The Dubai government's decision to pay the equivalent of $1.7 billion to redeem in full the sukuk instruments issued by crisis-hit property developer Nakheel was a painful one. But people familiar with the decision-making said the alternative would have been much worse, a possible showdown with hedge funds and distressed debt investors that could leave Nakheel with unfinished property projects and knocking confidence in the wider economy.
In addition, the emirate was concerned that failing to pay the sukuks, structured instruments that behave like bonds but which conform to the rules in Koran that prohibit the payment of interest, would hit the fledgling market for Islamic finance.
Nakheel is the property arm of Dubai World, Dubai's flagship conglomerate, famed both for its palm-shaped development off the emirate's coast and its towering debts which helped put its parent company in deep trouble. At the height of Nakheel's woes last December Nakheel's 3.6 billion United Arab Emirates dirham (about $980 million) 2010 and $750 million 2011 sukuks were trading at around 38% of face value. Repayment in full means hedge funds and distressed debt investors who bought then have made a mint.
Bloomberg News
Buildings under construction at Nakheel's International City project in Dubai, which has decided to redeem in full $1.7 billion of Nakheel debt.
The repayment, and hedge-fund profits, is only possible because Dubai will pump $8 billion into Nakheel and convert to equity some $1.2 billion in debt owed to the government. However, the people familiar with the plan said the emirate's hand was forced because Nakheel urgently needs to repay trade creditors to finish projects it has underway.
Under the restructuring plan the trade creditors will be repaid and work continue. But before this can happen, Nakheel's restructuring proposal must be approved by all creditor classes, including the sukuk holders.
One of the people familiar with the matter said an extensive cost-benefit analysis was done on whether the sukuks should be restructured instead of being paid in full. Proposals considered during the painstaking negotiations that have ensued since Nakheel's parent company Dubai World shocked international markets last November by asking for a debt standstill, have included creditors taking haircuts of up to 40%.
According to estimates from UBS AG analysts, half Nakheel's $22 billion of liabilities are related to trade creditors.
However, the person said it was decided the sukuks should be paid in full and on time because the economic cost to do otherwise would be too high as it would leave the restructuring process open to being blocked by a single class of creditors. The risk: distressed debt investors could hold enough of one class of credit to effectively veto the complete deal. It is a pattern common in other restructurings: distressed debt investors will negotiate hard for the most favorable deal for them, as they have far less to lose than the original debt investors, having bought when the debt had already tumbled in value. These aggressive tactics can stall restructurings for many months.
A spokeswoman for the Dubai government said a significant part of the rationale behind repaying the sukuks was to get the "Nakheel engine running again". "We looked at the cost of restructuring against paying them as they fell due and the conclusion was it would make more economic sense to pay them as they fell due," she said.
One person familiar with the matter said those involved with the negotiations were also mindful that they did not want to damage the sukuk market. Investor confidence in the sukuk market, which in 2009 was worth $31 billion globally according to Bank of America Merrill Lynch, has been shaken following defaults in the past year from Investment Dar of Kuwait and Saudi Arabia's Saad Group.
"The decision to pay-down Nakheel's sukuk should be perceived pretty positively by the sukuk market overall," said Okan Akin, a credit strategist at Royal Bank of Scotland in London. The person familiar with the matter said protecting of the sukuk market was also of particular importance because Nakheel's restructuring plan includes paying 60% of the amount owed to trade creditors via the issuance of new sukuks.
Under the plan, Nakheel and the Dubai government will negotiate with banks to provide a liquid market for the new sukuk, by acting as market-makers. This will allow trade creditors to cash-in the sukuks if they wish. If confidence in the sukuk market is hit, trade creditors could find their new sukuks worth less than expected, and the ultimate goal of getting Nakheel back on its feet would be defeated.
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