1990s, most developing countries focused on import 2.
substitution strategies. Many MDFIs refused to lend until these strategies were ended or
made less central to the policy of prospective borrowing nations; and,
Structural Balance of Payment Problems: Many developing countries could not qualify 3.

7  El-hennawi, Mohamed, Potential Islamic Certificates for Resource Mobilization, presented in the seminar on
Developing a System of Islamic Financial Instruments held in Kuala Lumpur, Malaysia, 1986, sponsored jointly by
IRTI/IDB and Ministry of Finance, Government of Malaysia.
Hennawi also reports on the Jordanian Government muqarada Bonds Act in 1981 which financed a project to set up
a commercial center by the Ministry of Awkaf. Unfortunately, the concept was not integrated into the local capital
market.

8  Refer page 22 (Mistry, 1995)

3

for MDFI loans whilst they were under International Monetary Fund (“IMF”) structural
adjustment programs. Since the 1990’s, very few countries have been under IMF’s
structural programs, and their administration is much shorter.9

MDFIs have always focused on core infrastructure. The concept of infrastructure, over the
years, has become a highly fluid and broad term. In the 1950s and 1960s, the term generally
focused on power, transport and water. These three areas were frequently scalable as they
could be integrated. Industrial development has also been an important area for MDFIs
whether the object of MDFI loans, or indirectly with MDFI activities paving the way for DFI.

In the late 1960’s and 1970s, MDFIs were sponsors of the “green revolution”10 which notably
boosted crop yields in Asia. Agriculture and social sectors including education, health,
nutrition, population control became mandates, as the visionary mission of MDFI became
poverty alleviation through the integrated planning of rural and urban development. When
oil prices increased sharply in 1973 and again in 1979, MDFIs added the energy sector,
including hydrocarbons and other energy resources, to their focus.

In the 1980s, the Latin American and African debt crisis shifted the focus of MDFI and donor
nations from financing economic sectors to financing balance of payments. As a result of
the crisis, commercial banks reduced their loan exposures to developing sovereigns which
expanded the role for MDFI funding. Nonetheless, MDFI funding was typically contingent on
compliance with an IMF mandated structural or sectorial adjustment program. The stated
aim, often never achieved, was to improve economic management. Into the 1990’s, newer
developmental priorities have become part of the development mandate. These include
environmental protection, gender sensitivity, and good governance. Figure 1 summarizes
the dynamic focus of MDFIs in the market.

9  One outcome of the 1997 Asian Financial Crisis was that Malaysia rejected IMF support and other Asian “beneficiaries”
felt that the IMF-imposed conditions were harmful. As a result, many of the countries affected by the crisis have
built-up both their own reserves and enhanced regional cooperation so as to insulate themselves from a future
need to seek IMF assistance.

10  Improved seed and agricultural methods introduced widely in Asia to break the famine cycle.

4

 • Infrastructure (power, transport & water)
 • Industrial development
 • Geographic bias: Europe & Japan

 • Agriculture (green revolution). Geographic expansion in Asia & Latin America
 • Social Sector (education, health, nutrition, population)
 • Poverty allevation through integration of rural & urban development
 • Energy sector (hydrocarbon & other energy resources) due to oil shock in 70s

• Balance of payment support under structural & sectoral adjustment program

 • Newer developmental priorities (environmental protection, gender sensitivity,
    good governance

1950-60s

Late 60s &
 1970s

1980s -
debt crisis

Late 80s
and 1990s

Figure 1: Summary of MDFI Dynamic Role in Development Funding

Interestingly, if one reads the mandates of many MDFIs and of various funds focusing on the
emerging markets, they discuss “infrastructure” extensively. The term has been broadened
to now include:

Power & Energy (including renewable and other forms);1.
Transport;2.
Water;3.
Agriculture;4.
Environmental;5.
Social Infrastructure including:6.

Education;a.

Health & nutrition; and,b.

Population control.c.

More recently, financial services, from micro-finance to conventional banking and capital
markets have been added to the term “infrastructure”. In essence, “infrastructure” is the
alternative term for “development private equity”, “development finance” or investment in
“economic development”.

Since 1989, private capital has been more willing to invest in long term infrastructure projects,
education and health (private university & hospital) due to liberalization of the economic
and financial system11 in many emerging markets. This has prospectively diminished the

11  Especially abandoning of interest rate and exchange control.

5

roles of MDFIs and is driving MDFI to shift their focus to:

Poorest developing countries1.  - Africa and South Asia, where the global capital market is
not yet willing to invest;
Human capital2.  – non-cash flow generating activities: Again, not interesting to private
capital. These areas include public primary & secondary education, and rural health care;
and,
Institutional infrastructure3.  - proper functioning of market economies: These are often
capacity-building activities involving the legal and judicial system, enforcement of property
rights, developing transparent accounting systems, and improved public administration
and political governance;

In the traditional focus areas for MDFIs, many are shifting from financing government and
their agencies to financing investment undertaken by the private sector. MDFIs deliver
finance to their constituents through various “hard” and “soft” windows.12 The former are
generally commercial forms of investment13 (i.e. funding according to market terms) whereas
the latter are concessionary.14 The MDFIs “hard window” are funded using equity (paid in
and callable capital15) and debt from the international capital market. MDFIs are very careful
to maintain the highest possible credit rating to ensure they can raise debt funding from the
market at a competitive rate.16 Unlike the hard window that is funded via the international
capital market, the soft window is often funded by a multilateral ‘club’ of donors. The soft
window is usually set up as a separate fund (commonly known as multilateral development
fund) or as a separate association (for example, the International Development Association,
IDA, is the soft window of the World Bank). As the soft window is funded via donation, the
MDFI cannot lend out more than the funded amount. (Mistry, 1995)

The impact of the shift to private sector financing on the MDFIs is significant as they seek to
supplement their equity capital, interbank, and bond resources. An important new resource
has been the emergence of funds as a source of capital. This study will review both IDB’s
experience and that of other MDFIs in the use of funds as a means to diversify their operation
and activity. We have dedicated Chapter 3 to discuss these experiences.

12  In this section, as the focus is on the main MDFIs, the report uses the terms loan, borrow etc. as this is not reflecting
IDB funding mechanism.

13  Similar to a commercial bank, the funding is based on market rate. Normally the forex risk is transferred to the
member country.

14  Beneficiaries are only charged a service fee to cover administrative cost.
15  Callable capital is not paid in by the member. It is basically a guarantee to pay if called by the MDFI. Thus the actual

paid in capital of the MDFI is only a small portion of the MDFI sources of fund.
16  For many MDFIs, there is a gearing ratio (loan to capital) of 1:1. Although their constitution allows for MDFIs

to borrow up to 100% of their subscribed (i.e. total capital), the market would consider this to be imprudent.
Many MDFIs, in practice, limit their debt ratio so it does not reach the cap. In addition, different rating bodies
have different interpretation of the notion of usable capital used in determining the debt ratio. The most common
definition of usable capital refers to only callable capital from OECD countries or countries which enjoy the higher
investment grade ratings on their own debt instruments in international capital markets; and countries with large
trade surpluses and reserves.

6

Evaluation Criteria for Alternative Resource Mobilization 1.3
Solutions

The study follows the IDB Group’s Vision 1440H which includes partnership as a strategic tool.
The three key elements of Resource Mobilization for Development through Partnerships,
comprise of:17

MC Partnership Strategy (“MCPS”) – Although many MDFIs pursue partnership strategies, 1.
IDB uses reverse linkage as a unique approach to implement this strategy where MCs help
other MCs. For instance, IDB worked with Turkey to assist Syria and other countries in
capacity building in Syria & other countries:18

Economic cooperation & regional integration –IDB’s subsidiary the International Islamic 2.
Trade Finance Corporation (“ITFC”) has played a crucial role in this form of MC-to-MC
trade, as well as MC to the world and MC within their specific regions; and,

Co-financing: PPP funds with other MDFIs or other investors like the IDB-ADB Islamic 3.
Infrastructure Fund.

IDB seeks to create a robust and sustainable source of funding. The structure of the funding
should embed a flexible design. Ideally, the solution should neither require pre-existing assets
on IDB’s balance sheet nor intend to deliver assets to IDB’s balance sheet. The outcome of
our analysis should be to preserve IDB’s leadership role in leading partnerships for growth
and development.

The importance of a well-defined portfolio of tactics is that it allows IDB to meet its objective
of balancing investor expectations for high return and MC demands for cheap funding. The
following criteria will be used as the benchmark in evaluating the proposed solution:

Off balance sheet – If IDB grows its balance sheet through more on-balance sheet, debt-1.
like instruments, then IDB needs to continuously raise more capital in order to keep
expanding its operations. Otherwise, if IDB is to maintain its AAA-rating, there will be
constraints on the expansion of on-balance sheet operations.

Cost of funds – as MCs constantly look for efficient funding options, we will examine a 2.
solution that will reduce the burden on both IDB and its Member Countries;

Diversification of investors – An expanded fund strategy admits the possibility that IDB 3.
may include a wider range of investors, including new relationships into IDB’s financing
and investment operations.

17  See “Vision” on page 38 of the IDB 2010 Annual Report. Accessed at www.isdb.org.
18  For detail on the framework involving Turkey, see the IDB 2010 Annual Report, p. 39.

7

http://www.isdb.org

The two key capital market areas that the study will examine are Sukuk and funds, which are
evaluated in Chapter 2 and Chapter 3 respectively. IDB has been an active issuer in the Sukuk
market, while it has only sparingly used investment funds as an alternative funding strategy.
Each of this study’s chapters addresses a key issue in building IDB’s fund strategy.

Chapter 2: The chapter will evaluate sukuk as a source of funding against the objectives
of this study. In order to do this, the study engages in a SWOT analysis of the common
sukuk types. The chapter also reviews the IDB experience with sukuk. IDB was a pioneer
in the development of sukuk structures and the general architecture of the sukuk market.
It has long term plans to access funds by issuing sukuk. These plans will be hemmed in
by the size of IDB’s balance sheet. The outcome of the evaluation of sukuk is that sukuk
needs to be complemented by off-balance sheet instruments to meet the long-term goals
of the IDB strategy. The chapter also includes a review of retail bond and Sukuk issuance
trends in selected markets. How retail bond/sukuk strategies might facilitate IDB in taking
an intermediate approach is analyzed in contrast to the pursuit of a full equity infrastructure
fund strategy.

Chapter 3: The third chapter compares various development funds, which have been in the
market since the early 1990s including IDB’s experience in the funds market. After a short
review of the Islamic funds market, the chapter will evaluate the funds market against the
research objectives. The outcome of the evaluation is that funds have significant capacity to
meet IDB’s goals in managing costs, delivering off balance sheet finance, and a prospectively
broader group of investors.

Chapter 4: This chapter addresses two main components; investors and fund domiciles.
The investor segment reviews market developments, investor interests and expectations
in different fund classes. The domicile section will focus on finding the jurisdictions that
facilitate a broad fund strategy. After elaborating on the domicile selection and evaluation
criteria, the chapter will perform a SWOT analysis on the individual domiciles and conclude
the chapter with evaluation of the different jurisdiction.

Chapter 5: This chapter discusses the proposed structure applying the master-umbrella-
feeder structure. It examines how the fund may benefit from a pooled investment in
infrastructure projects, trade finance, and participation in IDB’s existing portfolio. There
will be a dedicated discussion on socially-oriented funds and how IDB may leverage on its
reverse linkage policies in the MCPS to learn from the experience of other member countries
that have successfully transformed socially-oriented projects into commercially managed
projects. We also conducted a simple market survey with selected industry players to gauge
the market acceptance of the IDB funds strategy. A number of industry players still prefer
that IDB pursue the Sukuk strategy, instead of a fund strategy.

Chapter 6: In the final chapter we summarize the issues studied, recap the recommendations
and also summarize how IDB may benefit from the retail Sukuk market experience to finance
infrastructure.

8

Conclusion1.4
The importance of funds in IDB’s context is to find means to leverage IDB’s wealth of
knowledge instead of its balance sheet. As a result, partnership solutions to be investigated
will not add to IDB’s debt burden. The additional benefit is that the strategy will preserve
IDB’s AAA credit rating. The desired achievement will also balance properly between the
delivery of a reasonable return to investors and competitive pricing to IDB’s clients, the
member countries (the “MCs”).

The proper development of markets requires executing models which expand beyond
institutional funding of investment projects. This means that the IDB partnership solution
should ultimately allow middle and small investors in or from MCs to participate in financing
development in their countries. Such an expansion of these concepts will support Islamic
capital markets and Islamic financial institutions in MCs. As an intermediate solution, IDB
may choose to develop the retail Sukuk market in different jurisdictions.

The execution of the partnership-funding strategy applying investment fund structures is
meant to fit within the concept of the maqasid or objectives of the Shariah, as summarized
by the scholar Al-Ghazali:

“The objective of the Shariah is the well being of the people, which lies in safeguarding
their faith, their self, their intellect, their posterity and their wealth. Whatever ensures
the safeguarding of these five principles serves the public interest and is desirable,
and whatever hurts them is against the public interest and its removal is desirable.”19

By promoting sound economic development and leveraging IDB’s skills and knowledge
alongwith external resources, IDB is able to safeguard these five principles, with a particular
focus on wealth, its creation and preservation at the societal level. The proposed fund
strategy will achieve this in the following ways:

 Delivering an internationally accepted fund vehicle to key investor universes which 1.
support IDB Group’s MC’s needs;
 Build a blended return that offers attractive financing and investing alternatives to MC 2.
states, entities, or projects;
 Build a vehicle that leverages the IDB Group’s knowledge more than its balance sheet 3.
and allows for enhanced value to all stakeholders, all partners in the process.

The concepts that are raised in this report are meant to address a conundrum raised in an
Ernst & Young report:

“In the next 2-5 years, we do not foresee a dramatic change in the GCC market, unless
the institutional sector, sovereign wealth funds, pension funds, takaful companies,
etc. come into the Islamic funds market in a big way.”20

19  Al-Ghazali, 1937,VOL.1, P.139, cited by Dr. Umer Chapra in the appendix to the Minutes of the Third IDB 1440H
Vision Commission Meeting, 22 March 2006/22 Safar 1427 accessed at www.isdb.org.

20  Op. Cit. E&Y Funds Report 2011.

9

http://www.isdb.org

This is where the role of IDB comes, not so much to support the GCC funds market, but to draw
qualified investors from those not currently active in the Shariah funds and development
orbit, into it. Moreover, IDB’s success in building the right fund structures means that instead
of crowding the local financiers out of the development finance market, IDB will be able to
strengthen local capital and financing markets into which IDB fund programs direct their
efforts.

10

- Evaluation of Sukuk as Resource Chapter 2
Mobilization Tool

Introduction to Main Sukuk Types2.1

The sukuk market has proven beneficial to IDB. Over the past nine years, IDB has come to the
market 11 times21 and raised over four billion dollars in medium term funding. The purpose of
this chapter is to evaluate sukuk as source of funding against the study’s objectives. In order
to do so, this chapter presents a SWOT analysis of the common sukuk types and reviews the
IDB experience with sukuk. In addition, we will also analyze the development of retail bonds
and Sukuk in different markets.

The sukuk market has applied a wide diversity of concepts. The market is constantly subject
to experimentation. Often the market is faced with substantial obstacles in the absence
of well developed capital markets infrastructure. The most popular forms of sukuk have
been ijarah-linked (all markets) and Murabaha-linked (Southeast Asia) with fewer based on
Musharakah, Mudarabah, Wakalah, hybrid, and salam deals. One of the reasons that the
term ijarah-linked is used is that based on many local market laws, the ownership of the
asset to be leased cannot be easily transferred to an SPV (Special Purpose Vehicle) or SPC
(Special Purpose Company) or to foreign investors. This phenomenon has led to the use of
the term “asset-based” for the majority of sukuk as opposed to asset-backed, which applies
to securitizations. Even the capacity of non-banks to secure a charge or mortgage over an
asset means that many investors have an investment that refers to an asset, but neither own
it nor control it.

Ijarah:2.1.1

Strengths Weaknesses

Non-controversial to all investors1.
Asset-based, appear to be “secured”2.
Income is contractual3.

Require assets1.
Assets require maintenance2.
Residual risk3.

Opportunities Threats

Securitization of existing assets1.
Development of assets2.
Acquisition of assets3.

Limited number of assets1.
Not necessarily suited to general working 2.
capital
Cross border enforcement3.
Tax issues4.

Table 1: Sukuk Al Ijarah SWOT Analysis

21  As at January 2012.

11

The strength of sukuk al ijarah is that all scholars and markets are comfortable with the base
concept. For investors, the asset is owned by them or their intermediate investment vehicle
and this gives them “security”22. Moreover, the sukuk al ijarah investor enjoys the benefit of
contractual Shariah-permitted fixed income.

However, not every business has current assets to allocate for this purpose, and many may
not wish or need to acquire assets. If the client has or needs the assets to be leased, then
the general Shariah rule is that the investor side has the primary obligation for maintenance,
insurance and taxes. In many countries, rentals are taxed higher than interest. These
factors may either diminish returns to investors or affect pricing to the client. Finally, at the
termination of a lease, the asset has to be disposed of. If the obligor doesn’t take the asset,
then the investor has residual risks, which may include whether or not the investor can
recover capital upon disposal or must pay to dispose off the asset.

The opportunities for leasing include securitization of existing assets as well as the
development or acquisition of new assets.

The threats include the fact that there are limited numbers of assets in any company. And
the concept of leasing is not necessarily suited to general working capital finance as the
Obligor needs to have a tangible asset to raise funding. Beyond these issues, there are
sometimes cross-border enforcement issues arising from national regulations governing
asset ownership. And until now, tax jurisdictions do not give rent the same benefit that
they give to interest, which means that leasing can be more expensive than other forms of
investment: and this cost is transmitted to the obligor or borne by the investor.

Murabaha:2.1.2

Strengths Weaknesses

Ease of execution1.
Trade and cash concepts applicable2.
Comparable to traditional debt3.

Not tradable in AAOIFI jurisdictions due to 1.
restrictions on trading debts.
Some forms of Cash Murabaha are not 2.
permitted in certain markets or are
restricted.

Bai al-Inaha.
Tawarruqb.

Opportunities Threats

Expedient entry into certain markets.1.
Ease of convincing conventional financiers 2.
to join a deal.

Easily abused1.
Easy to make procedural errors2.
Becomes tool of first choice3.

Table 2: Sukuk Al Murabaha SWOT Analysis

22  Unfortunately, many so called sukuk al ijarah do not actually have factual ownership or legal hypothecation. This is
sometimes for technical reasons relating to the lack of development of the market or legal restrictions on foreign or
SPV/SPC ownership of assets in certain countries.

12

Murabaha sukuk have several forms including true buying and selling of goods, and cash
Murabaha (bai al ainah, and tawarruq). These are all fairly simple to execute. The end result
is a straight-forward fixed-yield debt. As a result, Murabaha-based sukuk are easy to execute.
This means that they may be applied expediently to facilitate entry into new markets, as was
the case with bai al ainah in Thailand and tawarruq in many countries. The use of Murabaha
for trade finance is almost universal. As a result, sukuk implementing true buying and selling
have near universal applicability. And, this means that conventional financiers are able to
join in deals.

The weakness of Murabaha-based structures is that they result in a debt. Apart from
Malaysia and Thailand, the trading of debt is restricted. As a result, the development of an
easily monetized, traded transaction is not widely accepted when using the Murabaha tools.
Moreover, bai al ainah is not allowed under AAOIFI standards, and tawarruq faces strong
resistance in many markets and among leading scholars.

One reason for the resistance to Murabaha structures, which is not unique to Murabaha
sukuk, is that they have been easily abused in the past. The abuse is often in the form
of a trade without a real object: buying and selling with paper “evidence”, but no goods
backing the paper. Even when executed with the purpose of buying and selling, the actual
rules of Murabaha require careful attention or else the sale may be invalidated resulting in
rescission of the gains or donation of any profits to charity. More fundamentally, the problem
in murabaha is that, whichever form is applied, its ease of use results in it becoming the
business practice of choice, crowding out all other methods.

Salam:2.1.3

Strengths Weaknesses

Delivers cash now1.
Simple procedures2.

Potential to be “1. tawarruq”
Requires commodities2.
Offtake required3.

Opportunities Threats

Strong product for commodity-based 1.
sectors
Good fixed income alternative2.

Ease of abuse1.
Procedural requirements2.

Table 3: Sukuk Al Salam SWOT Analysis

Until now, only a few governments, notably Bahrain, have issued sukuk al salam. In the basic
process, the investors buy a commodity from the obligor: the investors pay the full price in
advance, and the obligor will deliver the commodity at maturity.

At maturity, the obligor will receive the commodity, typically in the form of a warrant;
then, the obligor will arrange to sell the commodity on a spot basis for the investors. The
transaction generates upfront cash to the obligor, and should generate a profit to the
investors by establishing a spread between the initial purchase price and the exit price.

13

Musharakah – Mudarabah – Wakalah (MMW)

Strengths Weaknesses

Allow participation in a business without 1.
selling shares or listing.
High degree of permissible negotiability in 2.
each MMW form.

Limited universe of investors willing to 1.
accept losses in “bond”-like instruments.
Conflicts with ministry of commerce rules.2.
Not directly defined by financial papers and 3.
bond rules.

Opportunities Threats

Managing the need for highly structured 1.
deals.
Build greater appreciation for risk sharing.2.

Ease of violating 1. Shariah rules governing
MMW.
Ease of mischaracterization via structuring.2.

Table 4: MMW Sukuk SWOT Analysis

Musharakah:2.1.4

Since 2006, the market has seen many issuances of Musharaka sukuk. The errors or
structuring approaches taken by many banks offering Musharakah sukuk resulted in AAOIFI
issuing a strong clarification to encourage strict compliance with AAOIFI rules governing
Musharaka (as well as Mudarabah and Wakalah). Sometimes characterized as sukuk al
istithmar, Musharakah sukuk allow for a higher degree of flexibility in managing risk, profit
sharing, and assets. Unlike ijarah, Musharakah allows for the participation in the overall
operation of a business and does not require specific assets.

Mudarabah:2.1.5

All of the factors affecting Musharakah apply to Mudarabah. But many scholars noted in
the mid 2000s that the investment manager or mudarib was not submitting any business
plan, or was presenting a perfunctory plan to investors. As a result, most scholars required
a clear and detailed plan. This has dimmed the perspective of some issues for choosing the
Mudarabah structure.

Wakalah:2.1.6

These are also sometimes characterized as sukuk al istithmar. The Wakalah concept has
greater flexibility than Musharakah and Mudarabah under Shariah rules. As a result, the
market has become increasingly enthusiastic about the term “Wakalah”. But, is the concept
applied properly?

The first problem for Wakalah is that the agreements are often structured to mean that the
agent or wakeel offers a target yield that approximates the benchmark interest rate for the
customer with all additional yield granted to the wakeel as an incentive for achieving the
benchmark. Often structured so that there is no risk of loss, sukuk al Wakalah are often
almost pure debt as opposed to risk sharing instruments.

14

The second issue for sukuk al Wakalah is that they are often structured to appear as risk
sharing instruments. But the real business is to buy and sell commodity certificates in
tawarruq operations, as we will see in the hybrid Sukuk structure.

IDB’s Experience in the Sukuk market2.2

Similar to other MDFIs, IDB uses both equity and debt funding to support its operations.
IDB taps into the Sukuk market for long-term debt funding and leverages on the commodity
Murabaha market to raise shorter term funding.

Table 5: IDB Group Equity Capital

Source: (Islamic Development Bank, 2012), p. vii

Table 5 shows the equity capital of different IDB Group entities.23 As with other MDFIs, we
can observe that the paid-in capital (i.e. cash capital) of IDB and its group are a fraction of the
subscribed capital (i.e. callable capital), which is an even smaller fraction of its authorized
capital. Since its establishment in 1975, IDB has increased its authorized capital from ID2
billion to ID 30 billion in 2011. Similarly, the subscribed capital increased from ID 750m to
about ID18b, and the paid up capital has increased from ID 280m to ID 4 billion. Refer to the
“at inception” row in Table 5 for the amount of capital at the establishment of the different
entities. With the exception of ITFC, other IDB entities also increased their authorized capital
since their inception. All the IDB Group entities have increased their subscribed capital and
paid-in capital since their inception.

Before 2003, IDB relied mainly on its equity capital and reserves to fund its operation. In
2003, IDB launched its first Sukuk (5-year fixed-rate transaction) to raise US$400m. Then, in
2005, it set up a US$1 billion MTN program (listed in LSE) to have a longer and larger Sukuk
raising capacity. The MTN (Medium Term Note) size was updated to US$1.5 billion in 2009,

23  ICD = Islamic Corporation for the Development of the Private Sector, ICIEC = Islamic Corporation for the Insurance
of Investment and Export Credit, ITFC = International Islamic Trade Finance Corporation

15

and further updated to US$3.5 billion in 2010. Under the MTN program, IDB has issued
multiple Sukuk, with a mix of fixed and floating rate, public and private placement:24

Series 1, US$ 500 million issued in 2005 (matured in June 2010)•
Series 2, SGD 200 million private placement issued in 2009 (maturity in September •
2012)
Series 3, US$ 850 million issued in 2009 (maturity in September 2014)•
Series 4 & 5, two tranches of SAR 1.875 billion private placement issued in 2010 (maturity •
in September 2020)
Series 6, US$ 500 million issued in 2010 (maturity in October 2015)•
Series 7, GBP 60 million private placement issued in 2011(maturing in February 2016);•
Series 8, US$ 750 million issued in May 2011 (maturing in May 2016); and•
Series 9, GBP 100 million private placement issued in January 2012 (maturing in January •
2017)

Most of the Sukuk were issued in USD while some were in SDG and GBP. Besides the MTN
program, IDB has also issued two MYR Sukuk (totaling MYR400m) under a MYR1 billion MTN
program in Malaysia. Let us examine the two approaches that IDB has taken in structuring
its Sukuk.

24  Source: http://www.isdb.org/irj/portal/anonymous/idb_capital_en

16

http://www.isdb.org/irj/portal/anonymous/idb_capital_en

IDB Sukuk Istithmar Structure2.2.1

Figure 2: IDB 2003 Sukuk Al-Istithmar
Source: (Haneef, 2009)

Most of the IDB sukuk may be characterized as sukuk al Istithmar. In the first Sukuk deal,
IDB wanted to emulate the income bond issued by the IFC in 1995. IFC had given loans to
member countries, so they securitized their loan portfolio. These loans (73 in total) were well
diversified; where no single loan represented more than 2.5% of the portfolio. It was also
diversified by country, so no single country had more than 16% of the portfolio. IFC sold its
loan portfolio in a proper securitization approach with rating. IDB wanted to take the same
approach but they realized they didn’t have the diversity and many of its member countries
were not rated. So IDB didn’t have the type of underlying asset that IFC had. Therefore, the
securitization path was not viable and they chose the Sukuk Al-Istithmar route. The following
were the transaction steps for the first Sukuk issuance of IDB:

IDB selects a pool of assets to serve as the reference pool of the 1. sukuk. IDB is the
originator and sells these assets to the Islamic Corporation for the Development of the
Private Sector (“ICD”);
An SPV was structured in a suitable tax haven: in this case Jersey, Channel Islands. The 2.
SPV acquires from ICD the rights to a bundled pool of assets of which 51% are Ijarah
“hard” assets to assure tradability;
The SPV declares a trust over the assets;3.
The SPV appoints ICD to service the assets;4.
ICD delegates this role to IDB;5.
IDB provides a performance guarantee and purchase undertaking to the SPV; details are 6.
in Figure 3, and,
At maturity, the assets are sold back to IDB.7.

17

Liquidity Facility

Guarantee

Purchase Undertaking

• IDB undertakes to make an interest-free loan to the trustee to
ensure timely payment of periodic distribution

• Maximum amount is the accrued but unpaid profit plus the admin
expenses

• IDB guarantees to cover the shortfall in collection and prepayment
• Cover ICD’s liability and the liability of trustee with regards to tax

• The Trustee has agreed unconditionally to sell to IDB on the
Maturity Date or on the Dissolution Date the Sukuk Assets

• The purchase price equal to the aggregate Net Asset Value plus the
amount of any accrued but unpaid profit

Figure 3: Credit enhancement in the IDB 2003 Sukuk Al-Istithmar
Source: IDB Sukuk documents; SHAPETM Financial Corp

The second IDB deal used a similar structure, this time however, without ICD playing the
intermediary role between IDB and the SPV. The Shariah Committee viewed the second IDB
Sukuk as Mudarabah.25

25  From Page 8 of the Offering Circular; The Shariah Pronouncement Section: “The Trustee will invest the part
representing the Principal – Ijarah and the Principal of the Instalments under murabaha and istisna’a contracts to
purchase physical leased assets from IDB and in murabaha transactions to be entered into by IDB as Wakeel, and
will not be used for any redemption of the Trust Certificates. Accordingly, the Trust Certificates are investment
certificates or mudarabah Sukuk and not merely a sale of debts under ijarah, murabaha and istisna’a contracts. It
is permissible, according to Shariah, to conduct mudarabah transactions involving physical assets after estimating
their value, and in debts, after being commingled with physical assets in a separate and distinct portfolio. The return
of the investment in purchasing leased assets and in murabaha transactions should be added to the Profit Account
in favour of the Certificateholders and should be dealt with in the same manner as the Profit collected by IDB.”

18

Figure 4: IDB 2005 Sukuk Al-Istithmar

Source: (Haneef, 2009)

IDB selects a pool of assets to serve as the reference pool of the 1. sukuk.
An SPV was structured in Jersey with £2 capital. The SPV acquires the pool of assets from 2.
IDB of which at least 30%26 are Ijarah assets;
The SPV declares a trust over the assets;3.
The SPV appoints IDB as the servicing agent.4.
IDB provides a purchase undertaking and a liquidity facility to the SPV;5.
At maturity, the assets are sold back to IDB.6.

There are a few differences between the first and second structure. In the first deal, Shariah
scholars in the deal, particularly Sh. Taqi Usmani, were not comfortable with the idea that
IDB would sell the asset and buy it back at maturity. Thus, he insisted that ICD comes in as
the intermediary. This means that the investors bought the asset pool from ICD but sold it
back to IDB, avoiding a direct Bai al-Ainah discomfort that Sh. Taqi had. A different group of
scholars in the second deal did not have the same discomfort and allowed IDB to sell directly
to the SPV, on the grounds that the SPV can be viewed as an independent party. All other IDB
Sukuk followed the second approach.

26  Note that the scholars in the second IDB Sukuk Al-Istithmar are different from the scholars in the first deal with the
exception of Dr. Abdul Sattar Abu Ghuddah.

19

In addition, in the first deal, IDB provided a guarantee to cover any shortfall, in addition to
the liquidity facility. Since ICD was the servicing agent, the guarantee also provided comfort
to investors that IDB would back any non-performance by ICD. The second deal did not have
any additional guarantee as the liquidity facility and purchase undertaking was sufficient to
provide recourse to the investors. The purchase undertaking is an important legal mechanism
to create recourse to IDB.

Table 6 summarizes the effect of the purchase undertaking in the first IDB Sukuk issuance.
IDB basically promises to buy back the Sukuk asset from the SPV either at maturity or in
the event of default at principal plus accrued but unpaid profit. The second deal had similar
trigger events and pricing. Section 2.2.2 will discuss the role of the purchase undertaking in
further detail.

Finally, the ratio of the minimum Ijarah assets in the pool differs in the first (51%) and
second deal (30%). AAOIFI, in its Shariah Standard No. 12 (Financial Papers) allows trading
of company shares that have at least 1/3rd tangible asset.27

We can summarize that the ratio of minimum tangible assets to allow for the tradability of
Sukuk may be different according to different Shariah boards – AAOIFI allows 1/3rd tangible
asset. IDB’s second Sukuk used slightly less than 1/3rd. Nonetheless, the commonly applied
benchmark in the global market is 51% tangible assets.

Rafe Haneef, who had the opportunity to work on the first IDB deal, is of the view that the
IDB 2003 Sukuk Al-Istismar set precedents in the Sukuk market.28 The first three issuances
were later taken and expanded upon vastly by other Sukuk market participants:

Co-mingling of asset (1. khulta) – there is no need to have 100% assets supporting the Sukuk,
only 51% was sufficient. The second IDB deal brought this down to 30%.
IDB was the first deal to use the ‘incentive fee’ clause – if the return is more than certain 2.
benchmark, the Sukukholders will waive the excess. Naturally, people will ask about
the shortfall – so IDB provided coverage of the shortfall. This basically gave birth to the
liquidity facility and incentive fee clause that is now widely practiced in the market.
No due diligence was conducted on the legal transferability of the assets and consequently 3.
IDB will indemnify the Sukukhoders if there is any legal problem subsequent to the
issuance.29

27  Refer to pp. 380, 392-393 of AAOIFI Shariah Standards.
28  Mokhtar, Shabnam, Interview with Rafe Haneef, at ISRA on 23rd October 2009
29  The no due diligence clause commonly reads as follows: “No investigation or enquiry has been made and no due

diligence has been conducted in respect of the Sukuk Assets. Only limited representations have been obtained
from ICD and IDB in respect of the Sukuk Assets. In particular, the precise terms of the Sukuk Assets or the nature
of the assets leased or sold is not known (including whether there are any restrictions on transfer or any further
obligations required to be performed by IDB to give effect to the transfer of the Sukuk Assets). No steps will be
taken to perfect any transfer of the Sukuk Assets or otherwise give notice of the transfer to any lessee or obligor in
respect thereof. Obligors and lessees may have rights of set off or counterclaim against IDB in respect of such Sukuk
Assets.”

20

ICD intervention – IDB cannot give a guarantee if it was the wakeel. With ICD coming in 4.
between, this was seen as a form of exit. This was not required any longer in the second
and subsequent Sukuk issued by IDB.

Recourse to IDB2.2.2

As highlighted briefly above, the purchase undertaking provided by IDB is an important legal
instrument to create recourse to IDB instead of the investors taking the asset risks.

Table 6 shows the effect of the purchase undertaking in the first IDB deal. All other IDB deals
had a similar undertaking. In the event of a default, the investors will sell back the asset pool
to IDB and will claim the principal outstanding plus accrued but unpaid return. This takes
away the asset risk from the investors and provides assurance on their capital amount.

When Sell What At What price

Maturity date Underlying asset Principal plus accrued but unpaid Periodic
Distribution Amounts

Dissolution Date Underlying asset Principal plus accrued but unpaid Periodic
Distribution Amounts

Table 6: Effect of Purchase Undertaking (PU) in IDB Sukuk 2003

Essentially, this form of sukuk al-Istithmar is a form of MMW, depending upon how IDB’s
role is characterized. The investors participate in the pool of assets, but do not own them in
a manner that allows them to take control of the assets.30 This has been the base form of
almost all IDB sukuk. The method, however, does not remove the assets from IDB’s balance
sheet and the purchase undertaking creates an obligation on IDB (i.e. the Sukuk is treated as
liability in the balance sheet, and the assets remain on IDB’s book).

Although some documentation called this a form of securitization, IDB could not deconsolidate
the assets. In the securitization market, the regulators and the rating bodies will look at it
as if the asset-backed security (ABS) is credit linked to the originator. In other words, if the
portfolio of assets sold is non-performing, does the SPV have recourse against the originator?
If there is recourse against the originator, it usually does not fulfill the requirement of credit
delinking and thus does not qualify as a securitization deal. The purchase undertaking plays
this exact role – to create recourse to IDB in case of non-performance, thereby default.
Therefore, the deal carries IDB rating instead of the rating of the asset pool.31

30  From a Shariah perspective, the investors are the owners of the pool of asset. However from legal and accounting
perspective, the investors may have different rights – closer to a creditor that funded IDB, rather than owner of the
assets. This disconnect between Shariah rights and legal rights is a common challenge in many Sukuk deals.

31  There are misconceptions in the market that the rating bodies require the purchase undertaking. In reality, the
Sukuk structures put in place the purchase undertaking because they want the rating bodies to rate the deal
according to the credit of the purchase undertaking provider and not the asset pool in the deal.

21

Moreover, IDB makes no representations to the assets or their transferability: In a normal
securitization, the buyer receives representations and warranties as to the underlying assets
and the SPE (Special Purpose Entity) will take proper contractual ownership of the assets.

Another feature of IDB’s initial issuance is the delivery of a liquidity facility which allows
the investors to receive payments whether or not money has come upstream from the
underliers. Normally, in a securitization, the investors must live with the cash flows, regular
or irregular, as they come from the underliers.

Recent Innovation in Sukuk Structures2.3

Strengths Weaknesses

Structured to capture characteristics 1.
of more than one business method or
contract.
Allow asset light or new business strategies2.

Risk of error in the reconciliation of the 1.
methods – i.e. knowing which method has
precedence in governing the obligor.
Limits on tangible assets.2.
Complexity; inefficiency3.
Shariah4.  reputational risk

Opportunities Threats

Seemingly endless set of combinations1.
Capacity to address working capital and 2.
asset oriented business strategies

Errors in execution.1.
Drive out core methods 2.

Table 7: Hybrid Sukuk SWOT Analysis

Mudarabah/Tawarruq Hybrid2.3.1

Although the types of hybrids used in the sukuk markets vary, the blending of sukuk al
ijarah and Wakalah to engage in reverse-tawarruq began as a trend in 2011. In this latest
style, the quantum of ijarah assets is required to be big enough to allow tradable sukuk,
but requires that the issuer actually have the assets. Often, the obligor acts as a mudarib or
wakeel to manage the underlying assets: hence the ijarah leg is not always called ijarah, but
Mudarabah or Wakalah. Figure 5 illustrates this hybrid structure. If the Obligor is an Islamic
Bank, the Mudarabah portion is where the investors are participating in the Islamic bank’s
Ijarah portfolio via a Mudarabah placement.32 This is normally for 51% of the Sukuk amount.
The pool remains on the Obligor’s balance sheet and the Obligor as Mudarib has obligations
to source, manage and replace the assets in the Mudarabah pool.

Simultaneously, the Wakalah leg (49%), is meant to raise funds for the obligor to engage in
new business. The reason it is called a Wakalah is that the obligor will undertake to act as

32 If the Obligor is not an Islamic bank, the participation into the Ijarah portfolio will be replaced via a sale and
leaseback transaction, where the Obligor will sell an asset on a spot payment basis to the SPV and lease it back for
the term of the Sukuk. This was done in the ALim Sukuk arranged by Al-Rajhi Malaysia for Cagamas issuance in 2010
for example.

22

an agent for the investors to use their funds to buy commodity on a spot basis and then buy
these commodities from the investors on a deferred basis. As the owner of the commodities,
the obligor will then sell commodities on a spot basis to a broker to generate fresh cash
for the its business operations. This is the structure of reverse-tawarruq (R-tawarruq for
short).

Figure 5: Mudarabah-Wakalah Hybrid Sukuk Structure
Source: SHAPE™ Financial Corp.

The Wakalah/R-tawarruq arm is effectively like a zero-coupon instrument, compensating
for the possible risk under the Mudarabah element. In the Wakalah/R-Tawarruq arm, the
investors use, for example, US$200m capital to buy the commodities and sell it at US$220m
to be paid in, say, 3 years. The higher sales receivable effectively allows the investors to
recover their capital in the Mudarabah to the extent of the Murabaha profit amount. If the
Mudarabah is successful, the gross return will far exceed the benchmark or the expected
return, and the wakeel will be rewarded with the excess yield as a performance fee.

Traditional fixed income investors prefer the Wakalah leg because their exposure is not to
the new business initiated by the obligor, but to the tawarruq debt of the obligor to pay
them a fixed profit and an assured payment of the capital.

It should be noted that when the markup of the commodity murabaha (R-tawarruq) is
included, total debt of the underlying assets will exceed 49%, and might exceed 70% of
total assets of the sukuk. Further, the stipulated combination of Mudarabah and R-tawarruq
may be viewed as putting the mudarib in the position of guaranteeing the capital of the
Mudarabah. This may be viewed as conflicting with AAOIFI’s pronouncement on Sukuk
Musharakah, Mudarabah and Wakalah.

23

Common Operational Issues in the 2.4 Sukuk Market

Benefits/Challenges of Special Purpose Entities - SPCs & SPVs:2.4.1

The role of a special purpose entity (“SPE”) is to isolate risks and liabilities. Investors may
wish to own an asset, but direct ownership may generate upward liabilities from assets to
the investors. Investors would also like to isolate the assets from the estate of the seller lest
the seller should go bankrupt. Hence, SPEs are said to provide “bankruptcy remoteness”. If
this can be achieved, then there should be accounting deconsolidation (i.e. off balance sheet
treatment)33 for the asset, and “securitization” will have taken place.

As we discussed in IDB’s Sukuk al Istithmar, there is no separation of the asset from the
Bank’s balance sheet. So the investors must have another set of reasons for desiring to invest
through an SPE. And, the issuer will also prefer to issue the securities via an SPE. The first is
to agree on a common legal system and venue for orderly management of business when all
is going well, and the management of disputes when there are defaults. In both cases, the
issuer prefers the SPE as it will establish a single counterparty to deal with the issuer.

Investors will also select the jurisdiction of an SPE in order to manage their tax risks in the
most efficient manner. The determination of what type of SPE or in which jurisdiction to
locate an SPE is fundamentally the same for sukuk as it is for funds.

The two common forms of SPE are referred to as special purpose companies (“SPC”) or
special purpose vehicles (“SPV”). The difference between an SPC and SPV is that the former
is a company, and there is no trust declared over it. The latter may or may not be a company,
but is a trust. Whereas a company has legal form, owners, and potential tax obligations,
a trust is governed by an indenture which sets out rules for a trustee to follow governing
an asset, a company, or a business. Modern trusts are generally creatures of English law,
although a number of civil law jurisdictions like Bahrain and Thailand have introduced trust
laws to facilitate capital market transactions. As a general rule, once a trust is declared over
an asset, it is held in “trust” for a beneficiary, the “investors”.

During the financial crisis of 2008, SPCs and SPVs faced problems making claims in many
IDB member countries. The problem was that offshore SPEs were typically not admitted to
do business in the country where they thought that they had acquired an asset. As a result,
the need to register an SPE in the country where the assets will be located is frequently
considered, thereby increasing deal costs for investors.

Jurisdictional Issues:2.4.2

Investors will often have strong preferences to select the jurisdiction for an SPE in order to
secure the best protection of their rights during the life of a security. Sukuk-like funds may
have multiple jurisdictions. There is the jurisdiction of the SPE, the domicile of the assets,

33 “Accounting deconsolidation” means that an asset sale has met accounting tests for it to be removed from the
seller’s balance sheet. This is either because there are no contingencies in the sale, or the legal title remained with
the seller, but the risks and rewards or control of the asset have moved to the buyer.

24

and prospectively a completely different jurisdiction for the issuer or the obligor. This was
certainly the case with the different IDB sukuk al Istithmar issuances. Sometimes, even the
form of investment contract like an SPE will require recognition under local law. Multiple
jurisdictions may make it difficult for investors to collect on defaulted payments or to seize
an asset, whether it is from a securitization or is pledged as collateral.

Benefits of Listing Sukuk:2.4.3

Most sukuk are not listed. Generally, investors have justified listing sukuk, like conventional
bonds and equities for two reasons. Some issuers/obligors seek to raise their profile and
listing places them in the public light and provides a form of marketing.

For other issuers/obligors, they have consulted with the investors who wish to have an easy
means to exit their investment by selling on the market. Issuers/obligors often accept this
approach as it does not affect the terms and conditions of their deal, and facilitates investor
goals.

Tax Issues:2.4.4

Most sukuk have been structured to appear similar to traditional bonds. This is so that the
coupon payments will be treated as “portfolio interest” for international tax purposes. This is
because international tax treaties give a lower tax rate to portfolio interest than dividends.

Retail Bond and Sukuk Market2.5

We analyzed the trend of retail bond (and Sukuk) issuance in different markets, and further
scrutinized the application of retail bond and Sukuk for infrastructure financing. From our
review, we found that the experiences of India, UK and Malaysia provide most benefit
to IDB as they took different approaches in developing the retail bond/Sukuk market for
infrastructure finance.

In the USA, issuers may tap into retail investors if they have met the requirement under
Section 33 of the SEC Act. So retail bonds are not a new phenomena in the US. In fact, retail
investors hold about 50% of the muni-bonds in the USA, and they also hold about 15% of
corporate bonds (Galagher, 2012). However, this is not a common trend in other countries.
After the financial crises (both the Asian Financial Crisis, and the 2008 Global crisis), many
countries are aiming to develop their retail bond markets.

Among the ASEAN countries, Indonesia was the first one to launch retail bond (2006).
The purpose of these bonds was to fund the government budget. In 2008, Indonesia
then launched the first retail Sukuk. The government issues these retail bonds and Sukuk
periodically through domestic selling agents.34 In 2011, the government started exploring
the idea of using retail bond/Sukuk to finance infrastructure projects. At the date of this
report, the government has not launch any specific infrastructure retail bonds or Sukuk
(Standard Chartered, 2011).

34  Refer to (Asian Development Bank, 2012) Indonesia Bond Market Guide

25

Thailand, Singapore and Malaysia launched their retail bonds in 2009, whereas Philippines
only tapped into the market in 2012. In Singapore, the market started with the government
bonds and retail investors participated via ATM to buy the bond. Since then the retail bond
market has seen 11 corporate issuances including a Singapore Airlines issuance. Beginning
July 2011, the government and corporate bonds were available for trading on Singapore
Stock Exchange (SGX). Singapore is also aiming to become the hub for infrastructure bond to
meet Asia’s infrastructure need.

Besides the ASEAN market, New Zealand and Australia are also in the midst of enabling retail
bonds. The Auckland Council issued NZ$175 million fixed rate secured retail bonds to finance
the infrastructure need in October 2012. New Zealand has an active retail bond market as it
does not rely too heavily on external funding. Australia, which has always relied on external
funding, was more interested to develop the domestic bond market to avoid being squeezed
during financial crisis. Now let us examine the experiences of the three different markets;
India, Malaysia and UK.

India2.5.1 ’s experience with retail bond and infrastructure bond

The mutual fund industry in India dates back to 1963. Since then the government has been
liberalizing the industry in stages. In 2007, a committee was established to analyze the
possibility of establishing a dedicated development infrastructure fund. At the time of the
report, the investors could invest in the infrastructure sector only through the following
options:

Mutual Funds: invest in listed companies related to infrastructure sector. There were 1.
restrictions for these funds to invest in unlisted securities.
Private Equity (PE) - local and foreign high net worth investors investing in unlisted 2.
infrastructure companies. But this was not available to retail investors.

The committee recommended that launching dedicated mutual funds that are allowed
to invest in unlisted debt and equity securities would be the most suitable avenue to tap
into retail investors. Appendix 3 summarizes the recommendation of the committee with
its rationale on the different operational aspects (structure, liquidity, tenor etc.) of such
dedicated mutual funds.

In 2008, a joint venture between State Bank of India (SBI), Macquarie and IFC was established.
Two unlisted private equity infrastructure funds were subsequently launched in 2010
(Macquarie SBI Infrastructure Fund-MSIF) and 2011 (SBI Macquarie Infrastructure Trust-
SMIT). We will elaborate further on these funds in the next chapter.

Meanwhile, the mutual funds investing in listed infrastructure companies continued. Different
mutual fund companies even launched offshore funds to tap into this sector. For example,
in November 2009, Kotak Mahindra (out of UK) launched a UCIT III compliant infrastructure
fund to retail European investors. The fund was based in Luxembourg, and invests in listed
shares and equity-linked instruments of companies directly or indirectly linked to the Indian
infrastructure and realty sectors. Minimum investment was US$500 (£299).

Although the committee made recommendations about launching dedicated unlisted
infrastructure-focused funds in 2007, no retail mutual fund was launched at the end of this

26

research period. However, both the banking regulator (RBI) and capital market regulator
(SEBI) allowed the launch of the “Infrastructure Debt Fund (IDF)”, targeting institutional
investors. There was also regulation allowing Non-Banking Financial Institutions (NBFCs) to
issue retail infrastructure bonds.

In July 2010, the government announced tax-free status for NBFC infrastructure bonds.
However, the guidelines and regulations for IDF only came in the third quarter of 2011. IDFs
may be issued via the mutual fund (trust-based) route or NBFC route.

Figure 6 summarizes the differences between the two routes.

The mutual fund IDFs are at-risk investments targeted at local institutional35 investors. These
come under SEBI’s regulation. At least 90% of the fund must be invested in infrastructure
debt. These are close-ended funds, or must have a lock-in period of 5 years.

The NBFC-IDFs are targeted towards more risk averse investors. NBFCs will issue bonds
to both local and foreign investors and use the proceeds to provide debt in infrastructure
projects. However, NBFCs are restricted in providing debt to brownfield PPP projects, which
has a government buy-out of the concession.

IDF-NBFC IDF-MF

Regulated by RBI SEBI

Funding tool

Bond issuance, with min 5 years
maturity:

 Either Rupee or Dollar•
 No min. amount•

Mutual Fund unit issuance (close
ended or 5 year lock in period)

 Rupee only•
 Min fund amount INR250m•
 Min investment per investor INR •
10m

Investors Local or institutional offshore Local - institutional investors only

Investment Debt in PPP with at least one year
operation & tripartite agreement At least 90% debt instrument

Figure 6: The differences between two IDF routes in India

The first IDF-NBFC was launched in March 2012 by a consortium of financial institutions in
India (CICI Group, Life Insurance Corporation, Citicorp Finance India and Bank of Baroda). At
the same time, IDFC (Infrastructure Development Finance Company) also applied to SEBI for
launching the first IDF-Mutual Fund.

35 There must be strategic investors contributing (INR250m) and every other investor must invest at least (INR10m).
Each units are issued at a face value of INR1m.

27

In May 2012, SEBI issued guidelines to allow the establishment of Alternative Investment
Funds (AIF). There are three types of AIF:

Category I (Specific incentive from Government) - may be involved in venture i.
capital, social ventures, SMEs, infrastructure or other sectors preferred by the
government.
Category II (other than Category I and III): private equity funds or debt funds for ii.
which there are no specific incentives.
Category III (no incentive & deal with derivatives): Hedge funds or funds which iii.
trade with a view to make short-term returns.

Figure 7 summarizes the difference between AIF (Category I-Infrastructure) and IDF-MF.
Unlike IDF-NBFC, the IDF-MF did not allow foreign investor participation. AIF explicitly
allows foreign investors, and non-resident Indians to participate in the fund. Both IDF-MF
and AIF focus on institutional or high net worth individuals since the minimum investment
per investor is INR10 million. Unlike the IDF-MF, which must invest most of the fund in debt
instruments, AIF may invest in debt and equity securities, listed and unlisted.

AIF - Category I (Infrastructure) IDF-MF

Regulated by SEBI SEBI

Fund requirement

 Close ended•
 Min. fund amount - INR200m•
 Min investment per investor – INR •
10m

 Close ended•
 Min. fund amount INR250m•
 Min. investment per investor – •
INR 10m
 Requires strategic investors•

Investors Indian, foreign or non-resident
Indians (institutional) Local - institutional investors only

Investment

 At least 75% in unlisted securities •
(debt & equity)
 May also invest in listed debt •
securities

At least 90% debt instruments

Figure 7: The differences between two IDF routes in India

If we summarize the Indian experience, the committee in 2007 recommended that the mutual
funds route presents an opportunity to tap into retail investors for infrastructure projects.
However, in reality, the mutual fund route (both IDF and AIF) did not tap into the retail
market, and only focused on institutional investors and high net worth individuals. Other
parts of the recommendations, including permitting funds to invest in unlisted debt and
equity has been formalized in the AIF regulation. Instead, the IDF-NBFCs were issuing retail
bonds. This may indicate that in certain markets, it may be better to tap into retail investors
via the infrastructure bond route instead of the equity funds route. Also, according to (PWC,

28

2010), the majority investors (50%) in the Indian mutual funds industry36 are corporations.
They also observed that retail and High Net Worth Individuals (HNWI) investors exit the
mutual fund investments within two years.

Now lets briefly examine the experience of NBFCs issuing retail infrastructure bonds. Each
retail bond was sold at INR1,000 (US$18) and the minimum investment is INR5,000 (US$91).
Since the IDF-MF regulations were only issued in the third quarter of 2011, the NBFCs actively
came to market only in 2012. The government also sanctioned 10 approved infrastructure
financiers to issue these tax-free infrastructure bonds to mobilize the market. These
institutions were required to raise INR300b in 2012 and were expected to raise INR250b in
2013. There are two main issues that IDB should take note from the NBFCs experience in the
retail infrastructure bond market.

First, the inability of some NBFCs to deploy the funds raised. The National Highways Authority
of India (NHAI) for example raised INR100b in 2012 but was only able to use 25% of the
proceeds due to various delays37 in the Indian infrastructure market. As such, they decided
not to issue new bonds until after 2015. Figure 8 shows the amount that was sanctioned
compared to the amount that was raised by the different institutions.

Figure 8: Actual funds raised by NBFC against their sanctioned amount
Source: (Dasgupta, 2013)

36  This refers to the general mutual fund industry and not infrastructure funds
37  Including the inability of line ministries to get clearance in place before awarding projects

29

One financial institution, the Indian Railways Finance Corporation (IRFC) had a different
experience. As there were enough railway projects for it to invest in, IRFC successfully invested
the funds it raised via the infrastructure bond. As such it was planning to continuously issue
more infrastructure bonds.

The second challenge faced by the NBFCs was the price sensitivity (or unsophistication) for
retail investors. With the success of raising US$7b from retail investors in 2012, a number
of NBFCs decided to tap into the market again in 2013. However, during this period, the
government yield dropped, so the coupon rate offered in 2013 issuances was lower compared
to the 2012 issuances. As such, the NBFCs did not get the expected take-up from the retail
investors.

In summary, the Indian experience shows that it is possible to raise huge amount of funds from
the retail market, but the price sensitivity of retail investors may impede fund-raising when
rates fall. In addition, tax incentives and securities regulation to facilitate fund raising would
not be successful without the smooth running of the infrastructure projects themselves. As
(Kothari & Ladha, n.d.) mentioned: “Practitioners say that the way infrastructure operating
companies are ailing under a pile of debt and stuck operations, what is needed is business,
and not so much another line of funding.”

Malaysia’s experience with retail 2.5.2 and infrastructure Sukuk

Although Malaysia is the third largest bond market in Asia (by GDP), the regulators and the
Malaysian think tank felt that the investors were risk averse and only focused on high quality
issuances (AA and AAA). This limited the number of companies that can tap into the capital
market. In addition, the regulators also wanted to increase the secondary market trading of
bonds and sukuk. As such, the action plan in Malaysia included the following (PEMANDU,
n.d.):

Establishment of Dana Jamin. This is a financial guarantor established in May 2009 to 1.
facilitate the participations of companies with lower credit rating in the Malaysian capital
market.
Active promotional effort from the regulators & investment banks to encourage foreign 2.
investors & issuers in the Malaysian market.
 Strengthening of retail participation in the bonds & Sukuk market.3.

Prior to the retail participation framework, the minimum transaction size to participate in
the bonds and Sukuk market was RM250,000. So retail investors usually participated in the
fixed income market via fixed income funds in Malaysia. The Capital Market Master Plan
2, launched in April 2011, mooted the idea of retail participation in the bond and Sukuk
market.

Since then, the Securities Commission (SC) of Malaysia, has put in place a framework to
facilitate staged participation of retail investors in the fixed income market directly. The SC,
however, wanted to introduce retail bonds/Sukuk to the public in stages. Therefore, in the
first stage, only the government, or government guaranteed institutions were allowed to
issue retail bonds or Sukuk.

30

In the second stage, public listed companies, banks & financial institutions (including
Cagamas) or an unlisted company with guarantee from Dana Jamin or Credit Guarantee
would tap into the retail investors. The final guideline for the issuers was released on 28th
Dec 2012.

The “Eligible Sukuk” section in the guideline summarizes the characteristics of the retail
Sukuk allowed in Malaysia. Refer to Figure 9 for details. SC allows the issuance, fixed
or floating rate Sukuk, with our without periodic distribution, and even convertible/
exchangeable Sukuk. However, the retail Sukuk should not be subordinated, and should
have recourse to the Obligor/originator. The retail Sukuk may be issued either over the
counter (OTC) or on an exchange.

Figure 9: Guideline on Retail Sukuk in Malaysia

Source: (Securities Commission Malaysia, 2012)

Now, let’s briefly examine the Malaysian experience with retail bonds/Sukuk.

21.04 For an issue, offer or invitation to subscribe or purchase sukuk to retail investors,
a sukuk must be denominated in Ringgit Malaysia with a tenure of more than one
year and must have the following characteristics:

fixed term with principal and any profit payable at expiry;(a)
fixed or variable profit rate;(b)
except for sukuk without periodic distribution, profits are to be paid periodically on (c)
certain specified intervals from the issue date;
rank at least equally with amounts owing to unsecured and unsubordinated (d)
creditors; and
does not embed any swaps, options or other derivatives, except in the case of (e)
convertible or exchangeable sukuk where the option is to convert or exchange the
sukuk into shares:

the option is at the discretion of the investor; and(vi)

the underlying shares are listed on Bursa Securities.(vii)

21.05 Notwithstanding paragraph 21.04, retail sukuk must not include:

ABS that fall within the definition of “asset-backed securities” under the (a)
Guidelines on the Offering of Asset-Backed Securities (ABS Guidelines); or

sukuk that is structured like ABS, where the sukuk is without recourse to an (b)
originator or obligor, or where the ability to meet obligations under the senior
tranche is enhanced by less senior tranche(s), but does not fall under the
purview of the ABS Guidelines.

31

Merdeka Savings
Bond

Retail Savings
Sukuk Sukuk 1 Malaysia Dana Infra Sukuk

Date of Issuance 18 March 2009 14 May 2009 21 June 2010 8 Feb 2013

Tenor 3 years 3 years 3 years 10 years

Amount RM 2b RM 5b RM 3b RM300m

Return 5% 5% 5% 4%

Periodic
Distribution Monthly Quarterly Quarterly Semi Annual

Transferable No No

Yes, but only to
agent bank. Info
on public website
(Bond hub). 0.1%
admin cost to
agent bank

Yes - listed on
Bursa Malaysia

Eligible investors

 56 years and •
above; or
Retired on •
medical ground

Malaysian 21
years and older

Malaysian 21
years and older

Malaysian 21
years and older

Minimum
investment  RM 1,000•  RM 1,000•  RM 1,000•  RM 1,000

Maximum
investment  RM 50,000•  RM 50,000•

 RM 50,000 - •
not applicable
to purchase of
resale Sukuk

 NA•

Early Redemption

 After first •
profit payment
 Minimum is •
RM100

 After first •
profit payment
 Minimum is •
RM100

NA - because may
resell to agent
bank

NA - listed

Tax incentive  Returns are tax •
exempted

 Returns are tax •
exempted

 Returns are tax •
exempted

 Returns are tax •
exempted

Distribution
channel

 Commercial •
banks including
Islamic banks
& savings
institutions

 Commercial •
banks including
Islamic banks
& savings
institutions

 Commercial •
banks including
Islamic banks
& savings
institutions

 Application •
form
 Internet •
banking
 ATM•

Figure 10 summarizes this. As highlighted in the beginning of this section, Indonesia has
tapped in retail bonds (2006) and the retail Sukuk market (2008) prior to many other ASEAN
countries. Malaysia joined Thailand and Singapore in launching retail bond in 2009.38 One
month after the issuance of the Malaysian maiden retail bonds (targeted towards retirees),
Malaysia launched its first government retail Sukuk open to all Malaysian aged 21 and above.
With good demand, the government issued a RM5 billion Sukuk compared to the RM3billion
retail bond.

38  The government retail bond and Sukuk were issued via Bank Negara Malaysia

32

Merdeka Savings
Bond

Retail Savings
Sukuk Sukuk 1 Malaysia Dana Infra Sukuk

Date of Issuance 18 March 2009 14 May 2009 21 June 2010 8 Feb 2013

Tenor 3 years 3 years 3 years 10 years

Amount RM 2b RM 5b RM 3b RM300m

Return 5% 5% 5% 4%

Periodic
Distribution Monthly Quarterly Quarterly Semi Annual

Transferable No No

Yes, but only to
agent bank. Info
on public website
(Bond hub). 0.1%
admin cost to
agent bank

Yes - listed on
Bursa Malaysia

Eligible investors

 56 years and •
above; or
Retired on •
medical ground

Malaysian 21
years and older

Malaysian 21
years and older

Malaysian 21
years and older

Minimum
investment  RM 1,000•  RM 1,000•  RM 1,000•  RM 1,000•

Maximum
investment  RM 50,000•  RM 50,000•

 RM 50,000 - •
not applicable
to purchase of
resale Sukuk

 NA•

Early Redemption

 After first •
profit payment
 Minimum is •
RM100

 After first •
profit payment
 Minimum is •
RM100

NA - because may
resell to agent
bank

NA - listed

Tax incentive  Returns are tax •
exempted

 Returns are tax •
exempted

 Returns are tax •
exempted

 Returns are tax •
exempted

Distribution
channel

 Commercial •
banks including
Islamic banks
& savings
institutions

 Commercial •
banks including
Islamic banks
& savings
institutions

 Commercial •
banks including
Islamic banks
& savings
institutions

 Application •
form
 Internet •
banking
 ATM•

Figure 10: Retail Bond & Sukuk in Malaysia

We can observe a few evolutions in the different retail Sukuk and bond offerings in
Malaysia:

The first two bonds/Sukuk were non-tradable, hence allowing for early redemption i.
for the investors.
The third issuance (in 2010) introduced the idea of trading to retail investors - ii.
thus it did not come with early redemption. In Sukuk 1Malaysia, the investors
may sell the Sukuk to the agent bank, with 0.1% admin cost. However, the price
will be at par.

33

The first three Sukuk/Bonds were not listed on the exchange, and the investors iii.
deal with the commercial banks to participate in the Sukuk.
Dana Infra Sukuk - represented two important evolutionary stages in the iv.
Malaysian retail Sukuk experience.

First, unlike the general obligation Sukuk issued by the government prior a.
to this, Dana Infra is an infrastructure project Sukuk. The longer tenure (10
years) did not negatively affect the investor demand.
Second, the Sukuk was listed on the exchange. Unlike Sukuk 1Malaysia - which b.
introduced tradability at par, the Dana infra Sukuk will be trading according
the market demand. In addition, the distribution channel was also expanded
to include online banking and ATM, in addition to the formal application
form.

Since Dana Infra set up a program issuance, they raised funding in smaller tranches compared
to the Government. All the retail government bonds/Sukuk carried 5% return. Dana Infra
originally contemplated a 3.7% return, but increased this to 4% in the final issuance. Some
bankers highlighted that although issuing retail Sukuk expands the investor base, it comes at
a higher cost. For example, some think that Dana Infra could have issued the Sukuk at 3% if
it had tapped into the institutional investors. However, to entice retail investors, Dana Infra
had to increase the profit payment.

Figure 11 shows Dana Infra’s Sukuk price on Bursa Malaysia. It was issued at a premium and
has been trading at premium during the first month. This reflects the good demand Dana
Infra enjoyed.

Figure 11: Dana Infra Sukuk Price
Source: (Bursa Malaysia, 2013)

34

In conclusion, the retail bond and Sukuk offerings in Malaysia were driven by the long term
planning from the regulators and the government. Although Malaysia was not the first
to issue retail bonds/ Sukuk in the ASEAN market, it was the pioneer in raising the first
infrastructure Sukuk. Indonesia has an infrastructure Sukuk in the works, but has not yet
come to market. We anticipate that Malaysia may consider issuing inflation-linked Sukuk in
the next phase of its evolution.

UK’s experience with retail bond including issuance by2.5.3  a
infrastructure company

The Italian MOT (Monte Titoli)39 market is the biggest retail bond market in Europe, having
raised €700b as at May 2012. In June 2009, Eni, an Italian energy group, enjoyed a book
order of €6 billion when they tapped into the retail bond market to raise €1 billion. EDF, a
French utility company also had a similar experience. Although issuing retail bonds requires
onerous EU reporting requirements, a number of companies tap into the market as there is a
strong demand from retail investors who are looking for alternative investments due to low
interests in bank deposit. For example, Figure 12, shows the number of European corporate
bond issues in €1,000 denomination. In the first half of 2009, the number of corporate bonds
issued in this format exceeded the entire previous full year totals.

Figure 12: Number of Corporate bonds issued in €1,000 denomination
Source: (The Economist, 2009)

39  Bursa Italiana has operated for more than 200 years (first established in 1808). The fixed income market on Bursa
Italiana is known as MOT. It caters for regulated (domestic & euro bonds) and unregulated market. In 2007 there
was a merger between Bursa Italiana & London Stock Exchange. http://www.borsaitaliana.it/borsaitaliana/chi-
siamo/bicentenario/tappestoriche.en.htm

35

http://www.borsaitaliana.it/borsaitaliana/chi-siamo/bicentenario/tappestoriche.en.htm

http://www.borsaitaliana.it/borsaitaliana/chi-siamo/bicentenario/tappestoriche.en.htm

Motivated from the MOT success, the London Stock Exchange (LSE) launched its retail bond
platform (known as Order Book for Retail Bond - ORB) in Feb 2010. The portfolio grew from
£100m in first 10 months to £1.2b by Nov 2012. Initially, small companies that did not have
the size to tap into institutional investors utilized the market.40 The recent trend shows that
even larger companies that want to establish alternative funding options are tapping into
the retail bond market. In addition, due to the low interest rate, many companies want
to refinance their bank debt into a bond. The LSE’s retail bond platform allows fixed rate,
floating rate or inflation-linked bond issuances.

According to (KPMG, 2012), there are two principal routes for companies in UK to tap into
the retail bond market:

The listed market i.e. using the LSE’s ORB platform. Companies have issued both fixed-1.
rate coupons and index-linked coupon bonds. Investors may trade these bonds on the
LSE.
The unlisted mini-bond market. Companies like John Lewis, Mr & Mrs Smith and Ecotricity 2.
have tapped into this market, where they issue non-transferable bonds directly to the
retail customers. This type of retail bond even uses exotic coupon arrangements such as
store vouchers, products or customer discounts. (Bloomberg, 2012)

Figure 13 and Figure 14 show examples of bonds issued in both markets.

Figure 13: Retail Bonds listed on LSE - ORB
(LSE, n.d.), p5

40  These companies normally look for smaller issuance size - between £25 million and £250 million

36

Figure 14: Unlisted Retail Bond in UK
Source: (KPMG, 2012), p3

National Grid’s41 bond was the first inflation-linked bond to be traded on the LSE’s ORB
and was also the largest single amount raised through the retail bond market. They also
increased the issuance size from £260 million to £282.5 million due to good demand. We
can observe that (Retail Price Index) RPI-linked issuances have consistently enjoyed a longer
tenure compared to the fixed rate issuances. In the third quarter of 2012, the LSE itself
issued a £300m retail bond at 4.75% (tightest price so far), with a 9 year tenor (longest
maturity on non-inflation linked).

Also notice that Provident Financial, Tesco Personal Finance and Places for People have
completed repeat issues. (KPMG, 2012) shows that the ORB market has the potential to
allow companies to set up program issuances.

After National Grid’s pioneering role in issuing an inflation-linked bond, a number of
companies have tapped into this bond issuance, including Tesco Personal Finance, Places
for People and Severn Trent (water and wastewater services company). (KPMG, 2012)
highlighted that an inflation-linked bond was preferred by Severn Trent because it offered
a much more competitive rate compared to the fixed rate bond. Severn Trent also naturally
earns inflation-linked revenue in its water business.

Besides the retail bond market development in Europe, there is also another interesting
trend relating to bond funds in this market. Bond funds (that cater to HNWI and retail
investors) were an unchartered territory to the European market (unlike Asian and American
markets). In 2009, due to the financial crisis, the demand for bond funds increased from
3% to about 20%. Since this new investor group created further demand in the secondary
market, the institutional investors were willing to take a tighter price and issue in smaller
denomination (1,000 instead of 50,000). An example of fixed income/bond fund managers

41  This is an infrastructure company in UK

37

were M&G Investments and Invesco Perpetual that was managing £18bn AuM (Assets under
Management).

However, in late 2012, a number of private bankers (on behalf of the HNWIs) were cutting
down their investments in these funds as there were concerns regarding liquidity and the
ballooning size of these funds (doubled since 2008). The private bankers were worried that
the fixed income funds cannot meet the redemption requests. One has to keep in mind that
retail bonds are separate from bond funds. In retail bonds the issuer is directly dealing with
the retail investors instead of selling to the bond fund. As the bonds are listed, it provides an
alternative exit mechanism and investors do not rely on the fund managers to redeem the
bonds.

In summary, the development of the European and UK retail bond market spurred from
the pull factor (i.e. demand) instead of the push factor (active government efforts to
develop this market). Unlike Malaysia, which introduced a staged offering (government
then corporate), the European & UK market ventured directly into the retail corporate bond
market. In addition, if we refer to the pricing of the different retail bonds Figure 13, it shows
that the investors are sophisticated enough to deal in different pricing mechanisms (fixed-
rate vs. inflation-linked) and are able to understand factors that affect the coupon (timing,
the interest rate environment, risk factors etc).42 This is quite natural as the investors in
the European market have been exposed to capital market investments much longer than
emerging markets, reflecting a higher degree of sophistication.

Evaluation of 2.6 Sukuk against the Research Objectives:

Although this Chapter details many of the business problems with sukuk, it is not meant to
attack the value of sukuk as an investment tool. Indeed, IDB’s sukuk programs have provided
the benefit of low cost financing to IDB and its MCs. IDB’s issuances have been important
as part of market development: helping to kickstart the market in 2003; introducing new
markets; and experimenting with new forms.

Off Balance Sheet Funding2.6.1

Since its initial benchmark sukuk in 2003, IDB has been a regular issuer. Most of IDB’s sukuk
are characterized as sukuk al istithmar or investment sukuk. These sukuk are structured to
invest in a pool of assets that have already been generated by IDB. These sukuk are not
pass-through securitizations in which an asset is sold by IDB to investors. Rather, investors
have recourse or partial recourse to IDB. Because IDB did not securitize, the outcome is that
the assets remain on IDB’s balance sheet and the sukuk show on the balance sheet as well.
Therefore, IDB has limited capacity to issue these types of sukuk.

The capacity of IDB to securitize is a reflection of the development of capital markets in IDB’s
member states. Securitization is a complex issue which requires a series of philosophical

42  Notice that different issuers have different coupons - either due to timing, maturity or just the credit factor. This is
quite the contrary to the Indian experience in which the investors were price sensitive, without necessarily following
the change in the interest rate environment.

38

decisions which have knocked on meaning for commercial law, national ownership laws, tax
law, and securities laws. Only a few MCs have a modern coordinated securitization capacity
based on either the Anglo-Saxon model (Malaysia) or the German model (Egypt). As the
development of such laws takes many years in most countries, there is not going to be an
increase in the market capacity for securities and securitization in the short term. The MCs
may not be able to support IDB’s sukuk programs in the generation of securitized assets. Many
MCs have restrictions on foreign ownership and complex rules on the transfer of ownership
of assets. And, more critically, the emerging market, and sometimes “less developed” status
of many MCs, means that global institutional investors would be unwilling to invest in such
securitized assets.

This leads to a limit in the market as to how many sukuk IDB may issue without showing high
levels of indebtedness and jeopardizing IDB’s coveted AAA rating. The evolution of emerging
markets and their prospective openness to concepts like securitization is slow. Therefore,
IDB needs to examine how to pursue alternative approaches to financing its development
mandates. Although the on-balance sheet sukuk strategy has limitations, the anticipated
funds could themselves become issuers of different types of sukuk in order to expand their
funding mandates beyond the equity raised from certain classes of institutional investors.

Cost of Funds2.6.2

IDB Sukuk have the benefit of delivering low cost of funds since they rely on IDB’s credit
rating. Thus they are an efficient tool to provide competitive funding to member countries,
as long as IDB is able to maintain its AAA rating.

A strategy that aggressively issues sukuk or relies too much on IDB issuing more capital
market obligations may result in one of three problems for IDB: the cost to IDB may rise;
IDB may have to call more equity from its MCs; or IDB may face a negative credit watch
followed by a possible downgrade. This will diminish its ability to deliver competitive funding
in comparison to other MDFIs. This would have a negative impact on IDB’s secondary mission
to promote Islamic finance as well as its primary mission to finance development.

One could begin with a premise that expects a cheaper cost of funding by tapping into retail
Sukuk. Based on the evidence gathered in Section 2.4, this may not necessarily be the case.
As seen in the case of India and Malaysia, retail investors may not fully understand pricing
dynamics and expect issuers to deliver higher returns. In the sophisticated western markets,
where there is longer history of retail participation in the capital markets, there may be more
favorable pricing for retail bonds. Inflation-linked Sukuk may provide better pricing for IDB,
but this is untested in the Sukuk market.

Diversification of Investors2.6.3

Sukuk are an attractive investment for fixed income investors. This may include pension and
insurance company fixed-income divisions that look for stable investment, with medium to
low risk, within a medium to long-term horizon. However, pension and insurance investors
also have other dedicated investment sections that look for high-return investments. Sukuk
may not necessarily have captured this investor group. In addition, Sukuk in the current
market are focused on institutional investors who are dedicated to the bond markets. There

39

seems to be limited participation of non-bond investors, and even less participation of high
net-worth individuals (HNWI) and retail investors. Although there seems to be an increased
offering of Sukuk funds, again, the majority of investors are institutional investors. Fund
managers and family offices often complain that it is difficult to get their hands on Sukuk.43
Certain markets like Malaysia offers Sukuk funds to retail investors at an affordable minimum
investment. The retail Sukuk in Indonesia and Malaysia received a lot of traction. As proven
in India, retail bonds akin to Sukuk have a high potential for raising a large quantum of funds,
although not necessarily at competitive pricing. One has to keep in mind, the problem of
under-deployment of fund with this approach.

Table 8 shows the summary of the evaluation.

Research Objective Do Sukuk meet the Objective? Implication/Note

Off-Balance Sheet1. No

Additional debt burden
may affect AAA rating if not
supplemented by capital or
alternative funding.

Cost of Fund2.

Generally Sukuk offers a cheaper cost •
compared to funds.
In emerging markets, the evidence •
shows that IDB may have to pay a
higher profit rate to tap into retail
investors.

Depends on IDB’s rating.

Diversification of 3.
investors

Current IDB distribution is focused on •
banks and institutional investors.
Retail Sukuk promises diversification.•

Retail Sukuk market is still
new. Investors are less
sophisticated in emerging
markets.

Table 8: Summary Evaluation of Sukuk against Research Objectives

In conclusion, the function of sukuk as part of IDB’s global funding strategy is crucial. But, the
current nature of sukuk, particularly in IDB MCs footprint means that sukuk cannot generate
off-balance sheet funding for IDB projects and transactions involving MCs. Sukuk, when
sold institutionally, may be able to deliver the lowest cost funding to IDB, which may be
passed on to MC obligors (although IDB cost of financing to MC is higher than that of other
MDFI). However, this low funding cost depends on IDB protecting its AAA rating. This means
although Sukuk are a valuable funding tool for IDB, they must be complemented by other
funding strategies including investment funds that draw global institutional investors.

43 General sentiment gathered during National Bank of Abu Dhabi (NBAD) Islamic Finance Conference in 2011 from
presentations of fixed income fund managers and family office managers.

40

- Development Funds as Source of Funding Chapter 3
for MDFIs

Since the 1990s, development banks have been expanding their presence the investment
fund market. Funds allow MDFIs to take on different risk profiles without violating their
direct mandates and attract private sector investors to long-term projects and risks that
are not customary loan risks. This section surveys a small universe of funds, IDB funds and
others, in order to examine the challenges for IDB to build its full investment portfolio.

Experience of other MDFIs in using development funds3.1
As highlighted in Chapter 1, private investors are choosing many long-term, profitable projects
and sectors due to financial liberation that is taking place in many emerging markets. This
phenomenon has shifted many MDFIs’ focus from financing government to financing the
private sector.

(Perry, 2011) analyzed the trend of MDFI44 funding to developing countries and found that
funding the private sector increased rapidly while lending to governments was stagnant. Only
during the recent financial crisis (2009), MDFIs re-focused on government lending for a short
term period. After the crisis, government funding has been on a declining trend and private
sector funding has been on an increasing trend. Among the MDFIs, it was highlighted that
the European Bank for Reconstruction and Development (EBRD) and International Finance
Corporation (IFC) were the leading MDFIs that fund the private sector.45

Other MDFIs that were actively funding the private sector include the Inter-American
Development Bank (IADB) group, the Corporación Andia de Fomento (CAF), the Asian
Development Bank (ADB), and the African Development Bank (AfDB).

Figure 15 shows the total development-related operations - DRE (loan, equity and guarantee)
of MDFIs to private sector firms in developing countries. The total funding increased from
$9.6 billion in 2003 to $27.7 billion in 2008. In relative terms (private sector DRE to total
DRE), the funding rose from 21% in 2003 to almost 40% in 2008. Loan is the most widely
used funding option, followed by equity and guarantee.

44 IFC, EBRD, ADB, AfDB, IADB, and CAF. He excluded the European Investment Bank (EIB) as it focuses on developed
countries. He also excludes bilateral funding to private sector in developing countries, which he highlights has been
growing at a fast rate.

45  Refer to page 9, Figure 6 in (Perry, 2011)

41

Figure 15: Development Related Operation (DRE) of MDFIs
Source: (Perry, 2011), page 6

MDFI utilization of funds as a development 3.1.1. finance tool

An increasing number of MDFIs use the funds structure to finance their development
activities. The most common fund structure used by MDFIs is the private equity fund where
the investors take a minority interest in investee companies. (Chowdury, Orr, & Settel, 2009)
reviewed eight MDFIs’ use of private equity fund:

African Development Bank (AfDB)1.
Asian Development Bank (ADB)2.
European Bank for Reconstruction and Development (EBRD)3.
European Investment Fund (EIF)4. 46

Inter-American Investment Corpora tion (IIC)5. 47

International Finance Corporation (IFC)6.
Islamic Development Bank (IDB)7.
Multilateral Investment Fund (MIF)8. 48

46  EIF was founded by European Investment Bank as a public private partnership. In 2000, EIB became the majority
shareholder of EIF.

47  IIC is a member of the Inter-American Development Bank Group; it is a separate legal entity with different
shareholders.

48  MIF is a fund under management of IADB and is not a separate legal entity.

42

MDFI Acronym Region
# PE Fund

Investment
(at 2007)

PE Fund
Commitment

(US$m at 2007)
Primary Strategy

African
Development
Bank

AfDB Africa 9 155 Infrastructure
Development

Asian
Development
Bank

ADB Asia 40 763 Financial Market
Development

European
Bank for
Reconstruction &
Development

EBRD
Central
Europe &
Asia

100+ 1,590
Restructuring,
transition, and
efficiency

European
Investment Fund EIF Europe 266 5,602 Support to SMEs,

Entrepreneurship

Inter-American
Investment
Corporation

IIC Americas 16 31 Support to SMEs,
Entrepreneurship

International
Finance
Corporation49

IFC Global 150 2,200 Financial Market
Development

Islamic
Development
Bank

IDB Islamic
Countries 11 1,500 Infrastructure

Development

Multilateral
Investment Fund MIF Americas 40 119 Support to SMEs,

Entrepreneurship

International Finance Corporation 49

Table 9: Summary PE Operations of Different MDFIs

Source: (Settel, Chowdhury, & Orr, 2009)

(Settel, Chowdhury, & Orr, 2009) highlighted that IFC (mid 1980s) and ADB (1983) are the
earliest MDFIs that began private equity fund operations. Most other MDFIs began their PE
operations in the 1990s (EBRD in 1992, EIF in 1997, for example). A number of MDFIs have
formalized their private equity operations (have a dedicated group or entity); led by EBRD in
1997, IFC in 2000 and ADB in late 2002.

Table 9 lists the MDFIs’ PE operations as at 2007. In terms of commitment amount, EIF has
the largest commitment in PE funds, followed by IFC and EBRD. Although an early bird in
the market, the ADB’s charter restricts a tight ceiling on using equity, which does not exist

49 From IFC website June 2012: IFC has 180 funds with $3b total commitment.

43

with other MDFIs. Thus, although it has about 40 funds in its PE operation, it only has a
committed fund of $763m compared to IDB that only has 11 PE investments but with a $1.5b
committed amount. In relative terms (PE investment as % of total MDFI funding), EIF is still
leading, but IFC seems to have the smallest percentage of PE investment. Refer to Figure 16
for details.

The private equity funds of ADB, AfDB, IIC, IDB and MIF (clean energy) have mandates for
infrastructure. EBRD, EIF and IFC’s private equity funds do not focus on infrastructure in
particular, but have a broader mandate for financial market development and the SME sector.
In terms of performance, IDB has the best performing fund, while ADB’s IRR was 50% of that
of IDB. Some MDFIs like IFC does not disclose their return. The motivation behind MDFIs’
increasing utilization of private equity funds is to encourage private investor participation,
especially from pension funds and sovereign funds, since MDFIs’ participation in the fund
is viewed as a seal of approval for the relevant projects or investments. In addition, MDFIs
are of the view that commercial fund managers are much more efficient in deploying the
investment, compared to the longer process it takes at their own institutions. (Chowdury,
Orr, & Settel, 2009).

Figure 16: Private Equity Investment as % of Total Private Sector Investment
Source: (Settel, Chowdhury, & Orr, 2009)

44

Figure 17: MDFI PE Investment Performance – IRR Net of Management Fee
Source: (Settel, Chowdhury, & Orr, 2009)

Specific Examples of MDFI Funds3.1.2.

Multilateral Investment Fund (MIF)3.1.2.1.

Managed from the Washington, D.C. headquarters of the IADB, the MIF is not an
independent entity but a “trust fund” of the IADB. Established in 1993, the fund raised
a US$1.3 billion-dollar grant funded by 39 donors (member countries from LAC, North
America, Europe and Asia). The focus was to support microfinance and the energy sector
in Latin America and the Caribbean. The fund invests in private financial institutions
(banks, cooperatives, MFIs or NGOs) that then lend the resources to micro and small
businesses. So it does not lend directly to the end users, rather via intermediaries.
It uses grants, lending, and equity investments as its financial instruments. Since its
inception, the MIF has approved more than 1,000 projects worth USD 2.2 billion in all
26 developing countries of the IADB.

MIF has invested in four clean energy funds in Latin America. It invested $10m in
the $32m FondElec Latin America Clean Energy Services Fund (FLACES) that played
a fundamental role for clean energy development in Mexico. It also invested in the
Central American Renewable Energy and Cleaner Production Facility (CAREC) – a $17
million mezzanine financing facility that has invested in SMEs that use proven clean
energy technologies. However, MIF feels that its energy funds are not performing as
well as other private equity funds in the region. As the energy sector is still young, the
MDFIs are still exploring the best financing method to manage the risks in the sector
(Chowdury, Orr, & Settel, 2009).

45

MIF has also worked with an arm of the Brazilian government to establish a fund of
funds to develop the venture capital (VC) industry in Brazil. Instead of investing in
high-tech companies, the fund provides equity to many SMEs in various sectors. As at
2007, MIF managed to develop about 50 fund managers to enable an active VC market
in Brazil (Settel, Chowdhury, & Orr, 2009).

In 2010, the MIF had a portfolio of 659 active projects with a value of $739m; 68% of
which were grants, 27% equity investments, and 5% loans. Every dollar approved by
the MIF leveraged more than US$2 from partners in 2010. Since majority of the funding
is via grants, the business model is not fundamentally commercial. (IADB, n.d)

AIG African Fund Infrastructure Fund L.L.C. (the “Africa Fund I”):3.1.2.2.

The Africa Fund I was established in March 2000 and domiciled in Mauritius. The
Africa Fund I was structured as a private equity fund with a plan to acquire operating
businesses, hold the investments for three to five years, and then exit by either initial
public offering (“IPO”), private sale, or put back to the management or owners over a
ten year period. The fund manager was Emerging Capital Partners, a part of Emerging
Markets Partnership. The fund raised $407 million from a mixture of institutional
investors (AIG), development financial institutions (IFC, AfDB, DBSA, Proparco, EIB),
and an energy company ‘El Paso Energy’. Some of the investors represented PPP
investment bodies in their own right.

The investment commitment period was five years and had a 10 year term. Although
this is called an infrastructure fund, it has a wider scope; it includes all sectors but real
estate and financial institutions. The fund does not invest in a government controlled
company or a start up. The fund’s investment ranges from US$10 million to US$50
million, in projects or companies having total valuations of US$25 million to over
US$500 million. The limitation was 10–50% of a company’s equity. The fund was able
to make equity, quasi-equity and convertible debt instruments. The target yield was
20–35% annualized. The fund was followed by Africa II ($523 million) in December
2005 and Africa III ($613 million) in July 2008 with similar terms and conditions.

AIG Indian Sector Equity Fund (AISEF):3.1.2.3.

Established by AIG in 1996, this was the first private equity fund focused on India.
The fund was managed by AIG and a local partner, Infrastructure Leasing & Financial
Services Limited (IL&FS). The $100 million fund included the ADB as an investor with
$15 million, and attracted a blend of international investors, multi-lateral development
agencies, two Indian state governments, and major Indian companies. The fund was
domiciled in India under the Indian Trusts Act. The fund generated a 27% return. The
fund led to changes in Indian tax laws and changes in local regulations governing funds
like venture capital funds.

The fund made direct investments through equity and quasi-equity-related
instruments in infrastructure projects (65%), new technology, and other growth sector
opportunities in India. The fund had a 10 year life with a 5 year commitment period.
The ADB and AIG co-sponsorship helped to give comfort to diverse investors who
were new to the Indian equity market. This was the first fund to bring the largest US

46

pension investor CALPERS to the East Asian private equity market. The basic vehicle
accommodates investments via tax treaty countries like Singapore and Mauritius. The
fund was an early test of tax reforms introduced in 1996 that provided incentives for
equity investment in infrastructure.

The fund had development effect on telecommunication, toll roads and clean energy.
However, it did not have a vast impact on the water sector due to absence of an enabling
environment. At the time when the Fund was set up, the private equity sector was at
a very early stage, void of a clear policy and regulatory framework. The fund brought
the following key benefits:

Tax Benefits:i.  In 1996, a new Section 10(23G) was introduced in the Income Tax
Act that provides fiscal incentives for equity investments in the infrastructure
sector.
Fiscal Benefits for Funds:ii.  The Securities and Exchange Board of India (SEBI)
has recognized funds with a clear focus on the infrastructure sector as ‘Venture
Capital Funds’ (VCF) and has permitted registration of such funds. By 2004, there
were 50 private equity funds and VCFs established.

Macquarie International Infrastructure Fund (MIIF)3.1.2.4.

The movement to infrastructure investment received a boost when Australia privatized
its pension fund management at precisely the same time that the state governments
required massive reinvestment in domestic infrastructure. The leader in marrying
infrastructure investment to pension funds was the Australian investment bank
Macquarie. Subsequently, the bank has become a leading organizer of infrastructure
investment on a global basis.

The Macquarie funds are bifurcated into both public offerings and institutional private
placements. Macquarie has four (4) public funds, and twenty private funds. In some
of the private funds, Macquarie worked with MDFIs and has attracted pension funds
& other institutional investors.50

Macquarie International Infrastructure Securities Fundi.  (“MIISF”): Macquarie
vaulted into infrastructure fund leadership by taking advantage of the simultaneous
privatization of Australian pensions and budget shortfalls in Australian states
that required states to look at privatization or PPP for infrastructure. Macquarie
manages a large number of domestic Australian funds and specialized global
infrastructure funds. The MIISF is a fund investing in listed equities in the
infrastructure field. The minimum investment is A$20,000, but smaller allocations
are possible via investor directed portfolio services (“IDPS”), which form part of
the overall privatized pension schemes in Australia. The fund is a diversified global
fund heavily weighted towards the US and other OECD countries, and particularly
focused on electricity utilities which are known for their high dividend payouts.
As an Australian fund, it is domiciled and regulated domestically. The fund is
focused on institutional and large personal investors, but can also accommodate
smaller investors. It is not a UCITS fund and cannot be easily marketed outside
of Australia.

50  Refer to http://www.mirafunds.com/our-funds/private-funds

47

http://www.mirafunds.com/our-funds/private-funds

Macquarie International Infrastructure Fundii.  (“MIIF”): This Bermuda-domiciled
fund is listed on the SGX and managed by a Macquarie subsidiary in Singapore.
The fund pursues a blended strategy of buying direct stakes in operating
businesses as well as listed securities. The fund is allowed to take on leverage in
order to pursue its strategies, which have focused on Taiwan and China (although
the mandate also allows a broader Asian footprint). On its website, the MIIF
states: “Sustainable economic growth over time requires investment in new
infrastructure and maintenance of existing infrastructure assets.”

The fund draws from institutional and retail investors as well as Macquarie’s own capital:

Figure 18: Macquarie International Infrastructure Fund II
Source: MIIF Full Year 2011 Results Presentation 22 February 201251

The MIIF model has served Macquarie well globally, allowing it to balance institutional
and retail investors. But the fund has traded at a discount to NAV which is often a
problem with specialized, listed or exchange traded funds. The trade-offs to include
retail investors and trade on an exchange may be the source of the discount, meaning
that exchange buyers earn more than the original investors in terms of capital gains
and dividends.

The following are examples of Macquarie’s private funds in which they worked with
MDFIs:

Macquarie Mexican Infrastructure Fund: Established on Dec 20, 2010, the targeted size 1.
for this fund was $1.1 billion. The Inter American Development Bank (IADB) provided a
US150m loan to the fund. This drew further contribution from private Mexican pension
funds (known as Siefores), the National Infrastructure Fund (Fonadin), and other local
and international capital sources.
As highlighted in Chapter 2, Macquarie Capital Group Limited (Macquarie), State Bank 2.

51  Accessed at: http://www.macquarie.com/mgl/miif/investor-centre/corporate-information.

48

http://www.macquarie.com/mgl/miif/investor-centre/corporate-information

of India (SBI) and International Finance Corporation (IFC) established a joint venture in
2008. The JV established two different funds.

Macquarie SBI Infrastructure Fund (MSIF) – A US$910 million, unlisted private a.
equity infrastructure fund, MSIF was closed to investors in October 2010. The
fund targets investors located outside of India to invest in infrastructure and
infrastructure-like assets in India.
SBI Macquarie Infrastructure Trust (SMIT) is a US$260 million unlisted private b.
equity infrastructure fund targeting local investors. SMIT was closed to investors
in March 2011.

Both funds, MSIF and SMIT co-invest in India. The offshore fund (MSIF) was established first,
followed by the onshore (SMIT) establishment.

More recently, in July 31, 2012, Macquarie established a $625 million, 10-year close-3.
ended fund, known as The Philippine Investment Alliance for Infrastructure (PINAI). It
will invest in unlisted equity and equity-linked infrastructure projects and businesses in
the Philippines (both greenfield and brownfield projects). The core investors are Asian
Development Bank, the Philippines’ state pension fund Government Service Insurance
System (GSIS), Dutch pension asset manager Algemene Pensioen Groep NV and Macquarie
Group Ltd. (MQG). GSIS, the lead investor, committed $400 million. (Bloomberg, 2012)

Other Observations Related to MDFI Funds Operation3.1.2.5.

(Chowdury, Orr, & Settel, 2009) examined the preference in fund manager selection and
the level of involvement in a fund by different MDFIs. Some MDFIs (like IFC and AfDB)
prefer to use a new manager (localized) for each fund to support the development of
the local market and development agenda. Some other MDFIs, like ADB for example,
prefer to use a repeat manager with a proven track record for their funds. As far as
the involvement in the fund is concerned, some MDFIs prefer to be closely involved
in the fund’s governance. IDB and IFC, for example, closely oversee the investment
policy and sometimes even take some share in the general partner position. Another
group of MDFIs prefers the hands-off approach. AfDB and EBRD, for example, limit
their involvement to a fund’s advisory board.

(Settel, Chowdhury, & Orr, 2009) noted that there is a collaboration among MDFIs, and
bilateral development organizations in supporting peer funds, or sharing information on
new funds coming to market. They highlighted, “For example, the Asian Development
Bank often co-finances funds with European bilateral development finance institutions
that like to take part in development transactions in Asia, but have less access to deal
flow than ADB. Thus, when ADB discovers a promising private equity fund, it often
passes information to the Association of European Development Finance Institutions
(EDFI), an umbrella organization of DFIs in Europe. EDFI shares the information with
its member organizations.” They emphasized that MDFIs also co-finance with public
pension funds and sovereign wealth funds.

ADB, in the evaluation of its private equity fund operation, highlighted that it was able
to bring CALPERS to the East Asian market in 1997 when it invested $25 million in the
Lombard Asian Private Investment Company which was a regional SME fund. (Asian
Development Bank, 2008)

49

http://topics.bloomberg.com/asian-development-bank/

http://topics.bloomberg.com/asian-development-bank/

http://www.bloomberg.com/quote/MQG:AU

http://www.bloomberg.com/quote/MQG:AU

The operation of MDFIs in PE funds is not without challenges. The biggest challenge
is to find the fund managers willing to work in less mature markets, thus limiting a
fund’s investment in low income countries. IDB’s Infrastructure Fund for example was
only able to invest about 7% in very low income countries. ADB also faces similar
challenges.52 IFC’s approach to work with local general partner may be an alternative
solution to this. Besides the negative perception drawn by the high return on the PE
portfolio, MDFIs also need to create a developmental benchmark to complement the
traditional financial measure of PE fund performance.

Summary of Selected MDFI Funds3.1.2.6.

AfDB Infrastructure Fund
(Africa Fund)

AIG Indian Sector Equity
Fund (AISEF)

IaDB Multilateral
Investment Fund

Year
Established &
Manager

Year 2000•
Emerging Capital •
Partner (part of EMP)

Year 1996•
AIG & Infrastructure •
Leasing & Financial
Services Limited (ILFS)

Year 1993•
Managed by IaDB•

Size & Investor
info

$407m•
Core Investors : AIG, IFC, •
AfDB, El Paso Energy,
DBSA, Proparco, EIB

$110m•
ADB ($15m), 10 •
foreign investors
& local investors
(State Government &
corporate)

$1.3b•
39 donors (member •
countries from LAC,
North America, Europe
and Asia)

Investment
Aim

Private Equity Fund•
Infrastructure but wide •
meaning
Invest in companies & •
not projects

Private Equity Fund•
Hybrid: Infrastructure •
(65%) & new technology

Trust Fund: •
Microfinance & clean
energy (for SME)
Latin America and the •
Caribbean

Performance

Target: 20-25% return•
Two follow up funds •
-Africa II: December
2005 - $523 million.
Africa III: July 2008 -
$613 million

ILFS managed portion •
($40m) generated 27%
return with 3.6 multiple.
Development effect on •
telecommunication, toll
road and clean energy
sector

Since inception >1,000 •
projects (mostly
grants)
Total USD 2.2 billion in •
all 26 IADB countries.

The IDB Experience3.2
IDB has built a diversified experience with funds over the past 40 years. This experience
ranges with challenges in the development of suitable governance models, and the proper
location of the funds from the perspective of which part of IDB actually manages the funds.
For instance, the historical fund strategy of IDB is concentrated in the Treasury, which is not

52  (Perry, 2011) also reported that MDFIs private market funding are concentrated in the middle income countries –
80% on average during 2003-2009. In terms of per capita amount, the upper middle income countries have received
the highest support from MDFI. However, if MDFI funding is analyzed as a proportion of GDP, the low income
countries have received the highest support.

50

directly aligned with IDB’s expertise. With the expansion of the IDB Group into specialized
companies like ICD and IDB’s own affiliated asset management company (ASMA Capital
Partners), the capacity for IDB to properly manage funds is improving exponentially. This
means that IDB will be in an increasingly better position to place its fund business closer to
the project finance and business risk-taking skill-sets of its appropriate units. Another unusual
feature of IDB’s funds is that not all of them are truly commercial: some, like the Islamic
Solidarity Fund for Development (“ISFD”) are designed to provide concessionary funding
to projects in Least Developed Member Countries (“LDMC”), while others are designed to
focus on awqaf (even the ISFD is structured as a form of waqf).

Investment Deposit Scheme of 1980 (“IDS”)3.2.1 :

This is not strictly a fund, but an unrestricted Mudarabah placement. The scheme is
fundamentally short-term and invested in trade finance transactions. The typical deposit is
US$250,000 with a target yield of 7%. The size of a deposit restricts it to inter-bank, corporate
or high net worth depositors. The structure as a “deposit” means that the funds raised in
this project are treated as part of IDB’s Ordinary Capital Resources. The Bank deducts an
administrative charge covering its administrative costs. Except for the deposits made by IDB
staff, profits on the underlying transactions are shared with the depositors according to a
published profit sharing ratio (“PSR”).

Although a Mudarabah has features of an investment fund, this is treated as an on balance
sheet liability of IDB. As a result, the IDS affects IDB’s leverage. The restrictions could be
modified for more than trade finance, but the longer term for non-trade deals would change
the nature of the depositors or the obligation of IDB to cover redemptions in the short term
(the classic mismatch of deposit to lending maturities in conventional banking). Because it
is a direct placement with IDB, the concept faces difficulties attracting depositors from IDB’s
usual orbit.

Unit Investment Fund (UIF)3.2.2

The UIF was established in 1989 as a USD mudarabah fund domiciled in Bahrain. Listed on the
Bahrain Stock Exchange (“BSE”) in 1996, the fund subsequently changed the mudarib from IDB
to the ICD as part of IDB Group’s efforts to put all private sector activities under one umbrella.
The Fund launched with US$100 million, and was US$325 million when it listed.53 The unit
price of the fund during listing was $1.00 per unit. The minimum investment is $100,000.54
Prior to listing, IDB provided liquidity by offering to buy-back units at particular intervals as
a market maker. The fund may invest in member and non-member countries, private and
public sectors. The fund securitized some of IDB’s leases and Murabaha receivables. The
UIF also complements project and trade finance operations at IDB. The fund is meant to
have tenors between five and ten years. The fund has given different quality returns over its
life. In order to pay a steady dividend, the UIF established a Capital Preservation Account to
which it transfers 5% of the net income of the fund before the mudarib’s share; and then a
Dividend Equalization Account to which an amount, distributable to the unit holders above

53  Refer: http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://041e8c7942edf8df96e55bb9fd8630
99&LightDTNKnobID=328409947 for list of investors in the fund.

54  Refer http://www.bahrainbourse.net/bhb/market.asp?page=market&sec=Mutual_Funds

51

http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://041e8c7942edf8df96e55bb9fd863099&LightDTNKnobID=328409947

http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://041e8c7942edf8df96e55bb9fd863099&LightDTNKnobID=328409947

the amount actually distributed, is transferred. When the UIF liquidates, any excess balance
in these two accounts will be granted to IDB Waqf Fund and not shared with the unit holders
of record on the date of dissolution.

This vehicle is an open-listed fund that allows investors to manage their own liquidity by
trading units on the BSE. The funds are channeled directly to IDB’s project. The name is
neutral which could make marketing to non-Islamic investors easy. However, Bahrain is not
yet formally established as a global fund center, which may affect the attraction to the global
institutional investors. Finally, at liquidation, the reserve accounts will go to IDB’s Waqf Fund,
which will put off non-Islamic investors who would expect that any residual cash or asset
would revert to them at the termination of a fund.

Islamic Solidarity Development Fund (ISFD)3.2.3

Established by IDB as a form of waqf in 2007, the sole focus of the fund is alleviation of
poverty in least developed member countries or LDMCs. The fund’s financing is completely
on concessionary terms with modest service charges, grace periods of seven to ten years,
and repayment periods of up to thirty years. A key role of the ISFD is to promote co-financing
and to make investment into LDMCs easier for other development financiers as well as
commercial investors. The ISFD is structured to deliver specialized assistance in line with
IDB’s Millennium Development goals and projects like the Sustainable Villages Programme.
In programs like this and the Microfinance Support Programme for Poverty Reduction
(US$500 million five year initiative, US$100 million earmarked by the ISFD to seed projects)
or the Vocational Literacy Programme for Poverty Reduction (another US$500 million five
year initiative, US$100 million earmarked by the ISFD to seed projects), the ISFD makes
investments which are not strictly commercial. The ambition of the ISFD is to raise US$10
billion. But the process is akin to the trust fund process at the World Bank and involves
organizations like the Earth Institute at Columbia University in New York, the Qatar Red
Crescent Society, and the Arab Bank for Economic Development in Africa. The ISFD has raised
US$1.6 billion of US$2.6 billion pledged. At the end of 1432H/2011G, the ISFD had received
and invested US$1.6 billion generating an income of US$31 million.55 IDB has structured
the ISFD to have an exceptionally low overhead in order to stretch each of its dollars for
development purposes.

The ISFD has three challenges to attract investors from outside of the IDB orbit. Foremost,
the structure as a waqf means that funds will not be recovered by investors, and returns do
not have to be commercial for the satisfaction of investors. The non-commercial structure
restricts investor interest in the ISFD to charity-oriented parties from IDB member states.
Finally, the explicit use of the word “Islamic” along with “solidarity” does not attract secular
investors from outside of the IDB orbit.

55 Over US$18 million of the income comes from interbank placements and US$12 from investments in government
sukuk. As a result, the fund is entirely non-commercial and generates virtually none of its income from its work.

52

Awqaf Property Investment Fund (APIF)3.2.4

Established in 2001, this is a trust fund56 managed by IDB (as Mudarib). The investors are
mainly Awqaf ministries and some Islamic banks.57 The fund allowed two classes of investors;
Class A – the main authorized capital and Class B – in the form of Ijarah, Muqaradah
certificates. The fund may also raise funding via syndication and co-financing. IDB provides a
50% purchase undertaking for Class A shares from Year 4 onwards. From the waqf revenue,
the Mudarib is paid 20%, and up to 20% may be transferred to reserve before making
dividend distribution to investors.

The aim of the project is to develop greenfield projects and develop existing waqf properties
to transform them into income-generating assets. Since its inception, APIF has funded 47
projects worth US$1billion in 22 countries. At the end of 2010, APIF had $71.8 million capital
and access to an IDB line of financing for $100 million and a technical assistance pool of
$200,000.

However, IDB staff highlighted that Awqaf Boards (i.e. the beneficiaries) prefer grants more
than marketbased funding. This leads to limited funds that the fund may provide, as it would
be difficult to entice banks to provide funding for charitable activities. In Chapter 5, the
report will highlight how IDB may use its MCPS to coordinate with countries like Singapore
to share their experience in commercially managing their Waqf lands and mosques.

IDB also established a Waqf Fund in 1979 that pools IDB’s non-compliant income. The fund
is used to provide scholarships, grants, technical assistance etc. Currently the Waqf Fund
is managed by the Treasury and earns a low return. An internal evaluation suggests that it
would be better for the waqf fund to invest in infrastructure projects that generate much
higher returns that could be re-injected into the fund. Some of the waqf fund was invested
in the IDB Infrastructure Fund (IIF) and enjoyed a high return.

IDB Infrastructure Fund (IIF):3.2.5

The IIF was established in 2001 to support infrastructure projects in MCs. The General
Partner and Manager is the Bahrain office of Emerging Markets Partnership. The fund and
the fund manager are regulated by the Central Bank of Bahrain. The fund has a US$730.5
million private equity fund with a Complementary Finance Facility for US$200 million. The
Lead Sponsors are a number of sovereign wealth funds and pensions; Dar Al-Maal Al-Islami
Trust (“DMI”), the Government of Brunei, the Saudi Pension Fund, Public Investment Fund
(Saudi), Khazanah (Malaysia), and the Kingdom of Bahrain.58

The fund takes only minority stakes in private sector infrastructure companies involved in
brownfield59 development, expansion, restructuring, and privatization. Investments may go

56  Thus no separate domicile for the fund. The main US$57m capital is also known as Class A shares
57  Refer to http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://097e223be0761cdd343b213dfd8

55b77 for list of investors.
58  IDB Fund of Funds Concept Note p3.
59  The fund’s aim was to invest in brownfield project. However sometimes due to investor persistent recommendation,

the fund invested in some greenfield projects that led to a write off of about $60m.

53

http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://097e223be0761cdd343b213dfd855b77

http://www.isdb.org/irj/portal/anonymous?NavigationTarget=navurl://097e223be0761cdd343b213dfd855b77

up to US$150 million, but the actual range has been between US$10 million and US$73 million.
The fund has a broad definition of infrastructure and includes power, telecommunications,
transportation, energy, natural resources, petrochemicals, water, and related sectors.60 The
term of the fund is ten years, renewable for three years. The fund was fully committed
to twelve entities and includes publicly traded companies in the MCs. In 2006, the fund
returned US$420 million to investors. In 2010, the annualized return was 21%.61 The fund
will be fully divested in August 2012.

Domiciled in Bahrain, the fund required a royal decree to approve the GP/LP (General Partner/
Limited Partner) structure as it did not exist in the local law. The fund attracted conventional
and Islamic investors from IDB member countries. But it did not attract conventional investors
from outside of the MC footprint.

IDB committed $100 million to the fund and took an active role in the fund via the
establishment of Policy Management Company (PMC); a specific company established to
oversee governance & investment policy of the fund. The lead sponsors of the fund served
as board members on PMC. Separately, PMC is also entitled to share of performance fee
(Chowdury, Orr, & Settel, 2009).

IDB launched a $2 billion IIF II in June 2012. Originally, three fund managers were short-listed
for the second fund. However, with the establishment of ASMA,62 IDB’s asset management
company, IDB will self-manage the IIF II. ASMA has legal registration in Dubai and is an
asset management company. However, IIF II will continue to be domiciled and managed
out of Bahrain. The first closing of $800m has already received commitment from anchor
investors.63

IDB-ADB Islamic Infrastructure Fund3.2.6

Established in 2009, the fund is focused on PPP in twelve (12) common MCs64 of IDB and
ADB. CIMB Standard, a joint venture between Standard Bank and CIMB Group is the manager.
The fund is domiciled in Labuan and has a target of US$500 million for investment. IDB has
been hopeful that this fund would successfully attract a wider universe of investors than the
prior fund. The fund has committed US$110 million in five projects in four MCs. The ADB has
highlighted a number of problems with the legal infrastructure, lack of bankruptcy laws, and
issues relating to corruption in some environments.

This fund model uses the established Labuan jurisdiction, which is well understood in Asia
and the GCC. The manager is a joint venture of two well-known banking groups. But the

60  Refer to http://www.empglobal.com/portfolio.xml?f=fund&q=1005&id=1005&view=fund&media=history for the
list of investee companies.

61  From IDB’s internal evaluation, this was the only high performing IDB fund. Without the $60m write off due to
investment in Greenfield projects, the fund would have had a higher internal rate of return.

62  ASMA is both an Arabic word meaning “highly exalted” and an acronym for Asia Middle East and South Asia.
63  Interview with Zaffar Saleem of Islamic Development Bank.
64 Afghanistan, Azerbaijan, Bangladesh, Indonesia, Kazakhstan, Kyrgyz Republic, Malaysia, Maldives, Pakistan,

Tajikistan, Turkmenistan and Uzbekistan.

54

http://www.empglobal.com/portfolio.xml?f=fund&q=1005&id=1005&view=fund&media=history

insertion of the word “Islamic” in the name seems to have made it difficult to market the
fund to pension funds and institutional investors from outside of the IDB/ADB footprint.

Summary of Selected IDB Funds3.2.7

Unit Investment
Fund (UIF)

IDB Infrastructure
Fund

IDB-ADB Islamic
Infrastructure

Fund

Year Established
& Manager

Established 1989, no •
domicile, listed on BSE
1996
IDB is Mudarib, 2008 •
enter into sub-Mudarib
with ICD

Year 2001•
Domicile in Bahrain•
Emerging Markets •
Partnership (Bahrain)

Year 2009•
Domicile in Labuan•
CIMB-Standard is •
manager

Size & Investor
info

Authorized-USD500m, •
Initial $100m, Increased
to $325m in 1996
20 institutional investors •
from 11 countries.
Minimum 100,000 unit. •
$1/unit

US$730.5m private equity•
US$200m complementary •
finance
Lead Sponsors Dar Al-•
Maal Al-Islami Trust
(“DMI”), Gov. of Brunei,
Saudi Pension Fund,
Bahrain, Tabung Haji
Consortium

Target: $500m•
Core equity: IDB •
$150m, ADB
$100m, CIMB $7m,
Standard $5m

Investment Aim

Income Fund•
Securitizes IDB’s lease •
and installment sale
assets.
Complement IDB’s •
project & trade finance
operations.

Private Equity Fund•
Minority equity (<40%) •
in private sector
infrastructure companies
20% in listed companies•

PPP infrastructure •
projects in 12
common member
countries of IDB
and ADB

Performance

2010 - funded 257 •
financing operations for
$2.43 billion
2010 - $19.95m •
dividend, 5% annualized
return, $3 million capital
gain on IDB Invested
amount

Best performer among •
IDB Funds - 21%
annualized return,
$71.5m divided and $20m
capital gain (2010)
Follow up fund - •
Infrastructure Fund II -
US$ 2 billion (June 2012).

Approved five •
projects for $110 m
Difficult to entice •
investors due to
use of “Islamic” in
the fund name

Islamic Funds Market3.3
According to Ernst & Young, the Islamic funds market has grown to US$58 billion AuM at the
end of 2010. However, since the Islamic funds market only started growing commercially in
the early 2000s, it only represents 5.6% of the overall Islamic financial system. In terms of
asset classes, equity funds represent almost 40% of AuM at 2010, followed by commodities
(15%) and alternative investment & feeder fund (13% - included in other categories in Figure
21).

55

In absolute terms, the allocation for alternative investments remains small at US$7.8 billion
AuM. This gives two impressions. On one hand, the allocation to emerging market and
infrastructure products can grow substantially. On the other hand, investors may actually
be looking for managers to move their funds in investments outside of IDB’s MCs for asset
diversification and political risk management purposes.

The Islamic funds market is highly fragmented and two thirds of the funds are institutional.65
Depending upon the strategy pursued by IDB, some Islamic funds and some managers of
Islamic funds may be attracted to co-invest in IDB’s development funds, but their role for IDB
would not be meaningful in terms of investment volume.

Islamic Financial Services Industry

Estimated Islamic Finance
Assets US$ 1,033 billion

Islamic Assets
Managed

US$321 billion
31%

Islamic
Funds
5.6%

Figure 19: Components of Islamic Financial System 201066

Source: (Ernst & Young, 2011), p10

65  Refer page 9 of (Ernst & Young, 2011). Retail funds are defined as funds that have a minimum initial subscription
of US$2,000 or less

66  Other AuM include off balance sheet direct investments managed by banks and investment companies and
restricted profit sharing accounts

56

Figure 20: Growth of Islamic Funds Market
Source: (Ernst & Young, 2011), p7

Figure 21: Different Asset Classes in 2010

Source: (Ernst & Young, 2011), p1367

67  Others include alternative investment and feeder funds.

57

Figure 22: Breakdown of Shariah-compliant fund assets by region68

Source: (GCC Mutual Fund Industry Survey, 2011), p119

Another issue for IDB to consider when analyzing the Islamic funds sector is the degree to
which any Islamic fund has successfully attracted non-Islamic investors.

Figure 22 shows three important statistics:69

The first is that many Islamic funds are likely to invest in their own markets. Hence, the 1.
fact that over 85% of the funds are in the GCC and Asia, where respectively Saudi Arabia
and Malaysia are the most dominant markets for Islamic funds.
The majority (11.7%) of the rest of the assets are in North America and Europe.2.
Even the assets in Africa are in a relatively small number of countries (Egypt, Morocco, 3.
and South Africa).

The quantum of assets in North America merits consideration. The single largest Islamic

68  Based on fund manager location; December 2011.
69  Bloomberg data for Shariah largely omits funds domiciled in Bahrain.

58

funds group is the Amana funds. With over US$3 billion invested, Amana is fundamentally a
domestic US fund manager. The name ‘Amana’ not only has Arabic and Islamic connotations,
but also Hebrew and Judeo-Christian connotations. The funds’ primary manager is not an
“Islamic” company. Even though the funds’ trustees are majority Muslim and the funds are
Shariah-compliant, the funds sold their compliance softly for many years, allowing them to
attract socially responsible investors, church investors, and faith (Christian) based pension
funds as well as conventional pensions. Now that the Amana funds are well established with
twenty-six years of operation, the manager is raising the awareness of their Islamic profile
to a higher level.70

Islamic exchange traded funds exist in several markets: Malaysia, Singapore, London, and
Luxembourg. Listed Islamic REITS exist in Malaysia, Singapore and Dubai. There has been
a regulator sponsored push to develop both products since the mid-2000s. But many
developments have been set back by the financial crisis of 2008 as well as the lack of investor
education. Nonetheless, the factors that drive global institutional investors to allocate funds
to infrastructure ETF and REITs will become prevalent as more pensions and takaful investors
seek the same income benefits and cost structures inherent in these structures. Interestingly,
an ETF exit for a well performing IDB emerging market fund might well attract non-Islamic
institutional investors.

Another area in which Islamic funds have been active over the years is the single asset
private business fund. Many Islamic banks operate leasing funds, and over the years a
number of Islamic banks have developed trade finance funds. The leasing and trade funds
have generally been geared either to high credit quality, international trade or leasing in the
developed countries. Leasing funds provide medium term fixed income investments and are
able to expand “secure” credit delivery into emerging markets.

Trade finance funds allow for short-term self-liquidating real trade transactions. Trade
funds tend to replicate the characteristics of traditional money market funds. Yet IDB has
demonstrated in the past that short-term self-liquidating trade between, and to, MCs allows
for the expansion and improvement of trade, providing financing where it is not always
accessible from conventional banks.

The newly established Investments Department (IDBi) in IDB is expected to substantially
contribute to new directions in funding development. This includes the attraction of new
investor types to IDB and expanding the capacity of IDB to serve its MCs.

The Islamic funds market is immature with thin capital. It is dominated by numerous
small offerings sponsored by banks. The market has several challenges to overcome in the
development of skills, improvement of governance, and evolution of investor goals for asset
allocation. In summary, IDB should take stock of the existing Islamic funds industry, as well
as development funds. As a leader, IDB is in a position to establish new trends in the Islamic
industry serving development in Member Countries.

70  For more information, see http://www.amanafunds.com/retail/news/20110906amanx25thanniv.shtml.

59

http://www.amanafunds.com/retail/news/20110906amanx25thanniv.shtml

Evaluation of Funds against Research Objectives3.4

Off Balance Sheet Funding3.4.1

The commonly cited motivations behind MDFIs increasing utilization of private equity funds
are to encourage private investor participation and efficient capital deployment by the
commercial fund manager. In addition, compared to issuing bonds (or Sukuk in IDB’s case),
the funds approach also allows MDFIs to expand their activities without increasing their
balance sheet burden. As MDFIs normally limit their investment to 20% of the fund size,
this allows MDFIs to attract other investors to fund various projects. What is crucial is the
monitoring of the fund performance to ensure sustained confidence of private investors in
these types of investments.

Cost of Funds3.4.2

Sukuk have the advantage of providing cheap funding to member countries as IDB’s cost of
funds is low, backed by its AAA rating. As for the funds model, the fund itself may choose
to focus on either debt, equity or mixed funding to member countries. Debt would always
have the advantage of being cheap in cost compared to equity. However, one has to keep in
mind that during a financial crisis, or difficult times, member countries still have to pay the
cost of debt funding as these are not related to their performance. Equity in contrast, will
always cost more than debt. Nonetheless, as equity investment takes higher risk, and will
be directly affected by the performance of a project, the investee will have more resilience
to macro and cyclical shocks. IFC uses the private equity funds to implement its partnership
approach to funding, where IFC provides active advice and hand-holding (i.e. true partner)
instead of just sitting on the board of the investee companies (Wilton, Emerging Market
Private Equity: The Opportunity, The Risks & Ideas to Manage Them, 2012).

There are two views on the optimal scenario to use private equity funds in MDFI operations.
On one hand, IFC views private equity funding (by taking minority ownership interest) as a
way to manage risks in countries where the legal system does not easily support enforcement.
With IFC’s close involvement in the management of the companies, they put in place proper
governance and internal control to ensure the success of the investee companies.71 IFC’s
private equity funds have outperformed the market benchmark.

On the other hand, ADB which suffered a low return compared to market performance, is
of the view that private equity should be used sparingly. For high risk frontier countries (like
Afghanistan), ADB suggests the use of debt and technical assistance. Whereas for middle
tier countries (like Philippines), which warrant equity funding, the MDFI private equity fund
should focus on under-served sectors that are not targeted by traditional PE (Private Equity),
like municipal infrastructure and technology intensive sectors - clean energy for example
(Asian Development Bank, 2008).

By diversifying its investments, a fund may be able to provide funding to MCs at a relatively

71  IFC has developed the Environmental, Social and Governance (ESG) toolkit to systematically assess and manage
risks in prospective investment and monitor existing investment. Refer to https://www.estoolkit.com/Default.aspx
for further details.

60

https://www.estoolkit.com/Default.aspx

lower cost, meanwhile offering investors reasonable returns. Developmental projects vary in
terms of risk-return profiles. Some offer high risk-adjusted returns, some don’t. By carefully
selecting the portfolio projects, high-return projects would subsidize low-return ones. In this
manner, a fund may be able to offer low-cost funding to governmental projects without
jeopardizing returns to investors.

Diversification of Investors3.4.3

Sukuk attract fixed income institutional investors and the market just started tapping into
retail investors. In contrast, relative to the Sukuk market, there is higher retail participation
in the funds sector (although institutional investors still represent 2/3 of the funds investors).
In other words, there is a more flexible avenue to capture diverse investors using the funds
market. For example, at the same time that Macquarie began their private equity investment
in Australia in infrastructure, Australia inaugurated private pension based on the American
401K model. This requires the individuals to be responsible to manage their own pension
investment. Macquarie saw this as an opportunity to package the infrastructure investment
into investments for the private pension market.

Table 10 shows the summary of the evaluation.

Research Objective Do Funds meet the Objective? Implication/Note

Off Balance Sheet1. Yes

Expand activities without •
debt burden
Manage charter restriction, •
if any

Cost of Funds2.

Fund may use debt or equity •
funding
Private equity investors •
require higher return

Although debt is cheaper, it •
places Obligor under stress
during crisis
Although equity is more •
expensive, return is based on
performance, thus less stress
for investee during crisis

Diversification of 3.
investors

Flexible avenue to capture •
diverse investors

Effect of co-mingling retail & •
institutional investor is less
clear

Table 10: Summary Evaluation of Funds against Research Objectives

In conclusion, the funds sector provides off-balance sheet financing that would allow IDB
and its peers to expand their mandates. Funds can be structured in such a way that if the
underlying sector performs exceedingly well, investors would successfully achieve their high
return targets. However, the fund sector is not always geared towards income delivery except
in the case of product-specific concepts like trade finance and leasing funds. Benevolent

61

funds are especially placed to allow low-cost or no-fee funding to LDMCs. Fund strategies
would allow portfolio diversification or even singularity to achieve a wide variety of investor
goals and thereby assist IDB to adapt its funding to different MC needs or financing strategies.
In Chapter 4 we will analyze various investor segments further.

There are a number of useful lessons learned which can be applied to an investment
partnership strategy for using funds to supplement IDB’s capital and balance sheet. IDB’s
own track record is instructive as to the steps that should be repeated or avoided in the
process of launching various funds. What is less clear is the degree to which mingling ‘retail’
and ‘institutional’ investors in a fund is an appealing concept or whether or not it leads to a
dilution of strategy execution. In a similar vein, the execution of a listing strategy threatens
to dilute a fund from the perspective of the founder investor’s returns if the market in
which a listing takes place is subjected to a negative secular trend, perhaps delinked from
actual projects. The following chapters will examine, in further details, the structure and
components of an IDB ‘development fund’.

SWOT Analysis for Selected Infrastructure & Development Funds

Fund Strength Weakness Opportunity Threat

Investment
Deposit Scheme
(IDB)

Direct
relationship
with depositor

Direct obligation
on IDB. Difficult
to market outside
of IDB footprint.

Support of specific
short-term operations
like trade finance.

Increases IDB’s
leverage and
has limited
flexibility for
application of
funds.

Unit Investment
Fund (IDB)

Listed, open
ended fund

Residual cash
reserves go to
charitable trust,
not investors

Able to make longer
term investments

Placed with IDB
- increases IDB’s
liabilities

IADB Multilateral
Investment Fund

Able to make
development-
driven
decisions as
core mandate

Not fully
commercial

Able to seed
promising projects,
allowing them to
become commercial

Subject to
negotiated
mandates by
member states

ISFD/APIF/Waqf
(IDB)

Able to provide
concessionary
finance and
co-invest

Beneficiaries
prefer grants
than commercial
funding

Able to seed projects
that need help to be
“commercial”

Not interesting
to international
investors,
unappealing to
secular trust
funds

62

AIG Indian Sector
Equity Fund

Brought a
marquee of
international
investors

Certain sectors
(water) did
not achieve
development
effect

Development of PE
market in India

In initial
year, difficult
to obtain
transactions –
unfamiliarity
and large
transaction size

Macquarie MIISF

Easy for
domestic
Australian
investors to
buy units

Only buys listed
equities, not
truly investing in
development

Asset allocation
model can capture
growth opportunities
from emerging
markets

Allocation over-
weighted to
one sector in
OECD countries
and cannot
intervene
to improve
performance
of investee
companies

Macquarie MIIF

Wide
investment
mandate, able
to leverage and
fund equity

Listing allows
shares to be
discounted due
to uncorrelated
events

Wide mandate and
ability to leverage

Leverage may
harm returns
if underlying
investments fail
to perform

AIG Africa I
Clear
investment
mandate

GP/LP structure
limits investor
rights

Capacity to raise
significant pension
assets

Limited
flexibility to
change course

IDB Infra (2001)

Known GP and
IDB role. Best
performer
among MDFI
funds

GP was unable to
attract investors
from outside

Bahrain capacity as
fund center and IDB
footprint as attractive
market due to fund’s
high returns

Investment in
areas beyond
original fund
mandate

IDB ADB Infra
(2009)

Strong
sponsors in IDB
and ADB

Use of word
“Islamic” does
not attract
investors

Investment in high
growth markets.

Inefficient
bureaucracy; –
invest in bonds
and not projects

63

- Structuring Considerations - DomicileChapter 4
Introduction

This chapter addresses two main components; investors and fund domiciles. The investors
segment reviews market developments, investor interests and expectations in different fund
classes. The domicile section will focus on finding the jurisdictions that facilitate a broad
fund strategy. After elaborating on the domicile selection and evaluation criteria, the chapter
will perform a SWOT analysis on the individual domiciles and conclude the chapter with
evaluation of the different jurisdictions.

Market Development and Investors4.1
This section leverages off of published studies including Towers Watson 2011 Global
Alternatives Survey, and 2012 Preqin Global Infrastructure Report. These surveys and reports
provide extensive descriptions of key market developments especially for infrastructure
funds, and highlights investors interest & expectations in different funds.

Figure 23: Snapshot of Alternative Asset Classes

Source: (Towers Watson, 2011), p58

Towers Watson surveyed 197 fund managers who were managing 271 alternative investment
funds with US$2.3 trillion asset under management at the end of 2010. From the total AuM
surveyed, real estate is largest asset class, representing almost 50% of the total AuM. This is
followed by Fund of Hedge Funds, Private Equity, Infrastructure and Commodities. However,
pension represents the largest investor group in infrastructure; representing about 61% of
the AuM. This is followed by private equity, real estate, hedge fund and commodities. The
following sections will focus on the infrastructure market, followed with a relatively shorter
discussion on the trade finance and socially oriented funds market.

Infrastructure Funds4.1.1

This section leverages from the Preqin 2012 Global Infrastructure Report. Preqin was founded
in 2002 and operates out of New York, London and Singapore. Its infrastructure database
tracks 600 listed and unlisted infrastructure fund, 350 infrastructure fund managers and

64

1,600 active infrastructure investors. The Preqin 2012 Global Infrastructure Report benefits
from different segments of the database.

Growth Trend4.1.1.1

Majority of the unlisted infrastructure fund were launched after 2004, as an offshoot
of private equity funds. Figure 24 shows the number of funds that have come to
market at the beginning of each year with the capital amount targeted. As at January
2012, there were a total of 144 unlisted infrastructure funds that came to market with
a target of US$93.2 billion capital commitment.

Figure 24: Unlisted Infrastructure Fund in Market over Time
Source: (Preqin, 2012), p16

Figure 25 shows the number of funds that had their final closing at the end of each year
since 2004, with the committed capital (commonly known as fundraising). Fundraising was
on a growing trend since 2004 and peaked in 2008. There was a big drop in 2009 due to the
financial crisis but it recovered in 2010. In 2011, fundraising fell compared to 2010 due to
investor caution and economic uncertainty. However, compared to 2009, there was an 85%
increase in 2011. The average fund size raised in 2011 was US$575 million (compared to
US$776 million in 2010, and US$414 million in 2009). The largest fund raised in 2011 was
for US$3.31 billion by ArcLight Energy Partners that closed in November 2011. The fund
exceeded its targeted fundraising of US$2 billion.

65

Figure 25: Unlisted Infrastructure Fundraising Annually

Source: (Preqin, 2012), p15

The Asset under Management (AuM) for unlisted infrastructure fund is defined as the
uncalled capital commitment (dry powder) plus the unrealized value of the investment
portfolio. As at June 2011, the AuM stood at over US$170 billion. Figure 26 provides the
detail of both components. Figure 27 shows the breakdown of dry powder according
to the fund size.

Between 2003 and 2007, the average size of funds kept on increasing due to increased
investors demand globally, especially as governments used more PPP funding for
infrastructure projects. Since 2006, mega funds (US$2 billion and more) started
entering the market, contributing to the high dry powder (uncalled capital) of the
AuM until 2009. After the financial crisis, the target size of funds has become smaller,
contributing to more constant dry powder in the AuM. The 37% increase in the AuM
in June 2011 (compared to June 2009) is mainly due to fundraising and investment of
these funds in different portfolio. The unrealized equity values increased from US$92
billion in December 2010 to US$106 billion in June 2011; a 13% increase. It is quite
common to find funds that hold interim closing, allowing them to make investment
before the final closing (thus increasing the unrealized equity value).

66

Figure 26: Unlisted Infrastructure Fund Asset Under Management
Source: (Preqin, 2012), p13

Figure 27: Dry Powder according to Fund Size
Source: (Preqin, 2012), p13

67

Investors4.1.1.2

Based on 1300 active investors, Preqin summarized the role of different investor
groups in unlisted infrastructure funds (Figure 28). The top investor groups are:

 Pensions (public + private + super annuity) = 41%;i.
 Financial Institutions (Bank, Insurance & Asset Managers) = 25%; andii.
 Foundations & Endowments = 11%iii.

Three out of the top 10 global infrastructure investors in Preqin’s database are Canada’s
public pension institutions; Ontario Municipal Employees Retirement System (OMERS)
with US$15.1 billion current commitment to infrastructure, Canada Pension Plan (CPP)
with a US$9.4 billion commitment, and Ontario Teachers’ Pension Plan with US$7.9
billion commitment. Appendix 1 lists the top 10 institutional investors in infrastructure
funds – global investors, public pensions, non-pension global investors. SWFs only
represent 3% of investors in infrastructure funds, as many SWFs prefer to make direct
investments, instead of investing in funds.72

Figure 28: Investors in Unlisted Infrastructure Fund
Source: (Preqin, 2012), p31

Based on the active investor analysis, Preqin also reported that 44% of the investors
have a dedicated allocation for infrastructure investment while 27% invest via private
equity and 13% invest via real estate funds.

Besides the existing investors, Preqin also interviewed additional 150 investors who
are considering investment in infrastructure. 47% of these investors are from pensions
(public & private), followed by endowments (13%), insurance companies (11%) and

72  In a dedicated section for SWF, Preqin highlighted that aggregate SWFs investment in infrastructure has increased
from US$3.5 trillion in 2010 to US$3.98 trillion in 2011. However, 50% of SWFs prefer to make direct investment,
38% mix both direct investment and investment through fund, while only 14% invest solely through funds.

68

asset managers (9%). This shows that pensions will continue to be a key investor group
in infrastructure funds.

In a separate report titled ‘2012 Global Private Equity Report’, Preqin tracked different
groups of investors in the private equity sectors. Since private equity funds also invest
in infrastructure, the investor groups in private equity will also be of interest. Besides
pension, insurance companies, foundations and endowments, family offices also seem
to have a large allocation to private equity (29% targeted allocation in the long run).
Recently closed PE funds (2009-2011) investors also include HNWIs. Appendix 2 lists
the top five PE investors in different categories – endowment, foundations & family
offices, public pension, private pension etc. Most of the endowments are US university
endowment funds. In the infrastructure pension investor list (Appendix 1), Calpers did
not appear, but a number of Canada-based pensions were active investors. On the
contrary, Calpers and other US-based public pension were 4 out of 5 top investors in
private equity (refer Appendix 2). Figure 29 shows that most investors in traditional
infrastructure funds are located in Europe (42%) and North America (30%).

Figure 29: Infrastructure Investors Location
Source: (Preqin, 2012), p31

Previously, infrastructure investment was reserved for large institutional investors due
to entry barriers (like management fee, large minimum commitment size, liquidity
issues). With the emergence of Fund of Funds and specialist funds, smaller investors
are able to gain exposure to infrastructure investment. According the Preqin database,
22% of infrastructure investors have AuM less than US$1 billion, and 63% have AuM
less than US$10 billion. The infrastructure fund of funds is still at its infancy as the first
fund was only launched in 2008. Based on Preqin’s database, as at January 2012, there

69

are only 17 infrastructure FoFs (all are close ended) of which 11 have had a final close
and raised US$3.7 billion. Refer to Figure 30 for the trend of FoFs. 14 of the funds are
based in Europe, two in North America and one in Korea (the largest FoF with the size
of KRW1.2 b/US$1.2b).

Figure 30: Infrastructure Fund of Fund
Source: (Preqin, 2012), p49

A greater challenge is to understand the role of investors from different classes such
as SWFs and retail investors. The empirical evidence is that SWFs will selectively invest
in development finance when it fits a particular criterion. The same applies to SWF
investment in Islamic financial products. The criteria that needs to be presented to SWFs
include security of investor rights; capacity to achieve a high yield; and, diversification of
risk into asset classes or geographic sectors that are underrepresented in their existing
portfolios. On one hand, SWFs should be expected to make investment decisions
which mirror those of other institutional investors. On the other hand, institutional
investors that are not explicitly termed as SWF are, in fact, SWF. These would include
state pension funds like CALPERS, EPF, and similar entities.

State-controlled institutional investors are obliged by state policy to make certain
types of investments. As a result, Malaysia’s EPF has a formal mandate to buy sukuk.
Similarly, CALPERS has a mandate to invest in the renovation and improvement of
infrastructure in the State of California. Therefore, IDB may discover that specific fund
objectives will match mandates of various SWFs and state-controlled institutional
investors.

The retail side of the equation is more complicated to analyze. In a developed country
like Australia, Macquarie was able to sell infrastructure funds to self-directed retirement
funds. Infrastructure became an expertise that Macquarie parlayed into a global fund
management franchise. But on the global scale, Macquarie’s delivery has varied, with

70

institutional investors almost always more important than retail investors. What is
difficult to determine is whether this is because it is too difficult to sell infrastructure
funds to retail investors, or because as an investment manager, Macquarie prefers to
sell funds to institutional investors because it can achieve scale faster.

Both retail and institutional investors are challenged by the risk and reward problem that
has framed investing since 2001. Generally, the yield curve for most major currencies
has flattened. At the same time, risk premiums have flattened. The meaning in many
markets is that investing in apparently high risk portfolios yields no better than the
risk-free alternative, which, in turn, yields almost nothing. This investing reality means
that some investors aggressively seek risk and yields.73 Both seem to be more easily
found in emerging markets.

The appetite of retail investors for securities and investments in emerging markets is
largely untested. But the general preference for retail investors is to buy whatever is
familiar, mainly from their home market. The development of a retail investor class
is still conceptual in most emerging markets, and some middle income countries like
Malaysia have a well defined retail investor class. Others, like Turkey, have not yet
seen the successful emergence of a retail investor class. Some emerging markets like
Nigeria have a relatively active stock and fund market, but a small investor class. One
should be able to conclude that such investments in domestic markets led by IDB
would prove attractive to both local market retail investors as well as some Muslim
retail investors from external markets.

Investment of the Funds4.1.1.3

As investors are mostly from the western market, it’s imperative to examine where
the funds are invested. In 2011, there were 224 investments made by different funds
(compared to 256 in 2010).74 The biggest challenge for the investment of infrastructure
funds is to secure long-term debt during financial crises. Europe is naturally the most
popular investment target (104 deals – 49%) followed by North America (49 deals –
22%). Refer to Figure 31 for the investment region and Figure 32 for the industry sector.
The core infrastructure investments (energy, transportation, telecommunication and
utilities) are the most attractive sectors; representing 88% of investments made in
2011. Social sectors such as education and healthcare are also attracting investment.
In 2011, the investment preferences were secondary infrastructure (41%), followed by
brownfield (32%) and greenfield investment (27%).

73  Remarks by Datin Maznah Mahbood at the Global Islamic Finance Forum, Bank Negara Malaysia, September 18,
2012.

74  Preqin tracks a total of 2000 deals that the infrastructure funds have made over the years.

71

Figure 31: Infrastructure Fund Investment Target
Source: (Preqin, 2012), p26

Figure 32: Infrastructure Fund Investment by Industry
Source: (Preqin, 2012), p27

Infrastructure Funds in Emerging Markets and IDB Target Investors4.1.1.4

Even if the preponderance of financial capacity is in the OECD countries, the Milken
Institute has mapped several trends which point to a long term shift.75 According to

75  Accessed at www.milkeninstitute.org/presentations/slides/2940GC11.pdf

72

http://www.milkeninstitute.org/presentations/slides/2940GC11.pdf

data collated by the Milken Institute, commitments in the emerging markets show a
sustained positive trend since 2002. The Asian financial crisis led to a declining trend
that lasted for five years, and the graph shows a dip from 2008 (Refer to Figure 33).
(Asian Development Bank, 2008) highlighted that Asia is a dominant target for private
equity investment. For example, PE investment in Asia jumped from $2.2 billion in
2003 to $23.1 billion in 2007. Nonetheless, many of these funds are focused on India
and China. ADB also highlighted that an important source of equity for Asia are pension
and insurance funds in developed economies that search for higher return.

Figure 33: Asian Infrastructure Spending
Source: (Milken Institute, 2011), p12

Currency wise, for international funds, dollar is the leading choice, followed by the
Euro. Even for investment in Africa, Novare noted that a vast majority (91.4%) of
the mutual funds that they surveyed were denominated in USD. Novare discovered
that South Africa (a major source of funds in its own right), British Virgin Islands,
Jersey, Malta, Guernsey, Netherlands, US, Luxembourg and Mauritius were popular
jurisdictions: twenty five percent of the funds were UCITS III compliant.  Certain
jurisdictions that have developed domestic market like Australia, Korea and Malaysia
have also witnessed local currency issuances.

In their Middle East Fund Survey, Advent-MEED Insight noted that a top concern of
fund managers is the weak and non-transparent regulatory framework in most MENA
countries.77 This means that attracting non-MENA investors into MENA domiciled
funds may prove difficult. Another two issues that the survey identified were the
concern of distributors about the long term performance of MENA fund managers,
and the shortage of Islamic finance specialists in a market that increasingly requires
Shariah-compliant structures.

76  Investing in Africa: Funds and Managers Survey, Novare ® Investments Africa Report 2010. Accessed at: www.
novare.co.za/uploads/files/File/Africa%20Survey%202010.pdf

77  Middle East Fund Survey, Advent MEED insight, distributed electronically on November 11, 2012.

73

http://www.novare.co.za/uploads/files/File/Africa Survey 2010.pdf

http://www.novare.co.za/uploads/files/File/Africa Survey 2010.pdf

Investors’ Reach Out4.1.1.5

IDB would like to achieve two goals which are not consistent with one another. The
first is to build MCs’ market capacity by developing fund tools that result in introducing
modern capital market and fund technology into the MCs and attracting local market
investors. The second is to attract new capital from outside of the IDB orbit.

The first goal means that IDB will work with MC authorities to structure funds that
attract domestic retail investors as well as institutional investors and high net worth
individuals (“HNWI”) or family offices. The MCPS has resulted in commitments of US$4
billion in association with a diverse group of development finance entities, mostly
from the MCs, including the Arab Fund for Economic & Social Development, Arab Bank
for Economic Development in Africa, the Kuwait Fund, the OPEC Fund for International
Development, the Saudi Fund for Development, and the ADB. The next stage of this
program is to determine how to broaden the universe of participating partners.

The second goal means that IDB must evolve a clear “secular” presentation to attract
global institutional investors. This investor class normally makes large placements,
prefers discretion, and is not necessarily desirous to commingle its funds with retail
investors. Periodically, institutional investors find retail investors to be part of their
exit strategy.

Conventional investors are important in this process because the Islamic fund sector
has not demonstrated scale. (Ernst & Young, 2011) demonstrates the thinness of
the Islamic market. Despite achieving US$58 billion of assets under management (of
which US$7.8 billion are in non-conventional assets), the typical fund is small with
less than US$75 million under management.78 As a result, IDB cannot rely on the
Shariah-compliant fund sector to be its main source of capital. Indeed, sukuk issuers
are equally reliant on investors from outside of the “Islamic” orbit. Therefore, the fund
process requires a clear appeal to a diversified universe of investors for whom serving
the emerging markets is important, and for whom Shariah-compliance might not be a
top priority, and on certain occasions, may even be a discouragement.

Conventional investors for the emerging markets must be divided into three
constituencies. The first are sovereign wealth funds, state pensions, and other investors
from IDB member countries. These investors already have a good exposure to Shariah
compliant investing. Indeed, they may have mandates to allocate portions of their
portfolios to Shariah-compliant investments, or negative mandates: “not to exclude”
Shariah-compliant investments from their asset allocation strategies. Many of these
investors participated in IDB’s previous funds.

The second universe of conventional investors is both private equity and asset
managers who have ethical guidelines to consider. According to the GCC Mutual Fund
Industry Survey 2011, since 2008, there has been investor migration to either safety or

78  Keep in mind that the average UCITS fund may be of a similar scale to the average Islamic fund, according to
PWC.

74

higher yielding fixed income.79 This means that the basis exists to attract non-Islamic
investors, who are domiciled in the GCC, into the Shariah-complaint space. A number
of these managers have exposure to the Islamic investing sector and are open to
Shariah-compliant proposals offered to their core investment mandates. The second
universe, however, is not particularly significant in the potential volume of investment
funds to be allocated to projects in the IDB space.

The third, the conventional investor universe, however, is the greatest challenge. On
one hand, this might be the largest pool of funds available. On the other hand, the
universe is composed of large western pension funds like CALPERS and CALSTERS, TIA-
CREF, which are based in the US, Japan, UK or European countries. These investors
have less exposure to emerging markets, but substantial capacity. This pool has
frequently been important for various global emerging market funds, even if the
actual investment is not significant for the funds. These funds often have staff who
lack familiarity with Islam or are influenced by negative press and images resulting
from the last eleven years of conflict arising from the September 11, 2001 attacks.
As a result, this universe may have strong, unstated objections to investing when the
investment fund or terminology explicitly states “Islam” or “Islamic” or visible Shariah-
compliant terminology.80 Moreover, many western state pensions have explicit secular
mandates. As a result, co-investing with IDB in infrastructure or development activities
may meet the mandate. But, investing in a fund that uses the word “Islamic” in its
name or marketing may be deemed to violating the mandates.

The proposal to take advantage of a UCITS jurisdiction is based on the two primary
benefits of UCITS. On one hand, UCITS-compliance opens access to the retail and
institutional investor markets in Europe. Often UCITS funds are passported into non-
UCITS jurisdictions like Bahrain and Malaysia based on agreements between the UCITS
host jurisdiction and the non-UCITS jurisdiction’s regulator. On the other hand, UCITS
structures do not put off or impede institutional investors from co-investing. Unlike the
relatively more burdensome SEC fund rules in the US, which are restrictive on cross-
border sales and distribution, UCITS provides “right touch” oversight whilst facilitating
cross-border sales and distribution to multiple types of investor.

In summary, the IDB fund’s target investors will most naturally be pensions as they
look for long-term stable income generating investments. Other investors should
include insurance companies, foundations, endowments and family offices besides
SWFs. Keep in mind that private equity and real estate funds also have allocations for
infrastructure investment.

79  Gokkunt, Giyas, editor, GCC Mutual Fund Industry Survey 2011, p. 21. The Asset Magazine also concurs with
view that “Islamic” is not a disqualifying factor for conventional investors. See Cruz, Bayani S., UCITS key for Asian
managers to reach outside, February 2012, accessed at www.theasset.com.

80  These investors may also wish to avoid being named on various websites like www.shariahfinancewatch.org and
www.creepingsharia.wordpress.com. These are sites which are part of movements which have sought to ban
Shariah in US courts with some success at the state legislative level, although they were unable to win their cases
in court challenges.

75

http://www.theasset.com

http://www.shariahfinancewatch.org

http://www.creepingsharia.wordpress.com

As a general concept, there is a growing body of institutional investors who seek to
invest in emerging markets in order to enjoy ongoing fixed income from stabilized
infrastructure or capital gains from participating in the development of new projects of
different types. “It is not possible to achieve inclusive and sustainable growth without
the creation of enabling infrastructure in an economy.”81 Section 5.3 will examine some
steps that IDB may take to create an enabling investment environment for investors.
Table 11 shows the infrastructure fund SWOT analysis as a summary.

Strengths Weaknesses Opportunities Threats

Substantial OECD
pension money is
flowing to the sector.

Lack of clear definition Asian pension investor
capacity is growing

“ Islamic” is
not exactly SRI
and may not be
“politically correct”

Increasing trend of
MDFI funds to the
sector

Lack of clear regulation,
tax and investment
process in many investee
countries

Africa and MENA are not
really on the investor
road map

Risk of policy
changes at the
investee level

Infrastructure growth is
good proxy investment
for growth in BRIC &
N-1182

Managers are
concentrated in US and
UK; Australian firm is
biggest manager

Infrastructure is key to
growth

Poor corporate
governance in
many investee
markets

Demand trend trumps
multiple crises since
1997.

Developed markets
demand crowds out
emerging market needs

More scope for
increased investment
from OECD pensions

Deal flow takes
time to build,
giving investors
time to go
elsewhere

MDFI experience with
PPP is improving

Long duration to
achieve goals and
risk of overoptimistic
projections

Develop new investor
classes

Local currency
paybacks
against USD or
international
currency
obligations

N-11
82

Table 11: Infrastructure Fund SWOT Analysis

81  Sinha, U.K., Milind Barve, S. Naganath, and P.K. Nagpal, Report and Recommendations of the Committee on the
Launch of Dedicated Infrastructure (DIFs) by Mutual Funds, Securities & Exchange Board of India, Mumbai, July 23,
2007. Accessed at: www.sebi.gov.in/commreport/difreport.pdf

82  BRIC = Brazil, Russia, India and China. N-11 = Next 11 emerging economies after BRIC

76

http://www.sebi.gov.in/commreport/difreport.pdf

Trade Finance Funds4.1.2

(Towers Watson, 2011) categorized commodities as one of the alternative investment asset
classes. Investment in commodities provides investors diversification as it has a negative
correlation to investment in stocks and bonds. In the conventional market, a commodities
fund may use derivatives on commodities collateralized with bond investments (PIMCO).83

Besides collateralized commodity-linked funds, the market has also seen a number of trade
finance funds. According to Jacques-Olivier Thomann, the managing director of BNP Paribas
(Geneva), trade finance funds have a huge potential in the market; especially due to the
Basel requirements and liquidity shortages amongst European banks. He added that the
annual turnover of trade finance activities is between US$12-US$14 trillion. Thus the initial
size of the trade finance funds market may be a few billion dollars which will eventually
grow to US$100 billion market. BNP Paribas launched a trade finance fund in March 2012
following in the footsteps of Trafigura, an independent oil trader that established its own
hedge fund, Galena, in 2003 (Miles, 2012).

Galena already has an existing commodity trade finance fund which has been growing
annually at 7.9%. In 2012, Galena launched a new investment vehicle to expand this activity.
The initial fund size is US$1 billion targeted at pension, sovereign wealth funds, family offices
and supra-nationals. Galena aims to expand the fund to US$4 billion by the end of 2013.

Socially Oriented Funds4.1.3

For socially oriented funds, IDB may leverage on Singapore’s experience in launching and
administering an onshore retail waqf fund known as the Mosque Building and Mendaki
Fund (MBMF). The fund was established through an amendment of a parliamentary act –
the Administration of Muslim Law Act (AMLA) in 1975 - to allow collection of donations to
construct mosques and new housing. The initial focus of the fund was on mosque building
with an SGD0.50 contribution each month. In 1984, the fund expanded its operations to
include support to the Mendaki Foundation that focuses on education and social program to
uplift the disadvantaged segment amongst Singapore Muslims. The contribution rates have
been revised a few times.84 Currently the deduction is tiered according to the salary level,
and there is a clear division between the mosque building and the Mendaki component as
illustrated in Table 12.

83  Refer http://investments.pimco.com/Products/pages/287.aspx
84  In 1977 the contribution was raised to SGD1, then to SGD1.50 when the Mendaki component was added in 1984.

This was revised again to SDG2 in 1991 and in 1995 a higher rate was introduced for those earning more than
SGD1,000.

77

http://investments.pimco.com/Products/pages/287.aspx

Total monthly wage
(S$)

Total monthly
contribution

(S$)

Mosque building & religious
education component

(S$)

Mendaki
component

(S$)

1,000 and below 2.00 1.00 1.00

1,001-2,000 3.50 2.25 1.25

2,001-3,000 5.00 3.60 1.40

3,001-4,000 12.50 8.00 4.50

Above 4,000 16.00 10.75 5.25

Table 12: Tiered Salary Contribution in MBMF in Singapore
Source: (Jamil, 2009)

In 2008, the fund’s mandate was expanded to include madrassah education enhancement
(improved curriculum, IT services and teacher training).85 This required an increase in the
salary contributions. Therefore the public required that the fund be subject to external audit
and publication of financial statements for transparency. IDB could use its reverse linkage
strategy to transmit this experience of Singapore to other member countries in order to
properly manage waqf and charitable activities.

At a recent event for private equity investors, the rock and roll musician Bob Geldof, who
is known for his charitable actions in Africa, pitched the private equity community to turn
their attentions to Africa. Geldof’s appeal was to an attentive audience. Instead of calling
the fund a ‘waqf fund’, just branding it as an endowment fund may attract non-Islamic
investors as well. A number of specialized development entities are focused primarily on
emerging markets. These include bodies like the Bill and Melinda Gates Foundation, the
Soros Economic Development Fund, the Agha Khan Fund for Economic Development, and
the Norwegian Investment Fund for Developing Countries. All these funds seek social and
intangible benefits in addition to financial returns. As a result, they are willing to make smaller
investments, investments in areas that do not have the same initial financial dynamics that
attract traditional lenders and institutional investors.

Investors’ expectations4.2
This section will examine three sub-issues related to investors’ expectation:

Financial measures:i.  Reviewing issues related to fund performance, benchmark
and fee. This will also include a brief overview of profit equalization reserves (PER)
and whether or not this will be relevant to an IDB Fund.

85  This allows central pooling of resources which gives more efficiency to the collection and management of the funds.
It also relieves the madrasah from fund raising and focus on improving the education and its service provision.

78

Non-financial measures:ii.  Reviewing issues related to fiduciary ratings and other
non-financial risk management tools. This is important to provide confidence
to investors that their investment in new markets are properly invested and
safeguarded. The section will summarize IFC’s approach in working with local
partners and the ESG toolkit that it has developed to properly identify and manage
investment risks. Risk management will be applicable not only to commercially
oriented funds, but also benevolent funds.
Liquidity:iii.  This brief section will examine the growth of the listed infrastructure funds
and other measures that may be put in place to deal with liquidity concerns.

Investors’ 4.2.1 expectations - Financial Measures:
Infrastructure Funds – Benchmark & Performance:4.2.1.1

For investors of infrastructure funds, the challenge is that the risks and cash flows for
projects are inverted. When the risks are highest, during the primary (construction)
phase, the cash flows are negative. But once the project is operational and cash flows
are attractive, the risks are significantly lower. This inverted cash to risk profile is
called the “J-curve”. Primary market investors are growth oriented. Secondary market
investors are income oriented, and seek cash returns that are more like those from
income generating real estate or fixed income instruments like bonds and structured
notes.

In their 2007 analysis of infrastructure investment, Lazard Asset Management pointed
out that infrastructure has two prospective homes on the risk reward scale. Mature
infrastructure in developed markets or well-ordered emerging markets should enjoy
a higher return compared to traditional fixed income investments. But development
infrastructure entails greater risks and may require higher leverage. As a result,
infrastructure under development should enjoy a return like the one achieved with
private equity or hedge fund investments.

79

Figure 34: Infrastructure Risk Reward Profile

Institutional and pension investors have typically looked at infrastructure and
development as a form of private equity investment.86 This is consistent with
PPP approaches. Yet, as investors move from equity markets to private equity,
benchmarking these investments correctly becomes more difficult. Also, beyond the
performance benchmarking, an issue has emerged for many Islamic investors relating
to the fiduciary behavior and performance of managers: This causes many investors in
the Islamic and emerging markets to seek the establishment of a fiduciary benchmark
in order to rate the competence and performance of the fund manager.

According to the Food & Agricultural Organization (“FAO”) of the United Nations:

“There is currently no established benchmark for infrastructure investments.”
Establishing a means to engage the quality of performance to investors, according
the FAO means examining:87

 Absolute returns;1.
 Inflation plus margin – for instance, a consumer price index (“CPI”) with a factor added 2.
to it;
 Bond yield plus margin;3.

86  According to the Investment Company Institute, only 13% of mutual fund assets reside in Africa, Asia, Pacific and
only 16% fit into non-traditional, non-classified asset classes. This demonstrates an opportunity for all forms of
funds, private and public. Accessed at: http://www.ici.org/research/stats/worldwide/ww_09_11.

87  FAO.

80

http://www.ici.org/research/stats/worldwide/ww_09_11

 Inflation-linked bond index return plus margin;4.
 Bespoke blend of equity, real estate, bond and private equity benchmarks;5.
 Listed infrastructure index or global equity index or blend of the two; and,6.
 Peer groups of unlisted infrastructure funds.7.

Traditional standards of performance benchmarking, including measurements of Alpha
and the Sharpe Ratio, may not properly help investors understand what their risks are in
infrastructure and emerging markets. For instance, the simple act of investing in these
markets may be an Alpha strategy, but how is that Alpha correctly compared to the
Alpha gained in peer infrastructure or emerging market transactions. The Sharpe Ratio
has its own difficulty in the sense that the selection of the correct risk-free benchmark
may prove impossible and may actually cause a distortion in understanding what is
actually happening at the fund, or asset level. Therefore, thought has to be given to
the development of properly calibrated alternative benchmarks.

Australia has unlisted infrastructure data for over seventeen years, and the emerging
markets and global infrastructure investing markets are now able to show at least
five years of data, if not ten. Therefore, one should see the existence of a clear
“infrastructure benchmark” or a family of benchmarks, which are distinct from
the MSCI Emerging and Frontier market equity indexes. Even the specialized MSCI
Infrastructure Index’s self-description demonstrates the problems with the indices
designed in the developed countries:

“The MSCI Infrastructure Indices are free float-adjusted market capitalization-
weighted indices comprised of listed infrastructure companies based on the
Global Industry Classification System (GICS®). MSCI further aggregates GICS®
sub-industries into Infrastructure Sectors: Telecommunication Services, Utilities,
Energy, Transportation and Social Infrastructure sectors. Infrastructure Sectors are
not official GICS® sectors but aggregated subsets of GICS® sub-industries based on
the MSCI Infrastructure Indices Methodology.

In addition to the free float-adjusted market capitalization-weighting scheme, a sector
capped version of the indices is also available for clients who desire a benchmark
with more balanced sector distribution. The capped weighting is designed to reduce
excessive concentration in large sectors, such as Telecommunication Services and
Utilities, but without over-inflating a small sector, such as Social Infrastructure.”88

Foremost, the index cannot capture unlisted infrastructure, sukuk or infrastructure
debt, and is not dedicated to emerging markets. This leads to:

“…benchmarking alternative investments in comparison with traditional asset
class benchmarking. Furthermore, unlisted infrastructure as an asset class is still

88  Accessed at: http://www.msci.com/products/indices/thematic/infrastructure/. Dow Jones with Brookfield has
developed a competing approach with similar criteria - Dow Jones Brookfield Global Infrastructure IndexSM, see:
www.djindexes.com/.../downloads/.../Dow_Jones_Brookfield_Global, as has Standard and Poors, see: http://www.
reuters.com/finance/stocks/overview?symbol=IGF.P and Credit Suisse, see: www.holtindex.credit-suisse.com/pdf/
CSRTEI.pdf.

81

http://www.msci.com/products/indices/thematic/infrastructure/

http://www.djindexes.com/.../downloads/.../Dow_Jones_Brookfield_Global

http://www.reuters.com/finance/stocks/overview?symbol=IGF.P

http://www.reuters.com/finance/stocks/overview?symbol=IGF.P

http://www.holtindex.credit-suisse.com/pdf/CSRTEI.pdf

http://www.holtindex.credit-suisse.com/pdf/CSRTEI.pdf

developing in terms of performance data availability and investor expectations.
Consequently, investors have had to adopt a range of less-than-perfect
benchmarks.”89

One of the main challenges in this process is that infrastructure investment practice is
still highly evolutionary, and a very diverse universe of investment styles and asset types
are lumped together as infrastructure. As shown throughout this study, “infrastructure”
and “development” investments by institutional investors are frequent synonyms with
“infrastructure” the preferred term in the market, particularly as one moves to debt
and unlisted investments.

According to Colonial First:

“Single-asset class + margin or CPI plus margin and absolute return benchmarks
are the best alternatives among current benchmark options. However, as the asset
class develops, we expect blended asset class plus margin benchmarks and relative
performance measures to become more prevalent.”90

Based on the Australian experience, and focusing on unlisted infrastructure, Colonial
First proposes a composite index construction as follows:

Core infrastructure should return from around 8% to over 10%.•
Growth-oriented infrastructure should return between 10% and 14%.•
Diversified infrastructure funds returning from 9% to 13%.•
Greenfield infrastructure returns being at least 14% or above.• 91

Given IDB’s work with leading development organizations like the ADB, IDB might
wish to collaborate to construct country infrastructure and development investment
indices. These indices should consider the blended methodology proposed by Colonial
First. The indices should probably be focused on specific investee countries and
regions (India, the “Stans”, Indonesia, ASEAN …) and then be aggregated to an IDB
footprint index. Otherwise, the best measure is absolute return as compared to any
other fund.

Preqin analyzed the performance of 108 unlisted infrastructure funds. Figure 35 shows
the performance of the funds in comparison to matured funds that were launched
earlier. Funds that were launched between 1993 and 1999 had a median IRR of 9%.
Funds that were launched between 2000 and 2005 had the highest IRR (21%). Funds
that were launched between 2006 and 2008 had an IRR of less than 10%.

89  Setting the goalposts: A review of infrastructure fund benchmarks, Colonial First State Global Asset Management,
November 2010, accessed at www.cfsgam.com.au/Research.aspx.

90  IBID. (Colonial First).
91  IBID. (Colonial First).

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http://www.cfsgam.com.au/Research.aspx

Figure 35: Performance of Unlisted Infrastructure Fund

Source (Preqin, 2012), p29

Investors in infrastructure look for stable diversified return and as tool for hedge
against inflation. It is not meant to be a high risk-high return investment strategy.
Nonetheless, over the recent years, infrastructure funds have outperformed private
equity and real-estate funds. Refer to Figure 36 for illustration.

Figure 36: Performance of Infrastructure vs PE vs Real Estate Fund
Source (Preqin, 2012), p.30

In a separate survey by (EMPEA & Coller Capital, 2011), they surveyed 156 institutional
investors active in the private equity market. More than 54% of the investors expect
an annual net return of 16% from their emerging market portfolio.

83

Other Funds Performance:4.2.1.2

Trade finance funds returns are normally related to the Libor market. Nonetheless,
Latin America Export Finance Fund managed by Crecera Finance in San Francisco has
managed to post a 9.3%, 5 years compounded annual return (CAR). Similar funds
managed by Octagon Asset management and IIF Capital have also enjoyed similar
performance. Although some trade finance funds are able to attract investors,
these US-based funds were finding it difficult to attract investors despite their good
performance (McAuley, 2012).

As for the benevolent fund, since the aim is to assist and make below market return,
the non-financial measures will be more crucial for these investors.

Smoothing of Return:4.2.1.3

Many Islamic banks uses profit equalization reserves (PER) to smoothen the payment
of returns to ‘profit sharing investment account’ (PSIA) holders. Since PSIA is based
on Mudarabah, the depositors will be exposed to the performance of the bank rather
than enjoying a predetermined return. Therefore, when the bank is enjoying high
performance, it will allocate some of the return to the PER (which has both the bank
and the depositors portion) before making a distribution to the depositors. During
rainy days, the bank will use these reserves to pay the market return to investors.

In the banking market, PER is put in place to ensure that the depositors are paid the
market return and minimize actual exposure to the bank’s performance. In a funds
setting, PER may not be directly relevant as the investors understand the risks of
investment and do not require payment of pre-determined return. In cases where
the fund uses debt instruments, it may set up a financial services reserve account to
ensure it can meet the debt payments. Rather than income-smoothing mechanisms,
investors value proper investment decision and risk management to safeguard their
investment.

Investment Term:4.2.1.4

Investors in emerging markets often have shorter horizons than is required for assets
to be created in the same markets. Emerging market-domiciled investors frequently
prefer investments between three and five years with some willing to stretch to seven
or ten years. IDB’s first infrastructure fund had a ten-year initial investment period
and allowed for an extension of three more years. Global pension and life insurance
companies are comfortable with longer terms due to their business models which
require long term capital gains and a steady income to meet the need of pensioners,
annuitants and beneficiaries. Global institutional investors also dislike reinvestment
risk. As a result, a ten year horizon is best to attract global investors, but requires work
to attract investors from the local emerging and investee markets.

Management Fee:4.2.1.5

Since the mid 2000’s, investor representatives have been advocating a significant

84

change in fee structures.92 (Probitas, 2007) also raises the question of the costs to
invest. The typical general partnership structure is based on an annual fee assessed
against assets under management. This might be between 1–2% p.a. Then there is a
carried interest or participation in profits which may be anywhere from 10–30% of
absolute performance against a performance barrier. 93 Preqin, in its survey of investors,
highlighted that the most common reason cited for misalignment of interest between
the GP (General Partner) and the investors are a high management fee, paying a fee on
un-invested capital, carry structure and the poor structure of the performance fee (for
example, the performance fee is based on capital appreciation and not above certain
clear hurdle rates).

Table 13 summarizes the common structure for different fees charged by funds and the
changes that investors are increasing expecting fund managers to make.

Type Common Recommended

Management Committed funds Invested Capital or NAV

1 – 2 % Approach actual management
costs

Hurdle rates 8% Link to fund strategy

Cash flow
European waterfall: LP recovers
all capital before it is eligible (to
be clarified)

Catch up after return of capital

Only if GP achieves Alpha at a
high level

Transaction fees Cut to manager None to manager or

Transparency

Bidding PPP/PFI projects Costs to investors Split costs between manager
and investors

Table 13: Investors’ Concerns on Fee charged by Funds

92  In addition to Risk Metrics, see Towers Watson, A fairer deal on fees: Our thoughts on alignment of manager fees,
2007 - www.familyofficesummit.com/digital_assets/5487/A_fairer_deal_on_fees.pdf

93  Op. Cit., Probitas.

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Investors’ expectations - Non-financial 4.2.2 measures:

This section will examine two approaches to manage risks in a fund; fiduciary rating and the
IFC’s Approach in Managing Risks in the PE Fund.

Fiduciary Rating:4.2.2.1

In western countries, fiduciary ratings are now delivered by fund rating companies.
These generally cover investments managed by a regulated entity like a bank, an
insurance company, a registered investment company (mutual fund), or a registered
investment adviser. The rated investment must have a minimum track record, typically
three years.94

In order to be eligible for a fiduciary rating the same portfolio management team, and its
senior manager should be in place for at least two years. Turnover in the management
team or by the senior manager leads to lower ratings. Rated managers must have a
minimum quantum of investments under management across all classes.

The manager is rated for his performance in a particular type of asset class and actual
management skill in the class (i.e. is not tracking and is not over-weighted in cash). If
the manager fails to adhere to stated investment objectives then the manager will face
deductions from the fiduciary rating. The manager must show “style consistency”.

The rating services also examine the manager’s expense ratios/fees relative to peers.
Fiduciary ratings also examine the risk-adjusted performance of a manager relative to
its peers. The measures applied for risk-adjusted performance are the fund’s Alpha
and Sharpe Ratio.

In the studies seeking to establish a pan-African fiduciary rating agency, the distinction
is made between operational risk, which tends to relate to fraud, and fiduciary risk,
which relates to failing to perform ones duties properly. Refer to Table 14 for details.

The International Islamic Rating Agency (“IIRA”) has added a specific approach to the
fiduciary ratings in order to capture the unique characteristics of Islamic finance.95
The IIRA method builds on the manager or bank’s credit rating as well as the unique
fiduciary score that IIRA creates. The former is the capacity of the manager to perform
its financial obligations. The fiduciary score is driven by analysis of the corporate and
Shariah governance, i.e. the manager’s transparency and disclosure, compliance with
Shariah as the manager is governed by it, and, as with conventional, the manager’s
actual peer adjusted performance quality.96 For project level managers, IDB may apply
IIRA fiduciary manager ratings.

94  This discussion is derived from Fiduciary Score® methodology Updated March 26, 2011 and accessed at www.fi360.
com/fa/help/pdfs/methodology.pdf

95  The IIRA has developed its rating approach jointly with its technical partners and shareholders, JCR-VIS Credit
Rating Company of Pakistan and the Malaysian Rating Corporation.

96  Accessed at http://www.iirating.com/ratingfiduciry.asp. Also see: http://www.fa-mag.com/component/content/
article/1022.html?issue=51&magazineID=1&Itemid=27. Also see: www.jcrvis.com.pk/Images/FR-Methodology.
pdf.

86

http://www.fi360.com/fa/help/pdfs/methodology.pdf

http://www.fi360.com/fa/help/pdfs/methodology.pdf

http://www.iirating.com/ratingfiduciry.asp

http://www.fa-mag.com/component/content/article/1022.html?issue=51&magazineID=1&Itemid=27

http://www.fa-mag.com/component/content/article/1022.html?issue=51&magazineID=1&Itemid=27

http://www.jcrvis.com.pk/Images/FR-Methodology.pdf

http://www.jcrvis.com.pk/Images/FR-Methodology.pdf

Table 14: Operational Risks under Credit and Fiduciary Conditions

Source: Establishment of a Pan-African Fiduciary Rating Agency Project No. 2007/146028 97

IFC Approach – Local Partner & Environmental, Social and Governance 4.2.2.2
(ESG) Screening:

IFC has been investing in the private equity market since the 1990s, but reorganized its
operation into a dedicated department in 2000. The return on IFC’s PE fund (exclude
real estate, debt and listed equity funds) from 2000-2009 was 18%, compared to the
16% top quartile Cambridge Indices – Emerging Markets. Prior to the reorganization,
IFC return on the 1990s funds was 4-5% and the top quartile was 11.9%.

To support the development agenda, IFC prefers to use first time fund managers and
has considerable investment in Africa. It highlights that there are three widely held
misconceptions about investment in emerging markets:

A minority position in emerging market is risky due to lack of proper legal i.
systems, governance and transparency.
There is an exit constrain for emerging market PE.ii.
Small companies are risky and it’s double the risk when these companies are iii.
in emerging markets.

IFC refutes all of the above perceptions and its fund performance supports its view.
Based on 150 IFC PE Funds as of March 2009, it conducted a comparison of its top 10
and bottom 10 funds. First time funds were equally represented in the top and bottom

97  Accessed at www.acpbusinessclimate.org/PSEEF/Documents/Final/fiduciary_rating_en.pdf

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sample. And both segments have funding to countries with less than $1,000 per capita
income (IDA), with the top 10% having higher amount of funding to IDAs.

Table 15: IFC Fund Performance Comparison

The final column in Table 15 measures the quality of IFC’s general partners. IFC assigned
a score between 0 and 1 to reflect the extent to which the GPs have met the critical
success factors for emerging market PE success. Most of the factors evaluate whether
the GPs are locally based, their experience in PE and managing business etc.98 The top
10% not only delivered superior financial returns, but also had a higher development
impact. The difference between the two groups was the quality of the GPs. The top
10% have better GPs as reflected in the higher score in the final column. Thus, IFC
advocates that the success recipe for successful PE operation in emerging market is to
ensure that the GP is properly evaluated and selected.

IFC arrived at this approach from the experience that the IFC’s CIO gained while he was
with the World Bank’s pension fund private equity investment. David Wilton found
that GP teams with high number of investment bankers tend to use leverage as their
strategy to improve the IRR. While GP teams with former company managers tend to
focus on revenue growth and improved efficiency to build a higher IRR. Since in many
emerging markets there is limited leverage available, it is vital to have GPs with the
proper skills needed to improve the investee company. This is basically the crux of IFC’s
strategy. It is recommended that IDB works with IFC to leverage from its experience in
choosing a local partner with the right skill set to manage the PE investments.

Besides the local partner approach, IFC has also developed an online toolkit to
help fund managers and other stakeholders evaluate the environmental, social and
governance risks and opportunities of different investment portfolio. It involves a four
step process:99

Users will answer screening questions on the website that will generate risks i.
and opportunities appraisal questions.
Then the user collects information to these questions offline.ii.

98  Questions that IFC evaluated: was the GP locally based?; were a meaningful number of staff local nationals?; did
the team possess experience that would enable them to add value to companies such as prior experience in running
companies, as entrepreneurs or as consultants?; did someone in the team have prior experience in private equity?

99  https://www.estoolkit.com/HelpVideo.htm

88

Next, the user inputs the answers to the risks and opportunities appraisal iii.
questions online.
The system will then generate an action plan which the fund managers will iv.
keep to monitor the risk and opportunities in the investment.

IFC implements its performance and environmental standards in the toolkit. This
enables the local GP to effectively implement the required performance standard.
IDB is also recommended to work with IFC to adopt similar approach. This toolkit
will benefit the commercially oriented funds. It may also help put in place proper risk
management approaches to the socially oriented funds.

Investors’ expectations - Liquidity:4.2.3

Funds, unlike listed investments, lack the same liquidity profile. There is not necessarily a
ready market for these instruments, and the underlying investments are not necessarily
easy to monetize. Even when there is a secondary market, these types of investment may
not trade, or may trade at a wide bid-offer spread. This section will examine the trend in
listed infrastructure funds and briefly discuss whether alternative liquidity measures are
needed.

The listed infrastructure funds market started much earlier than the unlisted funds market.
The first listed infrastructure fund was pioneered in Australia in the mid-90s. Since then,
infrastructure funds have been listed in London, New York, Toronto and Singapore. The
market for listed infrastructure funds grew actively since the 2000s and peaked in 2008.
Since then, a number of funds have been delisted which brings the active listed funds to
41 in 2011. Kotak India Infrastructure Fund was the only fund launched in 2011; listed on
LSE. Most of the listed infrastructure funds are in Australia (32%), Canada (24%) and the US
(19%). The majority of listed funds are managed by a single vehicle except for Macquarie
that manages three funds (Preqin, 2012)

89

Figure 37: Listed Infrastructure Funds
Source: (Preqin, 2012), p55

Listed funds obviously have the liquidity advantage, thus investors may adjust their committed
amount at a short notice. When funds list, the units are liquid, but the price is not necessarily
the NAV, but whatever the market demand establishes and this could be a discount or a
premium. And from time to time, the market may not have demand for securities. However,
listed infrastructure funds have a higher correlation to the overall equity market – thus
limiting the diversification benefit that the unlisted infrastructure asset class brings.

Investors in the unlisted infrastructure funds are normally investors looking for long term
investment and not necessarily looking for liquidity before maturity. The historical trade-off
for private equity is that the payoff is long term and the investor’s liquidity preference is
subordinated to the investor’s preference for a high return on the investment. Normally, if
these investors want to exit the investment, they will have to find investors in the secondary
(mostly OTC) market.

In the private, unlisted funds market, some fund sponsors provide liquidity facilities whereby
the sponsor provides credit against a pledge of securities. Effectively, this makes the sponsor
the investor of the last resort. This means that the sponsor may lack capacity to provide
the facility. The sponsor’s capacity is prospectively limited by country risk, obligor credit or
investment risk, or even securities laws in the sponsor’s domicile.

Therefore, some funds arrange for secured liquidity facilities to be provided by third party
lenders. Even these facilities have limits. And during a crisis such as the 2008 financial crisis
or the 2012 Eurozone crisis, some lenders may not be able to honor their commitments.

90

A distinctive form of liquidity feature is a unit purchase pledge often organized by the fund
sponsor. Buy-back features often have a specific limit on the volume of units on specific
dates subject to notice. Sometimes these features are successful especially if the fund is
performing. But, a number of cases have been documented in which a fund underperformed
and the liquidity feature prompted a run on the fund with the investors attempting to treat
the sponsor as the residual equity owner.

UCITS or transferrable securities vehicles are an alternative to listing, but have some of the
same risks as listing in terms of the price of the units. Generally, UCITS-governed funds will
transfer at NAV if there is a buyer in the market.

Another tool to manage liquidity risks is to build cash reserves for allocated purposes.

In addition, the fund may also apply an exchange traded fund (ETF) strategy. A group of
investors that have the fund shares will deliver the shares in return for units in the ETF. The
holders of the ETF units may trade this for cash in the secondary market. This will provide
liquidity for the fund.

In India, the infrastructure funds are structured via a mutual fund vehicle to tap into retail
investors. The committee recommended that the Development Infrastructure Fund (DIF)
should be given 24 months listing option to avoid negative trading during the investment
phase. Besides the grace period for listing, the committee suggested that the fund is allowed
to buy-back the units from the market if the DIF is not able to fully deploy the fund. The
committee also recommended that the full drawdown is done at the closing to avoid
operational complexity with multiple drawdowns in the retail market.

91

Domicile Selection4.3
The top jurisdictions for Islamic funds were used as a basis to select the first group of
domiciles to be analyzed.

Table 16 lists the domiciles of choice for Islamic funds by (Ernst & Young, 2011).

Jurisdiction AuM (US$) Number of Funds

Saudi1. $19.9b 225

Malaysia2. $5b 171

Caymans3. $4.13b 57

Bahrain4. $1b 46

Singapore5. $0.72b 10

DIFC6. $0.51b 14

Luxembourg7. $0.48b 29

Dublin8. $0.22b 8

Mauritius9. $0.14b 3

Malta10. Application of Islamic Funds under review

 Table 16: Domiciles of Choice for Islamic Funds
Source: (Ernst & Young, 2011), p.37

Among the top five jurisdictions, only Saudi Arabia is a purely onshore focused jurisdiction.
This means that Saudi Arabia lacks the regulations and structures that would facilitate
outbound investments into the international markets. Therefore Saudi Arabia is excluded
from the analysis.

Besides the Islamic funds, the domiciles for infrastructure funds were the next selection
criteria. These tend to be domiciled in five jurisdictions reflecting certain forms of expertise:
Australia on the ASX, London, Singapore, Korea and Toronto. The listed infrastructure funds
have an interesting dynamic: they tend to be in jurisdictions with a Real Estate Investment
Trust (“REIT”) vehicle allowed under local law and regulation. This is partially because
infrastructure funds have copied REIT dynamics as income dispersing funds and the stapled
operating, management company concept (which will be discussed below).100 The ASX
reflects the unique position of Macquarie as an organized fund and the size of the domestic
infrastructure fund business. Yet, Australia is not a tax efficient international jurisdiction.
London and Singapore compete with Australia for the global business. Korea and Toronto

100  Infrastructure Funds: Managing, Financing and Accounting in Whose Interests? Risk Metrics Group, 2008. Accessed
at: www.maynereport.com/images/2008/09/01-13GEDV97N00.pdf.

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reflect domestic fund dynamics and are less international than the other jurisdictions. Since
Singapore already overlaps with Islamic funds domicile above, this means only London will
be added to the jurisdiction list.

Finally, the analysis will also include Qatar Financial Center (QFC) to test additional GCC
domicile, and two other offshore jurisdictions; Jersey and Bermuda; as these are used in Sukuk
and other Islamic finance transaction. The final list of jurisdiction analysis will include:

 Malaysia1.
 Luxembourg2.
 Caymans Island3.
 Mauritius4.
 London5.
 Singapore6.
 Bahrain7.
 Dublin8.
 DIFC9.
Jersey10.
Bermuda11.
QFC12.
Malta13.

We have ignored a large number of centers for one of two reasons. They are like Saudi
Arabia, fundamentally a domestic market catering to its own needs. This will surely be the
case for both Mumbai and Jakarta, both aspiring to become international as opposed to
domestic financial centers.

Other important centers like Tokyo, Hong Kong, Bahamas and Panama are considered in this
study. These centers are typically peripheral to the Islamic finance market: either they have
not done the footwork to attract the Islamic funds market or they have not yet built a track
record with GCC investors.

Other planned financial centers like Istanbul and Amman have not yet put all of the pieces to
their puzzle in place and are not yet ready to be considered. A challenge for many emerging
market cities to truly internationalize will be their ability to manage the pull between serving
transient global capital and fulfilling domestic financing demand. Larger countries like India,
Turkey, Nigeria and Saudi Arabia will be more like the United States than the United Kingdom
as robust domestic needs will shape regulation and financier focus.

Evaluation Criteria4.3.1

The research objectives are three fold; off balance sheet financing, efficient cost of fund
and diversified investor reach. Among these objectives, domicile does not affect the first
two factors directly, while the last factor may be used to evaluate the domiciles. Therefore,
the domiciles will be evaluated based on two groups of criteria; breadth of investors reach
and business factors. These factors will be assigned numerical values and applied to each
jurisdiction discussed in this chapter as summarized in Table 17

93

Evaluation Criteria Brief Explanation

A. Breadth of Investor Reach Primary evaluation criteria – 100% weight

Master-Umbrella-Feeder (MUF)i. Allows multiple structuring tools to capture broad
investor group (fund of funds tool)

Global investor Recognitionii. Qualitative evaluation whether it is widely used by
international investors.

Islamic Investor Recognitioniii. Qualitative evaluation whether it is already used by
Islamic funds/investors

UCITSiv. Provides European passport to reach global investors

Number of Funds (Volume)v.

Quantitative evaluation as a proxy for international
investor recognition. Not all international
jurisdictions have big volume. E.g. Jersey is
internationally recognized, but has a smaller market
share compared to Caymans or Luxembourg

Tax Treatiesvi.
Higher number of tax treaties facilitate free
movement of funds between jurisdiction, thus
allowing broader group of investors

Listingvii. Whether or not a fund may be listed; used as a proxy
to measure capacity to support liquidity.

Cross Registration: Managers & Fundsviii.

Whether jurisdiction recognized non-registered
manager and companies as local domicile. Positive
scores recognize this, thus enhances free movement
of fund and potential liquidity

Unrestricted Placementix.

Whether retail placements are available and
facilitated.

Positive: Retail available – broader investor group•
Negative: Only private placements•

ETF and/or REITsx. Availability of ETF/REITs provides an alternative tool
for liquidity and attract different investor group.

AAOIFI/IFSB Recognitionxi. Enhances Islamic investors’ confidence

B. Business Factors Secondary evaluation criteria – 50% weight

Low or no taxi. Lower taxes are better.

94

Establishment Costsii.
Lower costs are better. Usually costs below $30K are
an advantage (positive). Costs higher than $50K is a
disadvantage (negative).

Director Residency Requirementiii. Whether local directors are required. If yes, a
negative, since this will increase cost.

Require Local Fund Admin servicesiv. Whether fund admin services must be local. If yes, a
negative since this will increase cost.

Time to Marketv. Positive: < 2 months•
Negative: > 6 months•

Table 17: Domicile Evaluation Factors

Scale -1 0 1 2

Definition Doesn’t support Neutral Benefit Optimal benefit

Table 18: Definition of Scale used for Evaluation

The breadth of investors reach will be the primary criteria and will receive 100% weighting
based on the scale in Table 18. Business factors are secondary evaluation criteria and will
receive 50% weighting. Breadth of investors covers 11 different aspects that examine which
domicile allows reaching out to the largest group of investors. The business factors cover 5
aspects related to the cost of setting up and running a fund in the different domiciles. All
these factors are summarized in Table 17.

Evaluation Criteria Brief Explanation

A. Breadth of Investor Reach Primary evaluation criteria – 100% weight

Master-Umbrella-Feeder (MUF)xii. Allows multiple structuring tools to capture broad
investor group (fund of funds tool)

Global investor Recognitionxiii. Qualitative evaluation whether it is widely used
by international investors.

Islamic Investor Recognitionxiv. Qualitative evaluation whether it is already used
by Islamic funds/investors

UCITSxv. Provides European passport to reach global
investors

95

Number of Funds (Volume)xvi.

Quantitative evaluation as a proxy for
international investor recognition. Not all
international jurisdictions have big volume. E.g.
Jersey is internationally recognized, but has a
smaller market share compared to Caymans or
Luxembourg

Tax Treatiesxvii.
Higher number of tax treaties facilitate free
movement of funds between jurisdiction, thus
allowing broader group of investors

Listingxviii. Whether or not a fund may be listed; used as a
proxy to measure capacity to support liquidity.

A key factor for jurisdiction is the type of structure that it can support. To build a program,
there are a number of concepts to consider: one-off funds to purpose, structured from time
to time; fund of funds; feeder funds; and umbrella funds. The expected strategy should also
contemplate mixing the different concepts into a complex architecture managed by IDB, but
delivering simpler fund offerings to purpose as required. In order to do this, the key concepts
of collective investments need to be defined:

Collective Investments:i.  A collective investment scheme is a pooled investment and
may also be called a “unit trust” or a “mutual fund”. These programs are meant to
enable investors with common interests to work with a common manager through
the same legal entity. These funds may be private or public funds. An IDB-approved
fund is likely to be a private fund. But strategically, sub-funds may be mutual funds
or unit trusts under local market regulations which are open to retail investors. All of
the jurisdictions surveyed treat any form of fund as a collective investment scheme.
Regulators often are concerned about three other forms of fund vehicle that are less
common.
Fund-of-Funds: A fund-of-fundsii.  (“FOF”) is an investment fund that invests in other
investment funds. The investee funds may be managed by the sponsor or selected
from the market as “best of breed”. Instead of selecting its own portfolio constituents,
the FOF evaluates and approves managers of various investment classes. The FOF
then buys units in the approved funds. As a result, the concept is frequently called a
multi-manager investment strategy. Regulators like Malaysia’s Securities Commission
often restrict FOF from investing in other FOF. In other words, the Malaysian regulations
are meant to assure that an FOF strategy does not have multiple underlying FOF. The
proposed IDB structure will not apply a FOF strategy although elements of the strategy
may appear to do so for tactical reasons.
Feeder Fund:iii.  A feeder fund is similar to an FOF. Except that a feeder fund exists in one
jurisdiction with the purpose of investing in a master fund which may be in a different
jurisdiction. A master fund normally receives investments from feeder funds in jurisdictions
that may pose cross registration or tax challenges for the master fund. The master fund
is often an offshore fund, whereas the feeder fund is normally an onshore fund. Master–
feeder fund structures are meant to assure that master funds reach more investors
than their domicile facilitates. Master–feeder structures are often meant to reduce tax,

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manage different regulatory risks for the master fund, and improve the master fund’s
economies of scale for the fund. Master-feeder structures are also characterized as hub
and spoke structures. A feeder fund differs from a fund-of-funds strategy as the feeder is
not responsible for investment execution. The master fund is the asset manager.
Umbrella Fund:iv.  An umbrella fund is a collective investment scheme that offers its members
a choice between several distinct sub-funds. Each sub-fund follows a unique strategy.
Investors are often able to switch between sub-funds subject to an executed exchange at
the prevailing NAVs of each fund. An umbrella fund is similar to an FOF, but instead of the
umbrella fund’s manager allocating money, the investors direct funds to the sub-fund that
suits their investment goals.

Generally, a fund company is a limited purpose company or SPE as discussed in 2.4.1. A well-
structured regime for SPEs and their ease of formation and cost efficiency are important
factors in the determination of establishing a fund. The following section will examine
individual jurisdictions before conducting the overall evaluation of all jurisdictions, and the
friendliness of each jurisdiction to SPEs will be an important factor.

SWOT Analysis of Individual Jurisdictions4.4
Malaysia4.4.1

Malaysia possesses onshore and offshore capacity, although the market is overwhelmingly
domestic. The offshore capacity in Malaysia is available through both Labuan and the
Malaysian International Islamic Financial Centre. Both are increasingly used for cross
border investments. Integrating the MIFC, Bursa Malaysia, and the Labuan offshore center,
Malaysia fulfills the largest universe of potential needs. Important recent developments for
Malaysia include understandings with both Luxembourg and Ireland, which have recently
been tested so that Malaysian managers are able to access UCITS platforms and appeal to
European retail and institutional investors. A hub of Islamic finance innovation and talent
development, Malaysia has not yet built a deep recognition as an offshore center for
international investors.

Malaysia has an efficient trust law and low cost SPV process that is fast and efficient. The
regulators are well coordinated in their efforts to build a well-governed edge for Malaysia’s
established Islamic finance hub.

Unlike smaller countries, for instance Luxembourg or Bahrain, Malaysia is prospectively its
own biggest threat in that the offshore business must compete for talent and attention with
the vibrant domestic business.

Already a large domestic Islamic fund market and the leading global center for sukuk,
Malaysia presents one of the leading English law derivative jurisdictions to organize funds.
The strategic location and abundance of talent rank Malaysia as a top choice.

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Malaysia

Strength Weakness

Integrated Islamic supervision, tax & 1.
regulatory infrastructure including Malaysia
Int’l Islamic Fin. Centre (MIFC)

Developed IF market, education (INCEIF), 2.
professional services (legal, accounting, IT, …)
– Enforceability, standardization

170+ Islamic Funds with $5.1b in Assets3.

Labuan Islamic Financial Services & Securities 4.
Act 2010 (LIFSSA)

Labuan based funds have attractive regulatory 5.
costs: MYR 5,000 – non-Labuan operating
funds pay MYR 10,000

Taxes: Zero on capital/income/dividends – 6.
exemptions to 2020 – no withholding tax –
advanced tax ruling availability

64 Double Tax Agreements7.

Labuan IBFC to raise non-MYR capital8.

Islamic ETFs traded on Bursa Malaysia9.

High volume – low market capitalization 1.
transactions

Less familiar to global institutional investors 2.
for cross border investing

Has yet to overcome some negative 3.
perceptions from GCC.

Opportunity Threat

Heart of ASEAN1.

Proximity to Indonesia and Pakistan (largest 2.
Muslim populations in world) as well as India
& China

Largest Sukuk market - 65% of global3.

Competes with own onshore market1.

Competes with major offshore centers2.

Luxembourg4.4.2

One of the few offshore centers that is not a sunny island, the Duchy is taking the Islamic
capital market business seriously and has established good relationships with different Islamic
financial centers, notably Bahrain and Malaysia. Luxembourg is also a member of important
Islamic financial service capacity building bodies. As the world’s number two funds center
and a UCITS compliant jurisdiction, Luxembourg offers an almost perfect environment in
which to introduce global institutional investors to Islamic funds.

The business environment is constructive, makes it easy to market in Europe, and a large
number of tax treaties facilitate cross-border fund business. The main challenge for civil law
Luxembourg is its relatively high cost of doing business.

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Luxembourg

Strength Weakness

Hub for international funds distribution: 1.
Domicile of 75% of cross-border funds and
second largest investment fund center after
the US ($2 trillion AUM)

Part 1 of the 2010 UCI Law governs UCITS 2.
(Undertakings for Collective Investments in
Transferable Securities)

Applies to MM & Equity IFa.

HSBC Amanah’s UCITS domicileb.

Multiple legal formsc.

Sub fundsd.

No issue/redemption restrictionse.

No dividend distrib. restrictionsf.

Eligible for EU Passport, et. al: 700 Lux. g.
funds registered in Bahrain

Active government support for Islamic 3.
finance: Central Bank is a member of the IFSB
and IILM

30+ Islamic Funds with $0.58 AUM4.

Easy to do business: No IF-specific 5.
requirements; No residency requirement
for directors; Minimum prospectus content;
Quick launch (6-8 weeks once submitted).

Reasonable costs: Euro 2,650-5,000 annual 6.
license fee; and Euro 6,000 min. cost to
establish fund

Tax Authority gives clear tax guidelines: No 7.
dividend withholding tax and No corporate
income or business tax.

Higher cost of business vis-à-vis others1.

No specific IF tax provisions2.

Required services for UCITS:3.

Depositarya.

Central Admin. Agentb.

Auditorc.

Min. Euro 1.25 m capitalization within 6m4.

Reporting requirements5.

Annual subscription tax (0.05% of NAV)6.

Companies registered in Luxembourg City may 7.
be taxed at a combined 28.80% rate

May be offset by an extensive a.
participation exemption regime

Opportunity Threat

Microfinance Investment Vehicle (MIVs)1.

Door to Europe & int’l cross-border sales2.

Possible dual tax treaty benefits (SICAVs)3.

Tax authority has issued two tax guidelines 4.
covering Murabaha & Sukuk transactions

Possible to re-register or acknowledge fund 5.
company form another jurisdiction.

Competes with offshore centers globally.1.

Trapped between European giants France 2.
and Germany with own views on taxes and
offshore centers.

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Cayman Islands4.4.3

With 70% of the world’s hedge funds domiciled in the Cayman Islands and over 9,000
registered funds of all types, the Cayman Islands are a leading global fund hub. Based on
English law, the Cayman Islands are one of the most popular destinations for GCC and Islamic
investors to structure funds and securities. The Cayman Islands allow appeals of local law
decisions to the Privy Council in London. The ease and cost of doing business are favorable,
and this, along with easy to use trust and companies laws. The Cayman’s top legal firms have
all opened offices in London and the GCC. But the talent universe is somewhat limited and
funds are restricted to accredited investors. Another issue that surfaces from time to time is
the impact on the Cayman Islands from various pressures from the United States.

Cayman Islands

Strength Weakness

Flexibility of Investment Fund Regime1.

Mutual Funds Law (2009 revision)2.

Licensed: least common overalla.

Administered via existing Cayman Island b.
administration.

No $100k minimum investment.c.

Alternative Investment Funds established d.
as open or closed ended variants of unit
trusts, companies, or limited partnerships.

Dual Arabic registration for IF products3.

57 Islamic Funds with $4.13 b (AuM)4.

20-50 yr. profit/income/capital gains, tax 5.
breaks.

17 tax info accords including USA & UK6.

Expedited business processes and reasonable 7.
costs: 3-5 week timeline to launch Licensed
funds: US$10k-20k establishment costs;
$3,000 registration fee and $3,000 annual
licensing fee; No requirement for local audit
sign-off and No requirement for local service
providers

One-stop shop service providers: 31 law firms, 8.
35 accounting firms, 148 admin., 259 licensed
banks, 81 corp. serv. prov., 106 trust cos.

Same administrators oversee many funds – 4.
Agency issues

IF treated same as conventional funds5.

Viewed in negative light as a tax haven6.

$100,000 minimum investment and local 7.
audit sign-off for CIMA-registered investment
funds

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Opportunity Threat

Recognized Fund & Trust industry1.

Umbrella Funds are allowed: funds with 2.
“segregated cells”.

Possible to re-register or acknowledge fund 3.
company form another jurisdiction.

Multiple classes and currencies are permitted. 4.

Unlimited cap on fund equity.5.

Popular jurisdiction for Sukuk and Private 6.
Equity Funds

Aircraft and Ship Registration hub7.

Other offshore centers1.

Impositions by US to tighten regulations2.

Mauritius4.4.4

Although far from anywhere, Mauritius has built a good international funds business
leveraging tax treaties with India and many African countries. These have already allow the
blended law (Mauritius has both civil and English law environments due to having been
ruled by both Britain and France at different times). As a result, the bi-lingual island has
attracted a significant amount of global institutional investor activity.

Mauritius

Strength Weakness

Government actively supporting IF: Bank of 1.
Mauritius (Central Bank) is associate member of
IFSB and founding member of IILM

3 IF with $0.14 b (AUM)2.

Taxation: two tier tax system according to fund 3.
type: 3% for GBL 1 funds and 15% for GBL 2 funds

36 Tax treaties4.

Free repatriation of investment funds5.

$10,000 annual license fees6.

4-6 weeks to fund launch timeline7.

Liquidity1.

Distance to most markets2.

Opportunity Threat

One of few countries with a tax treaty with India.1.

Good treaties with most of Africa2.

HSBC Amanah uses it for many funds3.

Other offshore centers.1.

Trained manpower2.

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London4.4.5

On one hand, London is the leading global financial center. London has a long history
supporting the Islamic financial services industry and hosts five Islamic banks as well as large
number of asset managers currently serving the Islamic market and among the top global
asset managers. All leading and many mid-tier UK law firms are well represented in the GCC,
Africa, Asia, and the Americas.

Progressively, over the early 2000s, the UK regulatory and tax authorities have worked
carefully to facilitate a well governed environment for Islamic financial institutions, funds,
and securities. A notable outcome is that the London Stock Exchange hosts a large volume
of sukuk and can support Shariah-compliant ETF and other securities.

On the other hand, London is a high cost center.

London

Strength Weakness

Global Financial Center1.

Long regulatory familiarity with the Islamic 2.
finance business and funds.

One-stop shop for ancillary services3.

20 law firms specializing in IFa.

Training, advisory services, auditingb.

34 IF with $0.3 billion (AUM)4.

Home to 5 fully Shariah-compliant banks5.

High cost of doing business1.

Unfavorable onshore tax treatment2.

Onshore market3.

Opportunity Threat

Deep fund and fund management 1.
infrastructure

31 Sukuk worth $19 b listed on LSE2.

13. st Corporate Sukuk issued in 2010

ETFs traded on LSE4.

Competes with offshore centers1.

Managers may move to lower cost venues or 2.
closer to clients

 Singapore4.4.6

A leading global financial center, Singapore has been making a concerted push to expand
its market share in Asia. This has included a progressive series of regulatory and practical
decisions to facilitate Islamic finance including various tax waivers and qualifications to
attract sukuk investors.

With a strong talent base and good treaties with India, Singapore is a high cost provider. The
island state enjoys a good reputation for governance.

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Singapore

Strength Weakness

Stability, transparency, reputation, volume1.

Global Financial Center2.

Government revised regulatory framework & 3.
tax structure to facilitate IF

10 Islamic Funds with $0.72 b (AuM) including 4.
Islamic REIT

Offshore Funds tax exempted if 80% funds 5.
from foreign investors

Reasonable costs: SGD 4,000 annual license 6.
fee

Expedited business processes: 14-21 day fund 7.
launch timeline

Onshore Funds subject to 20% taxation1.

Local audit sign-off requirement2.

Opportunity Threat

Large domestic pensions and SWF1.

700 fund managers with SGD400 b (AUM)2.

Advantageous tax treaties with India, Japan 3.
and other countries

Government revised regulatory framework & 4.
tax structure to facilitate IF

Other offshore centers1.

Mauritius (for India)a.

Malaysia (more human resource)b.

Rising cost of doing business2.

Bahrain4.4.7

The long standing hub for Islamic finance in the GCC and a global leader, the Central Bank of
Bahrain has assured that the island is well regarded as a properly governed financial center.
Bahrain has good relationships with London, Luxembourg, Malaysia, and Bermuda. Bahrain
hosts two exchanges and has a deep pool of human talent. But Bahrain is frequently in
intense competition with neighboring offshore centers. Bahrain continues to serve as a key
intermediary center for Saudi Arabia and Kuwait.

Although a civil law center, Bahrain has a trust law for financial transactions. Along with the
capacity to create a low cost company, the Bahrain financial trust law has proven as a useful
tool for funds, sukuk and is expected to support more product innovation as the overall
business climate in Bahrain recovers.

Bahrain has a large number of Luxembourg-registered funds. In order to sell these, the CBB
requires a local selling agent registered in Bahrain. Until IDB’s first infrastructure fund, Bahrain
fund companies did not normally take form as partnership. The Bahrain fund company must
be managed by a domestic fund manager unless the management is provided by a manager
from a reputable regulated jurisdiction. If the fund sponsors are not in Bahrain, they must
appoint a Bahrain based administrator. Direct investment in assets, as well as Shariah-

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compliant leverage, are permitted.

Bahrain

Strength Weakness

Long established hub of Islamic Finance 1.
and home to many IF Institutions as well
as important industry capacity builders like
AAOIFI, IIRA & IIFM

46 Islamic Funds with $1 billion AUM2.

Bahrain registered funds are tax-exempted3.

Dual Taxation agreement with Bermuda4.

Reasonable cost of doing business: BHD 5.
2,000 annual fee per retail CIU and per each
additional sub-fund

Small scale operations, liquidity can be thin1.

Time to market is slow: 3-6 month application 2.
process

Opportunity Threat

Reasonable cost of doing business1.

Large number of well-trained competent 2.
professionals

Good and deep relations with regulators and 3.
banks in Saudi Arabia and Kuwait

Dubai has competed aggressively to move 1.
business from Bahrain

Arab Spring2.

Dublin4.4.8

The Irish Republic hosts an efficient offshore fund center and has a large number of tax
treaties, which include key home states for global institutional investors as well as important
target markets in IDB’s MCs. But Dublin is an expensive center to do business. Ireland is a
major UCITS center and one of the top jurisdictions for aircraft financing and leasing. Ireland
has a good trust law suitable for international funds, securities, and cross border transaction
management.

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Dublin

Strength Weakness

EU member, support for IF; hosts 24 Islamic 1.
Funds with $0.22 b (AUM)

UCITS: governed by EU laws; also allow Non-2.
UCITS which is governed by Irish law; allows
Qualifying Investor Fund

62 double tax treaties including US, UK, 3.
Turkey, the UAE, Bahrain & Kuwait

Alternative Investment Funds established as 4.
open or closed ended variants of unit trusts,
companies, or limited partnerships

Tax laws amended to accommodate IF5.

Irish domiciled funds not subject to tax6.

Possible dividends & withholding tax 7.
exemptions for non-Irish residents

Fund Timeline Launch: 5-12 weeks8.

Annual license fee per fund9.

Min. Euro 2,000 per funda.

Max. Euro 4,250 includes 5-subsb.

Bound to EU Listing Directives1.

Local annual audit requirement2.

Semi-annual and Annual audited financial 3.
statement requirement

Two local Irish resident directors required4.

Extensive regulatory reporting disclosures5.

Fund promoter must be regulated by a 6.
supervisory authority recognized by IFSRA

Irish investment funds must appoint Irish 7.
Administrators (management cos.)

UCITS Investment Companies managed by 8.
non-Irish UCITS management cos. must have
a min. capital of Euro 300,000

20% withholding tax on dividends9.

12.5% tax on investment management 10.
services

Opportunity Threat

Gateway to Europe & cross-border sales1.

Centre of excellence for aircraft finance and 2.
leasing transactions

Possible to re-register or acknowledge fund 3.
company form another jurisdiction.

Luxembourg (direct competitor)1.

London and other offshore centers 2.

DIFC4.4.9

Already an offshore center, Dubai has created the DIFC to be an internationally recognized
center in compliance with a wide number of international regulations. The DIFC has enjoyed
a strong growth since its inception early this century. The Government of Dubai has given
strong support allowing the DIFC to increase its intermediary market share in the GCC and
beyond. The DIFC is working hard to assure that the center builds a reputation as a well
regulated and properly governed financial center. Dubai’s excellent infrastructure and links
to the rest of the world also help to attract talent and business to the center.

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Dubai International Financial Center (“DIFC”)

Strength Weakness

DIFC has special rules for Islamic finance and 1.
requires a Shariah Supervisory Board, this
allows it to host 14 Islamic Funds w/$0.58 b
AUM

Double Taxation Treaties2.

English law allowing trusts among other 3.
benefits.

2 months fund launch timeline with 4.
reasonable costs including $12,000 annual
license renewal fee

Mutual Recognition Models: Islamic Product 5.
“Passportability”

Has not yet established Investor Confidence 1.
(but working on it)

Shallow liquidity2.

Rising cost of talent3.

Opportunity Threat

Standardization1.

Govt. intent to regain investor confidence2.

Reasonable depth of talent pool, recently 3.
lower costs of operating

Global transportation hub4.

Free Zones have established a name in the 5.
market

Abu Dhabi is building own financial center 1.
and is major source of investment flows)

Bahrain is a leading competitor2.

Channel Islands (Jersey)4.4.10

The Channel Islands host over £22.2 billion AUM in conventional funds. And, they have a long
tradition supporting both GCC and Islamic funds. Both Jersey and Guernsey are used, but
the former is somewhat more popular than the latter for GCC investors. They offer efficient
services in an English law environment and several of their law firms with trust services have
established offices in the GCC. However, funds domiciled in the Channel Islands have to
engage two resident directors.

An English law center, disputes decided in local court may be appealed to the Privy Council
in London.

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Channel Islands (Jersey)

Strength Weakness

English Law jurisdiction with a long history of 1.
serving Islamic investors.

No requirement for local service providers2.

No requirement for local audit sign-off3.

One stop shop for Fund ancillary services: 10 4.
law firms; 30 administrators; 15 trustees; 15
audit firms

12 Double Taxation treaties5.

28 Tax info exchange agreements6.

£2,000 minimum application fee; £2,000 - 7.
£20,000 annual fee

0% tax on investment management 8.
companies

Slow to market: 8-12 month fund launch 1.
timeframe

Two Jersey-resident directors required2.

All “collective investment schemes” are 3.
regulated

Opportunity Threat

English and trust law1.

Umbrella funds are allowed via segregated 2.
cells.

Multiple asset classes and currencies are 3.
permitted.

No cap on investment company capital.4.

Companies migrate to and from the 5.
jurisdiction.

London, Cayman & Luxembourg1.

Relative high cost of doing business,2.

Difficult to access3.

Bermuda4.4.11

This offshore center hosts a number of leading infrastructure funds and has established
relationships with the international investor community. Although Bermuda is new to the GCC
market, it has made up for lost time by adding to its rulebook to govern Shariah-compliant
funds, and has a cooperation agreement with Bahrain. Like other English law jurisdictions,
Bermuda has an established trust law.

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Bermuda

Strength Weakness

Over 2000 funds listed on Bermuda Stock Exc. 1.
(BSX)

BMA issued Guidance Notes on “Islamic 2.
Collective Investment Schemes” – covers
disclosure, role of Shariah Boards

Modern Corporate & Trust laws benefits 3.
– Bermuda SPV and Trust can combine to
create “off balance sheets” or bankruptcy
remoteness structures

No exchange controls for non-residents4.

No restrictions on repatriation of funds5.

No stamp duties6.

Largest off shore re/insurance domicile  7.
– 1200 int’l re/insurers are licensed

May adopt secondary non-Roman script8.

Lesser well known profile for Islamic investors1.

Opportunity Threat

Access to US and European investments1.

Bahraini cooperation: 2.
- Double Tax agreement with Bahrain
(opportunities for investment into GCC)

Luxembourg and Cayman Islands1.

Trained human resource2.

Qatar Financial Center (QFC)4.4.12

It remains unclear how important a role the QFC can play in the global and Islamic funds
market. Although the “offshore” center has grafted English law along with trusts into a civil
law context, the cost and process for establishing SPVs is not attractive to many investors.
One of the key issues that needs to be achieved domestically is a coordination of laws to
validate that QFC entities can do onshore business, and to facilitate clarity about how sukuk
are to be issued.

Beneficial tax treaties are in place with the UK, Malaysia and Singapore. The fundamental
beneficiaries of QFC are most likely to be businesses seeking opportunities in Qatar or Qatari
institutions looking to invest outside. Among the latest developments in Qatar is the closer
connection between the Central Bank and The Qatar Financial Center Regulatory Authority
(“QFCRA”) which has created an almost unitary regulatory environment as the Governor of
the Central Bank is also the Chairman of the QFCRA.

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Qatar Financial Center (“QFC”)

Strength Weakness

QFC funds are not subject to taxation1.

Double Taxation agreements including UK, 2.
Malaysia, Singapore

Advanced tax rulings3.

Reasonable cost to establish fund: $10,000 4.
annual fee after $2,000-10,000 registration
fees

High cost of doing business1.

Not a tax haven: 10% income tax on asset 2.
management company profitability

SPV rules may be too complex3.

Liquidity issues4.

Opportunity Threat

Can draw on domestic market1. Bahrain and Dubai1.

Attracting and retaining talent can be difficult 2.

Malta4.4.13

Another UCITS center, Malta has a strong universe of tax treaties and has recently begun
to court the Islamic market. Malta is a civil law country that has reference to English law.
Currently, Malta lacks the level of human resources that will help it to be competitive, but
this may change given the island’s focus on serving the Islamic market.

Malta

Strength Weakness

EU member, Maltese UCITS platform as a EU 1.
passport

Total of 45 UCITS (03/2010)a.

EU UCITS Directiveb.

UCITS not investing in Maltese real estate are 2.
exempt from income & cap. gains tax

Double taxation treaties w/ 50+ countries: 3.
Malaysia, Kuwait, Qatar, UAE, UK, USA

Fund Service Providers4.

15 Administrators; 5 Trust Comp., 12 law a.
firms, 4 auditors

Reasonable cost to establish: Euro 2,000 5.
application fee and Euro 2,500 annual fee

Acceptable time to market: 2-4 months fund 6.
launch timeline

Local audit sign-off requirement1.

Local resident director requirement2.

Maltese investment companies income 3.
tax of 35% but 6/7th of tax is refunded to
shareholders

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Opportunity Threat

Links Europe with MENA investors1.

Possible to re-register or acknowledge fund 2.
company form another jurisdiction.

Long ties to Libya3.

Not easily accessible1.

Human resources2.

Evaluation of Different Jurisdictions4.5
The evaluation of jurisdictions takes into account the capacity of a jurisdiction to attract
or serve a broad universe of investors, develop a business climate that facilitates a diverse
structuring toolkit, and ease of doing business factors. In the analysis of the applicable
jurisdictions, the question is whether English or civil law is better for the purpose of the fund
structuring.

As a general rule, the choice of law is meant to give investors protections that they believe
are necessary when placing their money with a manager who will have full discretion
according to the investment policy. But a legal venue is only as good as its courts, lawyers,
and regulatory framework. Hence, if the regulator is a light touch regulator, investors may
discover that courts in the fund’s jurisdiction have limited incentives to adjudicate disputes
which appear more over application of policy than fraud or some egregious wrongdoing by
one party or another.

English law and its derivatives govern the largest number of funds. There are some features
of English law like the trust concept that make organizing funds easy. And the historical
election of English courts, as well as courts in the Cayman Islands, Channel Islands, and
Singapore to hear cases that are not truly domestic cases has made many investors prefer
English law. One element of English law that bolsters investor and investee comfort with it,
is that it is factually the “common law” and derived from the urf or habits of the people.
The fundamental essence of the common law is that actions and behaviors are generally
presumed to be permitted unless explicitly forbidden, or in the case of a fund, unless
excluded from the fund management documents.

Civil law, however, has a different premise. Generally, the lawfulness of an action is defined in
civil law. This means that that the vast universe of un-contemplated behaviors is prospectively
unlawful until explicitly contemplated in the law. As a general rule, this has meant that civil
law jurisdictions have not been as liberal in the development financial markets as English
law jurisdictions. As a result, civil law jurisdictions have generally lagged the English law
markets. Nonetheless, important civil law jurisdictions like Luxembourg and Bahrain have
proven able to compete effectively in their capacity to host funds and provide investors with
the protective frameworks that they seek. As a result, this study neither prefers civil law
nor English law. Indeed, the expected approach is to look a master feeder framework that
supports both legal environments.

The next issue which rises prominently in the fund domicile SWOT analysis is the “cost
of regulation”. As can be expected, certain countries are better regulated with armies of
competent central bankers and capital market regulators scrutinizing the market, whereas

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others are laissez-faire, charging funds, managers and investors fees and taxes that quite
logically correlate to the cost of delivering a particular standard of governance to the market.
Some countries can provide the same quality governance at a lower cost, and this too shows
up in the SWOT analysis. Other countries think that the proper governance of funds requires
employment of their nationals as fund directors and branch offices of various vendors in
their country to provide various fund level services. All of this comes at either a financial cost
or a reputational cost.

Another factor that this study emphasizes is the benefit of the European fund program UCITS.
The European investor market under common regulation represents both a major investor
universe for IDB funds; and it is the market that shows the second largest desire to invest
in global infrastructure, an area that clearly overlaps with the focus of IDB’s prospective
investments in MC operations and infrastructure. But UCITS has requirements which may
not always suit the flexibility that IDB requires:

UCITS investments are not able to invest in all markets;•
UCITS investments have counterparty risk limits; Ø
UCITS does not accept direct investment in precious metals or other commodities or  Ø
other nonfinancial assets;
UCITS limits concentrations and imposes the “5/10/20/40” diversification rule; and Ø
UCITS does not permit most derivatives and forbids uncovered short; Ø

UCITS have a limit on absolute value at risk (“VAR”) requiring a monthly 99 % confidence, •
and a limit of 20%:

UCITS also have relative VAR with the same confidence levels; and, Ø
Relative VAR has to be less than 2 times the benchmark; Ø

UCITS funds must have sufficient liquidity to support the possibility of redemption; and •
NAV publication at least twice a month.
UCITS funds must disclose on an annual and semi-annual basis; and,•
UCITS funds have a basic disclosure obligation in the form of the key investor information •
document (“KIID”), and a detailed offering memorandum with standardized warnings.

Table 19 demonstrates the qualitative factors. Developed or established financial centers like
Luxembourg, Singapore, Dublin and London score well. With a dual UCITS and private fund
infrastructure which is widely used, Luxembourg tops the list. All of these centers have long
track records with investors and managers, as well as solid regulatory and administrative
frameworks.

Smaller, specialized offshore centers like Mauritius, the Cayman Islands, Jersey (Channel
Islands) and Malta score less well. Often, the pure offshore centers deliver very high
quality, targeted benefits to specific investor universes. Yet they often lack the framework
to accommodate smaller investors. Their regulatory and administrative capacities are often
questioned by some onshore regulators. And, sometimes, their tax treaty arrangements are
limited in scope and serve only a few investee markets.

Member country financial centers like Bahrain, Malaysia and DIFC perform well on qualitative
factors. Others like the QFC have not yet broadened their reach to build the same degree of

111

investor recognition as their peers in Bahrain, Malaysia and Dubai. Since no MC is inside the
UCITS framework, the qualitative factors evaluated their relationships with UCITS countries
and cross selling/listing arrangements with the UCITS countries.

In Table 20, the cost of doing business and efficiency factors are considered. The evaluation
criteria were established in Section 4.3.1 and applied to each of the jurisdictions discussed.
The evaluations are divided into two sections which address Section A: Breadth of Investor
Reach and Section B: Business Factors. Since a critical factor is investor reach and bringing
new investors under the IDB umbrella, the scores in Section A are given 100% weighting. In
certain cases, the outward business factors may appear undesirable, but investor factors
make dealing with that jurisdiction very attractive.101 Therefore, the Section B factors are
assessed a 50% weight.

The scoring ranges from a negative one to a positive two in whole numbers. A negative
factor means that a concept or legal requirement is missing; zero means that it is not a
business factor or can be added easily; one means that it is present, but is not optimal; and
two means that the factor is amongst the most attractive in the market. These subjective
allocations are based on the country tables delivered in this chapter.

The factors represent two distinctive features. First, what makes a financial center attractive
to investors, and facilitates the widest universe of investors? Second, does a financial center
easily facilitate Islamic financial and investment concepts?

Generally, the well-known global offshore centers offer the lowest costs and most attractive
service packages. Yet, some of these same centers impose costly or restrictive director
requirements. Other centers suffer from singular taxes that apply either to certain asset
classes or must be claimed through an administrative process that incurs costs and takes
time. MC centers include countries like Malaysia and Bahrain with reasonable costs of doing
business as well as countries like the United Arab Emirates and Qatar with much higher costs
of doing business. As can be expected, centers associated with major capitals like London
and Dublin, score poorly on cost factors.

101  For instance, CIMB Principal Asset Management selected to base their European fund operations in Dublin
because of their capacity to leverage off of the existing infrastructure that Principal has already implemented in
Ireland. Their cost of establishment is lower than if they selected a jurisdiction in which neither CIMB nor Principal
had an European presence. Remarks by Datuk Noripah Kamso at the Global Islamic Finance Forum, Bank Negara
Malaysia, September 19, 2012.

112

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114

When the qualitative and cost of business factors are balanced, the top five jurisdictions
are:

Luxembourg 23.5

Bahrain 21

Malaysia 20

Singapore 20

Dublin 18

Yet, as the Master-Umbrella-Fund (MUF) concept is developed, IDB should consider the
strongest centers as the hub location, and take advantage of the various other centers for
feeder or outbound investment purposes according to the strength of the centers.

The overall evaluation points to a number of feeder jurisdictions, as well as jurisdictions which
facilitate tax efficient outbound investment. These include Bahrain, which has treaties with
Malaysia, the various central Asian states, and Turkey; Malta, which is suitable for investment
into North African countries like Libya, Morocco, Algeria, and Tunisia; and, Mauritius, which
has favorable treaties for investment into Africa and India.

Although this study proposes an umbrella fund with a master feeder structure, the IFC
does not use the MUF approach. The IFC uses a different jurisdiction for different funds.
For example, the IFC uses Mauritius if an investment is aimed at India. For other funds, The
IFC uses domiciles like Caymans or Luxembourg as the IFC determines is suitable for the
investment direction. A strategic difference for IDB is the development of capacity as well
linkages between member states. The benefit to IDB of designing a flexible fund architecture
is that it makes facilitation of the linkages between MCs and from MCs to the global investor
markets. The difference between IDB and the IFC is that IDB has a broader mandate for its
MCs, whereas the IFC is focused on financing (directional flow). Chapter 5 will elaborate
further how IDB and its MCs may benefit from the MUF structure.

115

- Proposed Fund ConceptChapter 5

Proposed Structure5.1
In its ‘Fund of Funds’ concept note, IDB was planning to establish a platform to pool capital
from different investors (including Sovereign Wealth Funds – SWFs) and seed capital into
the first closing of multiple sector funds. IDB also highlighted that investors may be given an
option either to invest in the overall platform or selective sector funds. Refer to Figure 38 for
the illustration of the IDB Fund of Funds concept.

Figure 38: IDB 2011 “Fund of Funds” concept note

Based on the previous jurisdiction analysis, almost all offshore centers and many onshore
centers permit master feeder funds. This concept may be used to enhance IDB’s Fund of
Funds concept. The master fund will be hosted in a jurisdiction like the Cayman Islands
or Luxembourg. The role of the master fund is to collect from multiple feeder funds in
other jurisdictions or via other permitted investment vehicles.102 The simple purpose of
the master feeder structure is to upstream funds to a common purpose. Refer to Figure
39 for illustration of the master-feeder-umbrella structure. Once aggregated, the funds
are applied into different sectors. The platform may pool commercially-oriented funds as
well as benevolent funds. Investors will specifically identify the amount they would like to
allocate to the benevolent funds. Investors will have the ability to switch within the funds
(within commercial sectors, and within the benevolent funds focus) and switch between the
commercial and benevolent funds. The next sections will discuss further the mechanisms of
the commercial and benevolent funds.

102  The concept has developed a bad name due to its abuse by Bernard Madoff for his Ponzi scheme.

116

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117

Commercially Oriented Funds5.1.1

IDB focuses on three main strategic areas; human development (which includes education,
health & gender equality), agriculture and infrastructure development. Most of the human
development 103 and agriculture 104 strategic focus activities are not necessarily commercially-
oriented operations. The IDB Group’s cumulative operation (1976 – 2011) amounted to $78
billion of which 51% was focused on project financing and 47% was trade operations. Within
project finance, the top five sectors are:

Energy 24.6%i.
Transportation 23.2%ii.
Water, Sanitation & Urban Services 12.8%iii.
Agriculture 11.1%iv.
Industry & Mining 8.5%v.

Therefore, the proposed structure has focused on infrastructure and trade finance as the
illustrative sectors for the proposed fund. The downward fund flow into specific countries
is done via an SPV in a jurisdiction with the best tax treaties. For example, since Mauritius
has superior tax treaties with African countries, for investment in Nigeria, the downstream
from the master is best done via a Mauritius SPV. Given IDB’s focus on building local capital
markets, the downstream fund may co-invest with a local market fund (which may include
onshore retail investors) for a project financing in the target business activity. This allows
broader resource mobilization for different projects. Section 5.3 elaborates further on
how IDB may adopt IFC’s approach in using local GPs and a systematic governance and risk
management toolkit to develop local market. This helps not only in capacity building for local
managers, but also enhances local governance and trust to mobilize local resources.

Besides funding a specific project, the fund may also invest into arrangements that IDB has
developed with other MDFIs. For example, in April 2011, IDB and the World Bank Group
launched the Arab Financing Facility for Infrastructure (AFFI) that targets to fund infrastructure
development in non-GCC MENA countries. The proposed fund may invest through the Arab
Infrastructure Investment Vehicle (AIIV) that has been set up for the AFFI project.

The fund approach allows IDB to make a number of specific investment decisions. These
include the basis under which IDB will provide funds, and what that means in terms of cost.
Funds like the benevolent sub-fund would have the capacity to make non-interest bearing
loans or to provide highly concessionary pricing on trade or other transactions supporting
MCs and their projects. Even within country or asset specific funds, an allocation may be
made to provide finance at below market costs. The fund approach, however, will require
that investors are aligned to fund strategies which may include below market returns being

103  Education includes basic education, science, math, technology, vocational & technical education, and non-formal
literary program. Since inception, IDB has funded $2.5b for 455 operations. Health includes prevention, access
to healthcare and alternative financing program. IDB has spent $1.6 billion for 277 operations. Gender equality
programs focuses on women access to finance and education. Refer to page 8 and 9 of (Islamic Development Bank,
2012)

104  Agriculture includes food security, water & irrigation and microfinance activities with the aim to alleviate
poverty, rural development, increase market linkages and infrastructure development. Refer to page 10 of (Islamic
Development Bank, 2012)

118

contracted when delivering investments to MCs and their projects.

The proposal also suggests that a certain minimum investment amount is collected at the
closing date. Any amount that is not invested in the sector funds (as there may not be
approved projects yet) is placed with IDB via Mudarabah to invest in IDB’s existing operation.
The placement with IDB may be callable when a project is approved and funding is needed
for the different funds.

IDB, in its concept paper highlighted that investors may be given an option either to invest
in the overall platform or selective sector funds. To enhance this further, the proposal
recommends building in a switching mechanism between sectors as well. This may be done
by leveraging on the umbrella fund concept where there are different classes of investors. In
the above example, the trade finance fund may have lower risk, shorter term105 and lower
return. Let’s call this Class A investors. Any amount placed with IDB may also fall under Class
A. The infrastructure fund may have higher risk, longer term, thus higher return. Let’s call
this Class B investors.

From a Shariah perspective, since Class A invests in trade finance, which may mostly be
based on Murabaha, this class represents a debt certificate (dayn). The participation into
IDB operations may also wholly invest in Murabaha and Istisna`a financing.106 Investment
into the infrastructure fund may be viewed as an investment into a non-monetary asset
(`ain). These two certificates may be exchanged freely from the Shariah perspective. This
will enable investors that are in the lower return class to switch to the higher risk, higher
return class. For practical purposes, the fund may charge a switching cost and outline any
conditions that must be fulfilled107 to manage the switching process. Refer to Figure 40 for
illustration.

105  Common trade finance facilities are less than one year. IDB may, for capacity building, even have a 2-3 year facility.
Compared to the infrastructure fund, 2-3 years is still a relatively short term.

106  From a Shariah perspective, since the switching is to enable those who have debt certificates to exchange it for
non-debt certificate, Class A may be fully invested in Murabaha and Istisna`a. It may also invest into non-debt
instruments like Ijarah etc.

107  Matching investor demand from other class, liquidity and minimum size of a particular class to be maintained
etc.

119

Figure 40: Switching between Classes in Commercially Oriented Funds

Socially-Oriented Funds5.1.2

Since IDB has a number of strategic focus areas that may not appeal directly to commercial
private investors, the master fund may include a sub-investment in socially-oriented funds.
Similar to a commercially oriented fund, the socially oriented fund may also have two
classes; benevolent fund and waqf fund. For the waqf fund, investors endow capital for good
and are not looking for repayment of capital or any return. These may include purification
funds from Islamic financial institutions and other charitable donations by either corporate,
financial institutions or other donors. The waqf fund invests these contributions (either in
the infrastructure fund, trade finance fund or even the benevolent fund) and uses the profit
generated to invest in not necessarily commercial activity like human development, poverty
alleviation, food security etc.

The capital of the waqf is preserved while the return from the investment is used to fund non-
commercial activities. IDB has already applied the Waqf Fund in its operations. The proposal
recommends that the Waqf Fund is brought under the same platform and is used to invest
in other umbrella funds. This ensures that the investment in the waqf not only supports
the overall fund structure, but also that the waqf fund is applied in the most effective and
profitable investment opportunities available.

120

Class C: Benevolent Fund Class D: Waqf Fund

Investor Expectation
Investors provide capital with aim
of repayment and earning a below
market return in order to help
beneficiaries.

Investors endow capital (i.e.
not looking for capital being
returned)

Fund Operation

The fund uses the capital to
finance beneficiaries that need
subsidized funding. However, the
aim of the fund is to instill financial
discipline in the beneficiaries i.e.
they have to pay back capital and
some return. The financing may be
in the form of Murabaha, Ijarah
etc to SMEs, MFIs, social housing
etc.

The fund invest the capital,
then uses the return generated
(not capital) to invest in not
necessarily commercial activity
like human development,
poverty alleviation, food
security etc. The waqf may
invest in the infrastructure
fund, trade fund or even the
benevolent fund.

Table 21: Benevolent and Waqf Fund in Socially Oriented Umbrella Fund

Since the waqf fund is more charity-oriented, and the capital is endowed, the proposal
recommends another sub-class; a benevolent fund. The investors in this sub-class are
entitled to get back their capital and earn a below market return. The investors may make a
contribution in the form of Qard or Wakalah investment. The fund will use these contributions
to directly fund beneficiaries that need subsidized financing. The fund will use commercial
contracts like Murabaha, Ijarah etc to support the SME, MFI and social housing for example,
but with a low financing rate. The fund will not, however, use grants in its operations as it
aims to instill financial discipline in the beneficiaries i.e. they have to pay back capital and
some return, albeit low. Table 21 summarizes the difference between the sub-classes under
the socially oriented umbrella.

121

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122

Figure 41 illustrates the operations of the Waqf and the Benevolent Fund. Although the waqf
fund is focused on charitable activities, it may also be used to modernized and commercially
manage waqf properties. The Islamic Religious Council of Singapore (MUIS), for example,
has even issued Sukuk to fund the modernization of its waqf properties. This model allows
onshore collection for the waqf fund. The waqf development in Singapore not only focuses
on masajid, but also residential, service apartments and commercial buildings. The aim of
the modernization is to ensure the waqf properties generate income which may be used for
other charitable activities. Besides the Sukuk issuance for waqf, Singapore has also set up a
Mosque Building and Mendaki Fund (MBMF) wherein Muslim employees in Singapore make
small monthly contributions through an automatic Central Provident Fund (CPF) deduction.

The benevolent fund may also build an onshore fund collection to widen the resource
mobilization. Unlike the waqf fund that does not pay any return, this fund pays a lower than
market return on investment. Thus, it may have a different appeal to investors; be it retail or
corporate. In both of the socially oriented funds, IDB needs to assist with capacity building,
proper management and proper governance of the funds.

Since the fund strategy accommodates investment in projects, businesses, listed companies
or listed financial instruments, it should help to support the development of domestic
capital markets. This, in turn, should create access to medium and small sized investors.
The retail investors in the investee country have an opportunity to profit from their financial
participation in the development of their own countries. In the process of building local
market investor access, the IDB fund strategy would also support the evolution and growth
of domestic asset managers and Islamic financial institutions in their home markets.

Murabaha Funds & Market Feedback5.2
Money market funds (based on Commodity Murabaha) have been a popular short-term
placement in many markets. In Saudi for example, as at September 2012, the total size of
mutual fund is SAR90 billion, of which 62% are Murabaha funds. Refer to Figure 42. The
returns on these funds are low, ranging from 0.3% to about 1.4%. Refer to Figure 43.

Figure 42: Types of Mutual Fund in Saudi
Source: (Alinma Investment, 2012)

123

Figure 43: Performance of Various Murabaha Funds in Saudi

Source: (Alinma Investment, 2012)

This trend of growing popularity of Murabaha funds led us to test the following hypothesis
with different market participants:

“If money market funds, which are not AAA and pay low returns, are attracting HNWI & retail
investors, wouldn’t they be interested in development mutual funds? IDB has high quality
assets, with a very low default rate, government guarantee etc. With IDB’s experience, if it
issues a mutual fund targeting retail investors & HNWIs, it can channel the funds to finance
new projects - with its proper due diligence. With this quality, IDB assets are not much
different than the existing Murabaha funds in terms of credit risk. Hence, IDB may be able to
pay 1-1.3% on these without having them rated AAA. Since such funds are off-balance sheet,
this will relieve IDB from the debt burden of the sukuk.”

We wanted to validate the following from market players:

Would the idea of a ‘development mutual fund’ (i.e. mutual fund investing in a.
development projects in OIC countries) be appealing to retail investors & HNWI?
Why or why not?
Is a development fund more appealing than a Murabaha fund to these investors? b.
Why or why not?
What challenges would IDB face with this ‘development mutual fund’?c.
Would a retail Sukuk have a different appeal than a ‘development mutual fund’? d.
Why or why not?
What is the best distribution channel to reach individuals & HNWI?e.

To get input from market players, SHAPE® contacted twenty (20) international investors,

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Islamic and conventional, all Saudi Arabian banks and three (3) Saudi Arabian investment
banks. The response rates from the international investors were good with thirteen (13)
investors giving feedback, which ranged from highly detailed to short, covering a specific
aspect of the inquiry.

Saudi Arabian banks and investors were reluctant to reply and only three provided replies.
Some of the Saudi Arabian institutions appear to have misunderstood the inquiry and treated
it as if it was competitive to their business interests. For instance, they would like to promote
Murabaha funds and not be displaced by an IDB-led fund.

We have reconstituted the responses into issues for the international investors and Saudi
Arabian investors.

International Investors:5.2.1

1. Regulations: The most common issue brought up was whether or not the underliers
in an IDB fund would be tradable. This is because many fund managers are targeting the
UCITS markets or their home country regulator is adopting UCITS like regulations. The issue
with mutual funds is that most countries, including Malaysia, require the underliers to be
liquid. The benefit of a mutual fund is that it allows open-ended investment accumulation.
But illiquid assets have to go into closed fund structures and may have liquidity like REITs,
Business Trusts, or ETF by issuing shares. Then the only way to grow equity is to have a rights
issuance or secondary offering.

The purpose of a mutual fund is to allow daily liquidity and open-endedness. An example
of an illiquid fund that obtained liquidity was the Malaysia Fund Inc. (AmBank and Morgan
Stanley). This was a business trust that listed itself.

If the underliers are not eligible for mutual funds or UCITS funds, then the option is to seek
a close ended fund. This may limit the distribution strategy and restrict the number of
jurisdictions in which a fund may solicit investors.

Another concern was anti-terrorism and whether or not institutions would be subject to
either guilt by association or directly under FACTA (the US regulation).

2. Selling: Most did not think that the term Islamic is necessarily a barrier to buyers, but many
felt it would be better to de-emphasize the work in the fund or the security’s documentation.
One even felt that ‘socially responsible’ is a better term.

The predominant reply from the international managers was that performance is the best
way to sell such an emerging markets or infrastructure fund. This is further amplified as
one manager noted that investors generally assume that Islamic investments are inferior.
Generally, selling international emerging markets to retail investors and HNWI was considered
to be difficult.

These were important parameters highlighted by the respondents:
If the IRR is less than 10%, it will not be appealing;a.
There must be a clear exit strategy;b.
The duration will be considered; andc.
The covenants will matter.d.

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Product complexity affects whether or not emerging markets products can be sold to retail
domestic investors or sophisticated investors (5 respondents). The term of the product
would be important as many investors do not seek long-term investments (3 respondents).
The capacity to sell such emerging market investments is impacted directly by the reputation
of the investment manager (3 respondents).

Target investor should drive the network for distribution. Even though many markets have
excess cash and lack good Shariah-compliant retail investments, reaching these potential
investors is challenging given the fragmentation of distribution systems serving them.

One manager noted that a multi-fund platform would be the best way to reach these
investors. Another worried that markets like Qatar do not have a deep experience with
mutual funds yet.

One respondent pointed out the costs of selling retail products. For example, retail distribution
is often complex and has costs which vary by market:

“Retail mutual funds are very much a “Pay to Play”108 vehicle and this is expensive.
Wire houses have to be paid off by sponsorships, loads and other placement fees to
sell your funds and this is not cheap.”

Two managers thought that the product should be sold as a close-ended fund which could
later be listed.

“One distribution channel would be to solicit funds locally. For example, create a local
Mudarabah with the community; locals will be more inclined to believe in a project
and invest in it since they will not be subject to the same biases as an international
investor may be.”

3. Emerging Markets/Development/Infrastructure Investment: This investment target is
attractive to institutional investors due to its low correlation with other asset classes; low
volatility; income orientation; and frequent government backing. One investor felt that the
support of IDB or stronger IDB member states would make a fund attractive. The extension
of this thought is that a domestic investor will be encouraged by the support of the investor’s
own government. Yet, the view is that emerging markets investing is a specific area and does
not have a broad appeal. For investors who are not seeking emerging markets risk, this is
deemed to be a “hard sell”.

“The biggest challenge for investors in a ‘development mutual fund’ will be the
valuation of the projects while in development. Completed projects can be assessed in
terms of growth and income potential but it is hard to evaluate development projects
that are in process, especially infrastructure related projects such as bridges or roads.
For these reasons a development mutual fund is probably not very attractive to most
investors.”

108  “Pay to play” refers to market conventions in which brokerages only distribute funds for which they receive some
form of compensation. Retail costs are not necessarily the same level as institutional distribution.

126

Four (4) respondents noted that the perception of risk in emerging and frontier markets
means that a fund must pay a premium or higher yield to investors, even if IDB is accepted
as a suitable manager.

One investor worried that OIC countries have a stigma attached to them compared to other
emerging markets and this would affect the fund.

“In my opinion the [investor] segment that would be interested would be the Arab/
Islamic segment within OIC countries. I don’t see that foreign conventional investors
would be that interested. Unless you are selling an asset directly in which case some
international banks may be interested.”

4. Balanced Fund Alternative: The only comment about whether or not infrastructure or
development funds could act as “balanced funds” was negative. In this investor’s view,
despite their potential to generate income and capital gains, development funds’ primary
characteristic is to take risk in emerging markets. As a result, the investor did not think that
emerging market and infrastructure funds should be sold as if they were balanced funds.

5. Sukuk: One investor noted that sukuk would be attractive, but inconsistent with emerging
markets investing. The manager noted that sukuk are defensive and emerging markets
investing is risk-oriented. Project-recourse-only sukuk would be difficult to sell, but those with
government or international agency backing should be marketable. IDB’s risk is acceptable in
the institutional investor markets.

Overall, five (5) investors felt that sukuk would be more attractive to various investor
universes. One reason for this is that sukuk may be structured with a recourse to the sponsor
or a guarantor, and until now Islamic institutional investors prefer recourse investments.
One pointed out that emerging market sukuk for infrastructure are largely untested.

6. Asset Manager: One manager felt that Bahrain was no longer a stable market in which to
operate as an asset manager. As a result, this would deter institutional investors from a fund.
Another felt that IDB would not be a competent asset manager and felt that it was more of
a political body than a financial institution.

Saudi Arabian Responses:5.2.2

1. Regulation: Saudi bankers wondered if a fund involved in illiquid assets would face
regulatory restriction. If it were a public fund, the same manager wondered if it would face
problems relating to the raising of funds in KSA and their export to high risk markets.

2. Sukuk: All three Saudi respondents wondered if a sukuk issuance would be better than a
fund offering. “Sukuk have high demand in Saudi market.”

3. HNWI: The Saudi Arabian respondents argued that wealthy individuals and family offices
will want an above average return and may want unique deals. This implies more costs, and
higher returns.

4. Selling: The Saudi Arabian market likes to buy Saudi Arabian assets. If a business concept
is not well understood, it must be sold.

127

“Development fund(s) will be welcomed if they have same liquidity profile (daily liquidity
for subscription/redemption) as money market funds, given your point that such fund(s)
will be having superior risk/return profile. Generally Saudi investors invest in money
market funds to park excess liquidity and such investors are sensitive to a better return, if
they think there is no risk to their investment.”

Retail development fund has not been tested as a concept.

5. Yield: Two (2) of the Saudi respondents noted that the yield on IDB funds or sukuk must
show a premium to Murabaha funds to sell in the Kingdom. This means that it must be much
higher than the 1.3% which the highest yielding Murabaha funds currently offer. Even then,
cracking the retail market would be a challenge, but there might be some opportunity with
HNWI.

6. Liquidity: Murabaha funds allow redemptions twice a week. There was doubt as to
whether funds that would be investing in emerging markets could truly have such frequent
liquidity.

In summary, the market players still prefer a Sukuk issuance to a ‘development fund’ idea.
Murabaha funds are used in the market as short-term placements, with frequent redemption
options. As such, a ‘development fund’ will not be a natural alternative to this group of
investors. As for tapping into retail investors, the market players highlighted that the cost of
retail distribution is high, this is regardless if IDB is aiming to issue Sukuk or funds.

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- ConclusionChapter 6
The objectives of this study are for IDB to find a balanced approach to the cost of financing
and management of IDB’s balance sheet and rating. The task is monumental. Even civic
minded pension funds like CALPERS have found that investing in the rejuvenation of
Californian infrastructure is not as easy as they would like given the historically low interest
rates and a flat yield curve.109 For an MDFI like IDB, MCs require financing to bear a margin
akin to a triple “AAA” debt. On one hand, a highly rated MDFI like the World Bank offers a
lower cost than a smaller but highly rated MDFI like IDB. On the other hand, the real risk of
the MCs combined with the nature of Islamic financial tools means that the cost of financing
would be higher than a traditional loan. The cost of financing is usually way below the risk
of financed projects.

The two key capital market areas that this study examined are Sukuk and funds. These are
evaluated in Chapter 2 and Chapter 3 respectively. IDB has been an active issuer in the
Sukuk market, while it has only sparingly used investment funds as an alternative funding
strategy.

Since 2003, IDB has been a regular issuer in the global sukuk market. This has allowed IDB
to obtain external financing with thin margins based on its AAA credit rating. Yet, reliance
on the strength of IDB’s balance sheet to reduce the risk to investors in its sukuk means that
IDB will either face a maximum capacity limit for new issuances, have to raise more equity
capital, or face the risk of a change in its rating. Therefore, one of our aims for this research
was to identify off-balance sheet tools, which could give IDB the means to raise funds for
its MCs without stressing the its own balance sheet whilst striving to achieve a low cost of
funding to MCs when appropriate.

From the perspective of financial cost, sukuk issuances are currently the best tool for IDB
to raise capital. In terms of investor diversification, retail Sukuk provides an opportunity to
reach a much broader group of investors. One intuition that we have is that the broader
the investor group, the cheaper the financial cost will be. From the Malaysian experience,
the evidence indicates otherwise. IDB has to be prepared to pay a slightly higher cost than
the non-retail Sukuk offerings, especially if the Sukuk is offered in emerging markets. One
limitation of continuously pursuing the Sukuk strategy is the burden on IDB’s balance sheet.

In finding an alternative to the current Sukuk strategy, we examined whether using a funds
strategy will allow IDB to broaden its investor base and provide different cost alternatives
for MCs. We analyzed the behavior of MDFIs and various development funds. The evidence
indicates that MDFIs have pursued the private equity fund route to finance infrastructure
developments. Macquarie, based on its success in Australia, has experimented with a
blended approach – using two different jurisdictions to tap into different investor groups.110

109 Walmsley, Shayla, CalPERS ‘cannot compete’ with cheap finance on infrastructure, on October 18, 2012 accessed
at: http://www.ipe.com/realestate/articleprint.php?id=47973.

110
  MIIF, for example, used the Bermuda fund to tap into institutional investors, and complemented this with a listing

on Singapore stock exchange to tap into retail investors. Singapore was chosen as the fund was focused on the China
& Taiwan market. Macquarie also used similar approach for the Indian market with MSIF being the offshore fund,

129

http://www.ipe.com/realestate/articleprint.php?id=47973

Funds, however, need the right infrastructure. In the fourth chapter, the study delivers a
SWOT analysis of 13 jurisdictions. The goal was to find which domiciles are best suited to
draw investors of different types, and to facilitate IDB’s delivery of a master umbrella fund.
IDB members like Bahrain and Malaysia performed well in the review. So did some global
jurisdictions – especially Luxembourg. Therefore, the opportunity is there for IDB to consider
a blended approach to jurisdictions.

We proposed that a master-umbrella fund which accommodates multiple sub-funds
(infrastructure, trade finance etc.) including a charitable fund, provides IDB the most
flexibility. IDB may also develop local capital markets to tap into retail investors where the
projects are taking place. The master fund strategy requires IDB to provide seed money,
but does not expand IDB’s balance sheet. An advantage of this strategy is that it allows the
introduction of natural hedges in the sub-funds, which sell units in local currency to local
investors or international investors who have reason to earn in that currency.

Based on our analysis of different investor segments and their expectation in Chapter 4, we
believe the funds strategy will allow IDB to access investors outside of IDB’s traditional space.
These may include institutional investors from the global markets (pension, insurance, family
offices, HNWIs and SWFs) as there is an increasing interest in infrastructure investment.
Although funds have a significant capacity to deliver off balance sheet finance and tap into
a broader investor group, this strategy may not easily allow IDB to deliver finance at an
attractive cost to its MCs. Indeed, IDB would have to work with focused sub-funds that have
either charitable or special return parameters to achieve the lowest cost of funding to MCs.
In general, there is a negative relationship between off-balance sheet strategy and cost of
funding. If investors do not have recourse to IDB, they will necessarily require higher return.
This is the tradeoff that IDB has to keep in mind when pursuing the funds strategy. From
Preqin’s database, the infrastructure funds have been paying around 10% IRR, with a peak in
Years 2000-2005 that reached to 20% return. Most of these funds are investing in developed
markets.

Fund investors have been keen on the emerging markets and “infrastructure” has become the
code word for funding investment in high growth developing countries, as well as countries
that are perceived to have the capacity for high growth. IDB member states are prominent
among these markets. The encouraging outcome from our analysis of the infrastructure
investment is the fact that a highly diversified group of investors look for fund investments
in both infrastructure (developed and emerging markets) and emerging markets. They
require, however, a trusted partner to lead them to these markets, and IDB can easily play
this role. A sub-issue, which may raise some concern, is that anti-Muslim bias would mean
that IDB should choose fund names that stress on emerging markets and ethical investment
as opposed to overplaying the word “Islam”. Likewise, such fund structuring may require IDB
to avoid using transliterated Arabic words in fund documentation. Instead, IDB could use
plain English language descriptions of the investment processes. The objective is to avoid
dismissal of IDB investment opportunities prior to the prospective investor’s analysis of the
true risks and benefits of the offering.

We also conducted a small survey with about 20 respondents to get their input on the
following two areas:

130

Will current investors who place their money in 1. Murabaha funds that pay about 1.3% be
willing to switch to an infrastructure fund, with a similar return profile?
What are the investors’ views about a ‘retail development fund’, and or a retail 2. Sukuk
strategy?

On hypothesis (1) - switching from Murabaha funds to development funds, the general
view from the respondents was that the ‘development fund’ is not a natural alternative
to Murabaha funds. The reason being –Murabaha is a short-term placement for these
investors while waiting for the right investment opportunity. This is why the return is low.
The Murabaha fund also has a very frequent redemption built in – some even allow a
twice-a-week redemption window. A ‘development fund’ will not be able to offer this type
of liquidity unless a strong fund sponsor provides a liquidity facility. The challenges with
liquidity facilities are that do not necessarily dampen an investor’s they desire for returns,
and they may not satisfy the full demand for liquidity during a market event. As a result, the
fund may be forced into an involuntary wind-down.

If the liquidity is not there, investors will necessarily require higher return. There was still a
lot preference for Sukuk in the market, instead of a ‘development fund’ strategy.

On hypothesis (2) – ‘retail Sukuk’ or ‘development funds’, one of the most frequently given
feedback was the cost of tapping into this investor group. There are two cost components
– first the distribution to retail investors, and second the return expectation from the retail
investors. Investor sophistication will be the main factor that drives pricing. ‘Retail Sukuk’ or
funds do not automatically mean tighter pricing for IDB. In certain markets, IDB may have to
pay higher prices to retail investors, especially when they only look at past rates.

Another point to keep in mind when dealing with retail investors is the frequency, thus
the quantum of funds that IDB wants to raise from the retail market. From the review we
conducted in Chapter 2, India took the approach of raising one large tranche, but faced
the problem of under-deployment of the proceeds. It was common to have smaller, much
frequent issuances in London and Malaysia. This will definitely need investor awareness and
education. In the field of development investment, the concept of a ‘retail fund’ remains
untested. Nonetheless, this is a natural fit to provide funding for development projects. If IDB
is able to invest in its MCs as well as other infrastructure projects (i.e. proper diversification),
the overall return might be appealing to investors. At the domestic market level, initial
years may need IDB to pay a slightly higher cost than the traditional Sukuk funding option.
However, in the long run, once the investors become more familiar with the concept, this
may prove to be a cost efficient funding option for IDB.

The fund investors who seek infrastructure and emerging markets investment are a specific
group of fund managers. Therefore, we believe that it is more suitable for IDB to pursue
these investors via private equity investment style – which it has been doing with its
two infrastructure funds. This allows IDB to deal with sophisticated investors during the
development period, and once the project is generating cash flow, IDB may seek listing of
the fund, thus providing the greenfield investors with the return that commensurate with
the risk they took. This will also allow IDB to tap into retail investors once there is a stable
cash flow generated from the project.

131

As liquidity and currency risks are two of the main perceived issues for a ‘development fund’,
IDB may consider a number of structural approaches. On the hand, the quantum of money
invested through IDB’s International Islamic Trade Finance Corp. (ITFC) would be allocated
to a higher proportion of short-term self-liquidating trade deals. On the other hand, IDB and
its co-sponsors may determine that they should make a contingent allocation of capital to
fund redemption requests under specific conditions. Moreover, IDB may select to absorb the
currency risk and provide specific hedging through its own treasury to cover expected future
payments from funds to investors. Tapping into domestic retail investors to raise funding
locally may minimize the hedging need for exotic currency of various MCs. In addition, by
offering various funds in various jurisdictions (e.g. USD in GCC, Euro in Turkey etc.) the overall
fund network will be able to naturally hedge the currency risks and match the SDR currency
structure of IDB’s balance sheet.

IDB cannot find a panacea for their delivery of low cost financing via only a fund strategy.
What it can do is build a highly diversified fund strategy that addresses a wide variety of
investment forms and delivers different forms of capital at different return levels. This would
create greater capacity for IDB to serve as many MCs as possible in as many suitable ways as
can serve the dynamic needs of the MCs.

132

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Appendix I: Top 10 investors in Unlisted Infrastructure Funds
Source: Preqin Global Infrastructure Report, p.36

Global – including Public Pension1.

Public Pensions Only2.

Global – excluding Public Pension3.

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Appendix II: Top 5 investors in Private Equity Funds
Source: Preqin Global Private Equity Report, p88

Endowments1.

Family Offices and Foundations2.

Insurance Companies3.

Private Sector Pension funds4.

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North American Public Pension5.

European Public Pension6.

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Other investors to watch in 20127.

‘Other investors to watch in 2012’ (Contd.)

142

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Appendix III: Extract of Indian Committee Report on Development
Infrastructure Funds

Structure: The Committee believes that DIFs should operate as close-ended schemes with a
maturity period of seven years and a possibility of one or two extensions, subject to adequate
disclosures in the offer documents and approval of trustees.

Liquidity1. : The proposed DIF’s should get listed within 24 months of the launch of the
scheme and be allowed to buy-back the units, from the market within certain limits to

safeguard the interests of investors.
Types of investments permitted2. : In terms of Investments, it is suggested that the DIF’s
may be allowed to invest up to 100% of its funds into unlisted securities including both
equity and debt instruments. Exposure to listed companies, however, should be limited
to 10% of the NAV at the time of making the investments. Further, the DIF’s may be
allowed to take control of the asset, if they so desire, and own up to 100% of the paid up

capital of a company.
Fees and Expenses3. : In light of the unique nature of DIFs like dedicated teams for the
management of such schemes, requirement of in-depth research because of companies
being unlisted and information not being available, higher level of monitoring of
investments, the fee structure of such funds will have to be different from the existing
Mutual Fund schemes, in line with global practices. The Committee therefore suggests that
maximum overall permissible expense ratio for DIFs including investment management
fees be additional 1% over and above that specified in the Mutual Fund Regulations.
Additionally, the DIFs should also be allowed to charge a performance fee after providing
a certain minimum return to the unitholders, as per global practice.
Valuation Norms and Disclosures4. : The DIF’s should report the fund NAV at the time of
each asset valuation and also at quarterly intervals. About valuations, the Committee
believes that current SEBI guidelines to value unlisted equity shares will need to be suitably
amended for the proposed asset class. The proposed DIFs should engage an approved
consultant to value the assets semi-annually. Such an approved list can be drawn up by
the SEBI registered rating agencies. Approved consultants for respective DIFs, however
may be replaced every three years as a matter of good corporate governance.
Eligible Sponsors5. : The Committee proposes that the DIFs can be launched by all SEBI
registered Asset Management Companies (AMCs), but should have a dedicated team for
managing the funds and their trustees should be satisfied in this respect.
Investor Profile6. : The Committee suggests that all the individual/ companies/ corporates/
institutions and FI’s should be eligible for making investment in such mutual funds. The
profile of DIFs in terms of tenure, risks and returns are also complimentary to liability
side of insurance companies and pension funds. Therefore, Govt./concerned Regulators
may also consider modifying the investment guidelines for Insurance/pension funds and
provident funds so that they could invest directly in such type of mutual funds, as it will
serve the twin purpose of meeting sectors’ capital needs as also in managing risk-return
requirements of Insurance Companies and Pension Funds.
Disclosure of risk factors and reporting of compliance7. : Risk factors relevant for such
schemes may be disclosed in the offer documents and advertisements for the launch

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of such schemes so that the investors may take well informed investment decisions. In
addition to disclosure of the NAV’s and annual accounts of the scheme, the DIFs may also
report financial review of each investee company and the status of implementation of
various projects, on quarterly basis. The valuation methodologies may be approved by the
trustees and may also be disclosed to investors. The trustees shall review the performance
and compliance of regulations in case of DIFs in their periodical meetings and shall report
it to SEBI in their reports submitted to SEBI in accordance with regulations.
Tax Benefits8. : Considering the long-term and close-ended nature of the proposed DIFs, the
Committee believes that it will be extremely important to provide some tax incentives to
retail investors to motivate them to invest in DIFs and therefore help in and benefit from
the infrastructure creation in the country. The Committee also believes that without the
tax incentives no retail investor would be motivated to invest in a DIF. Tax benefits may be
provided by (i) enhancement of limit under Section 80C from Rs.1,00,000 to Rs.2,00,000
with the incremental limit exclusively set apart for investment in designated infrastructure
funds and (ii) Capital gains arising on account of transfer of long term capital assets may
be exempted from tax if the capital gains amount is invested in DIF units for a period of 7
years. However, such tax benefits should be available only to the original investors.

Recommendation rationales (Section D of the report)

Maturity Period1. : start with 7 years (allow project to go into brownfield and generate
cash flow), then move to perpetual later. Global practice 7-9 years with extension of 1-2
years
Liquidity - listing & timing2. . Listing provides liquidity to investors, however this should be
done after 2 years since the fund will be deployed in a staggered basis. Allow buy back for
20% of initial unit capital.

The main driver of this recommendation is to cater for retail investors •
preference to exit the fund and not tied for long run. Listing after 2 years
prevent negative trading during investment & green field period. Australia,
Singapore, Korea & Europe have listed infrastructure funds. Australia has 30-

35% retail participation. Korea’s initial retail participation was quite low.
The purpose of buy back arrangement is to use excess fund not deployed to •

buy back unit and reduce discount trading.
Draw Downs3.  - single draw down, invest in money market during interim period. This will
make it easier to manage operational issues in dealing with retail investors. Some global
funds buy infrastructure assets, then seed these into the fund.
Types of Investments Permitted (i.e. Asset classes)4.  - allow 100% investment in unlisted
securities, both debt & equity. Listed company investment should be limited to 10% of
NAV. 20% (NAV) single issuer limit. 50% (NAV) in unrated paper (existing 25% for mutual
funds). No restriction in sectors
Exit5.  - strategic sale (i.e. To any interested investor), sale to financial investor (FI, bank or
fund), IPO, buy back (sponsor), expiry of concession is a natural end (make sure get IRR)
Fees and Expenses6. :

Overall expenses ratio: 1% higher than existing mutual fund (because there is a.
higher expenses )

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Management fee: up to 1%b.
Performance fee/Carried Interest: 20% above the hurdle rate (minimum hurdle c.
rate = 10%)

Investor Profile7.
All individuals/co/FI - may need to adjust investment guideline for insurance & a.
pensions because these are natural investors in these type of funds
Encourage (positive recommendation) of pension & insurance to invest in DIF. b.
Even 1% from pension allocation will make significant difference & give comfort
to foreign pensions to invest.

Tax Benefits8.  - is crucial to entice retail investors.
Upfront tax incentive - since lock in and no liquiditya.
Capital gain exemption if satisfy minimum holding period (India - 7 years)b.
Income distribution exemption if satisfy minimum holding period (India - 3-5 c.
years)
Incentives only applicable to original investors in fund, not those who bought d.
after listing

Appendix IV: Selected Infrastructure debt fund (IDF) Regulation by
SEBI August 30, 2011

49L - For the purposes of this Chapter, unless the context otherwise requires-

(1) “Infrastructure debt fund scheme” means a mutual fund scheme that invests primarily
(minimum 90% of scheme assets) in the debt securities or securitized debt instrument of
infrastructure companies or infrastructure capital companies or infrastructure projects
or special purpose vehicles which are created for the purpose of facilitating or promoting
investment in infrastructure, and other permissible assets in accordance with these
regulations or bank loans in respect of completed and revenue generating projects of
infrastructure companies or projects or special purpose vehicles.

(2) “Infrastructure” includes the sectors as specified by guidelines issued by the Board or as
notified by Ministry of Finance, from time to time.

(3) ‘Strategic Investor’ means;

(i) an Infrastructure Finance Company registered with Reserve bank of India as Non-
Banking Financial Company;

(ii) a Scheduled Commercial Bank; (iii) International Multilateral Financial Institution.

49O - Conditions for the IDF

(1) An infrastructure debt fund scheme shall be launched either as close-ended scheme
maturing after more than five years or interval scheme with lock-in of five years and
interval period not longer than one month as may be specified in the scheme information
document.

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(2) Units of infrastructure debt fund schemes shall be listed on a recognized stock exchange,
provided that such units shall be listed only after being fully paid up.

(3) Mutual Funds may disclose indicative portfolio of infrastructure debt fund scheme to its
potential investors disclosing the type of assets the mutual fund will be investing.

(4) An infrastructure debt fund scheme shall have minimum five investors and no single
investor shall hold more than fifty percent of net assets of the scheme.

(5) No infrastructure debt fund scheme shall accept any investment from any investor which
is less than Rupees one crore (Rs. 10m)

(6) The minimum size of the unit shall be Rupees ten lakhs.

(7) Each scheme launched as infrastructure debt fund scheme shall have firm commitment
from the strategic investors for contribution of an amount of at least Rupees twenty five crores
before the allotment of units of the scheme are marketed to other potential investors.

(8) Mutual Funds launching infrastructure debt fund scheme may issue partly paid units to
the investors, subject to following conditions:

(a) The asset management company shall call for the unpaid portions depending upon
the deployment opportunities;

(b) The offer document of the scheme shall disclose the interest or penalty which may
be deducted in case of nonpayment of call money by the investors within stipulated
time; and

(c) The amount of interest or penalty shall be retained in the scheme.

49P - Permissible investments

(1) Every infrastructure debt fund scheme shall invest at least ninety percent of the net
assets of the scheme in the debt securities or securitized debt instruments of infrastructure
companies or projects or special purpose vehicles which are created for the purpose of
facilitating or promoting investment in infrastructure or bank loans in respect of completed
and revenue generating projects of infrastructure companies or special purpose vehicle.

(2) Subject to sub-regulation (1), every infrastructure debt fund scheme may invest the
balance amount in equity shares, convertibles including mezzanine financing instruments of
companies engaged in infrastructure, infrastructure development projects, whether listed
on a recognized stock exchange in India or not; or money market instruments and bank
deposits.

(3) The investment restrictions shall be applicable on the life-cycle of the infrastructure
debt fund scheme and shall be reckoned with reference to the total amount raised by the
infrastructure debt fund scheme.

(4) No mutual fund shall, under all its infrastructure debt fund schemes, invest more than
thirty per cent of its net assets in the debt securities or assets of any single infrastructure

147

company or project or special purpose vehicles which are created for the purpose of
facilitating or promoting investment in infrastructure or bank loans in respect of completed
and revenue generating projects of any single infrastructure company or project or special
purpose vehicle.

(5) An infrastructure debt scheme shall not invest more than 30% of the net assets of the
scheme in debt instruments or assets of any single infrastructure company or project or
special purpose vehicles which are created for the purpose of facilitating or promoting
investment in infrastructure or bank loans in respect of completed and revenue generating
projects of any single infrastructure company or project or special purpose vehicle, which
are rated below investment grade or unrated:

Provided that such investment limit may be extended upto 50% of the net assets of
the scheme with the prior approval of the board of trustees and the board of asset
management company.

Appendix V: SEBI ALTERNATIVE INVESTMENT FUNDS)
REGULATIONS, 2012 (May) – Selected Clauses

1. Category I Alternative Investment Fund- Venture Capital Fund

2. Category I Alternative Investment Fund- Social Venture Fund

3. Category I Alternative Investment Fund- SME Fund

4. Category I Alternative Investment Fund- Infrastructure Fund

5. Category I Alternative Investment Fund- Other

6. Category II Alternative Investment Fund

7. Category III Alternative Investment Fund

Investment in Alternative Investment Fund.

10. Investment in all categories of Alternative Investment Funds shall be subject to the
following conditions:-

(a) the Alternative Investment Fund may raise funds from any investor whether Indian,
foreign or non-resident Indians by way of issue of units;

(b) each scheme of the Alternative Investment Fund shall have corpus (total committed
investment) of at least twenty crore rupees; (Rs 200m)

(c) the Alternative Investment Fund shall not accept from an investor, an investment of
value less than one crore rupees: (min inv = Rs 10m)

Provided that in case of investors who are employees or directors of the Alternative
Investment Fund or employees or directors of the Manager, the minimum value of
investment shall be twenty five lakh rupees.

......

148

(f) no scheme of the Alternative Investment Fund shall have more than one thousand
investors;

(g) the fund shall not solicit or collect funds except by way of private placement.

Tenure.

(1) Category I Alternative Investment Fund and Category II Alternative Investment Fund
shall be close ended and the tenure of fund or scheme shall be determined at the time of
application subject to sub-regulation (2) of this regulation.

(2) Category I and II Alternative Investment Fund or schemes launched by such funds shall
have a minimum tenure of three years.

(3) Category III Alternative Investment Fund may be open ended or close ended.

(4) Extension of the tenure of the close ended Alternative Investment Fund may be permitted
up to two years subject to approval of two-thirds of the unit holders by value of their
investment in the Alternative Investment Fund.

(5) In the absence of consent of unit holders, the Alternative Investment Fund shall fully
liquidate within one year following expiration of the fund tenure or extended tenure

Listing.

(1) Units of close-ended Alternative Investment Fund may be listed on stock exchange subject
to a minimum tradable lot of one crore rupees.

(2) Listing of Alternative Investment Fund units shall be permitted only after final close of
the fund or scheme.

Conditions for Category I Alternative Investment Funds.

(5) The following conditions shall apply to Infrastructure Funds in addition to conditions laid
down in sub-regulation (1):-

(a) at least seventy five percent of the corpus shall be invested in unlisted securities or
units or partnership interest of venture capital undertaking or investee companies
or special purpose vehicles, which are engaged in or formed for the purpose of
operating, developing or holding infrastructure projects;

(b) notwithstanding clause (a) of sub-regulation (5), such funds may also invest in listed
securitized debt instruments or listed debt securities of investee companies or special
purpose vehicles, which are engaged in or formed for the purpose of operating,
developing or holding infrastructure projects.

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Appendix VI: Dana Infra Retail Sukuk Distribution Channels

Source: (Dana Infra, 2013)

150

The Financial Product Development Center (FPDC) was established in Muharram 1432H (December
2010G). Its main purpose is to enhance the leadership of the Islamic Development Bank Group in
the development and promotion of innovative Islamic financial products within the framework of
the Maqasid al-Shariah. This is accomplished while further strengthening the financial soundness
and relevance of the IDB Group.

The Center is the focal point for the development of new and innovative financial instruments at
IDB Group, and for this purpose it also collaborates with various institutions in the Islamic financial
industry.

Strategic Objectives

The Center has three major strategic objectives:
Developing Business Process for new product development. v
Building capacity of product developers. v
Designing new financial products. v

These three objectives are summarized by the “3Ps” that the Center works along: Process, People,
and Products.

For any queries, please contact:
Financial Product Development Center

Islamic Development Bank
19th Floor, HQ Building

Jeddah, Kingdom of Saudi Arabia

Email: fpdc@isdb.org
Tel: +966 12 646 7469
Fax: +966 12 636 7554

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