ISLAMIC PROJECT FINANCING
STELLA COX
In the past, Kleinwort Benson has tended to concentrate on developing business for Muslim customers through the delivery of its core product expertise to its Middle Eastern Islamic client base.
As one might expect, we maintain a segregated Islamic banking department, but enjoy the support of specialists throughout all of the product areas of our organisation that bring their individual skills to the varied activities of the department.
We have focused on cross-border trade finance, asset finance and specialised fund management, including an Islamic Global Equity Fund and an Islamic Commodity Fund. Incorporating Islamic funds in structured project financing is an initiative that is high on our agenda and, we anticipate, will form a larger part of our activity in the years to come.
Sourcing Project Finance from the Global Markets
Conventional project finance has enjoyed a global surge in popularity in recent years. Finance is now raised for start-up and new-build projects, against the security of that project’s own cash flow, across the full range of industry sectors and geographical locations.
A major attraction of conventional project finance in developed markets is access to a diversified range of financing techniques that can be raised and combined to provide the most effective solution to funding the project.
The provision of loans by international and local banks and the multilateral agencies is at the forefront, and project lending by commercial banks has become very sophisticated.
Established Export Credit Agencies will lend to a project to support the efforts of their domestic contractors and their willingness to assume the political risk of some of the more challenging countries is likely to increase their level of involvement still further.
Local capital markets have an important role, whereas international capital markets may have a more limited appetite for the inherent risks.
The international capital markets may have been extensively used for financing of existing infrastructure assets initially through debt and, more recently, equity issuance, but international markets have been relatively little used for smart-up or new-build projects.
The massive construction and completion risks result in the issue having difficulty in achieving the investment grade rating that attracts foreign investment, without strong completion guarantees that may be unacceptable to the project sponsor.
Finally, there is Islamic project funding, which, although proving quite a challenging step forward for the market, can, even if not provided directly, be deployed as an individual tranche in a large-scale project to combine with export credits and, in principle, stand parallel with conventional financing raised through one or more of the techniques highlighted above.
Application of Islamic Financing Techniques to Project Development
Let us consider the institutional involvement in project financing in both the Middle East and in Malaysia and address some of the structuring issues, as well as the benefits and disadvantages for both project and investor.
In fact, criticism is often levied at the Gulf-based Islamic banks’ lack of involvement in long-term project development when involvement is synonymous with the tenets of the Sharia. We should therefore consider the level of their participation in relation to the present status of the regional Islamic banking system.
Although development is ongoing, both Islamic interbank and capital markets are yet to be implemented and, in the absence of market liquidity, it is clear that a significant percentage of an Islamic bank portfolio must not be invested in illiquid assets (particularly with the associated risks of a non-recourse project finance) if prudent balance sheet management is a consideration.
As recourse to liquidity is largely limited to bi-lateral arrangements (and therefore results in the inability to mismatch long-term investment against short-term deposits), it is surely understandable that the first priority is to ensure sufficient liquidity to meet obligations.
This tends to result in the banks opting for secure, short-dated investments with a small selection of the balance sheet designated for the longer-term financing and equity participation.
The substantial risks and absence of cash flow in the long development phase of a project remains prohibitive to capital investment by most Islamic institutions (and certainly the banks) that are required to provide a regular return to depositors.
Capital participation may, however, take place on either a profit-sharing or profit-and-loss-sharing basis, although, again due to the long lead-up of major infrastructure projects, capital may be raised here through the floatation of Special Bonds or Participation Certificates.
In Malaysia, the involvement of a growing number of institutions, has amassed sufficient active participants to implement an alternative Islamic interbank money market and Islamic capital market. Accordingly, project finance is starting to be raised not only through bi-lateral financings, but through domestically-rated capital market issues that substantially expand the prospective investor base.
Following the first Islamic Private Debt Securities (IPDS) issue for Shell MDS in 1990, the IPDS market in Malaysia has become a sought-after source of finance, particularly of late, for large infrastructure projects.
The recent success enjoyed by institutions submitting Islamically structured solutions when bidding for project financing mandates against conventional alternatives demonstrates the versatility and application of the concepts, although some of the techniques used for the securities issues and concepts, such as Bai A1 Dayn, have proven controversial in the International Islamic market.
Long-term project funding that is undertaken by banks is usually made available through the extension of committed facilities and typically through repayment, deferred payment and instalment sale, utilising the concepts of Bai Bithaman Ajil, Murabaha and Istisna, for example.
Deferred payment sales can have short or long-term application depending on the underlying asset flow within the project. The latter offers a fixed rate financing package and the former is comparable to a conventional, floating rate structure that is effective when it is anticipated that the project will generate a revenue stream for investors at quite an early stage.
Under the terms of this contract, the project sponsor or facility recipient can opt for the benefit of term, fixed-rate finance that will enable easier management of cash flow and protection against rate fluctuation. Individual Islamic institutions outside of Malaysia do, however, have differing views about the application of fixed and floating rates extended through this mode of financing.
To facilitate investment, credit enhancing instruments such as corporate, institutional or even sovereign guarantees can and have been incorporated in the structures. Amongst the benefits to parties accessing Islamic funds is that contrary to popular belief, even long-term facilities can be competitive and deferred sale contract values can be calculated to compete or equate with a conventional alternative.
Furthermore, the opportunity for the purchaser to raise up to 100 per cent of a financing requirement is particularly appealing and one that is not always available from traditional sources.
Despite the continuing issue of liquidity, we do see examples of Arab Islamic banks employing both established and more recently developed financing techniques, including Istisna, Ijara, Murabaha and Salam, to provide elements of complex multi-sourced financings.
By example, the US$1.8 billion Hub River Project in Pakistan involved two separate Islamic financing components. These included a US$92 million Istisna facility arranged by ANZ Grindlays, and provided by A1 Rajhi Banking and Investment Corporation of Saudi Arabia. The terms provided for A1 Rajhi to make advance payment for the purchase of purpose-built equipment from Western suppliers for marked-up onward sale.
Additionally, there was a US$ 110 million Murabaha facility arranged by the Islamic Investment Company of the Gulf. Conventional financing was provided by the World Bank, assorted export credit agencies and commercial banks. Although perhaps not of extended tenure, the participants demonstrated the value of Islamically provided funds within a multi-system financing and initiated cross-border development.
Both the Kuwait Finance House and the International Investor have also had involvement in advising, arranging and providing domestic and cross-border finance for start-up projects.
Leasing is now, increasingly, a preferred structure for extending medium-and longer-term finance, particularly for large-ticket, capital goods equipment required by the project. Regular re-pricing of a lease to ensure that returns are competitive within the prevailing market is a less contentious issue for the trade Islamic banking and lease securitisation is viewed as one of the more likely methods of developing the secondary market.
The Al Tawfeek Company for Investment Funds and the A1 Amin Securities Company have both provided medium-term asset finance, the latter underpinning its transactions with tradable certificates that some consider to be the basis of the future capital market.
An additional benefit of the leasing structure in Islamic countries is its enforceability in law. Due to structural similarities with conventional leasing, the concept is also easily understood, both by those accessing the facility and conventional co-financiers who have limited practical knowledge of Islamic financing techniques.
The Role of the Islamic Development Bank
In reviewing Islamic project financing initiatives, we should briefly consider the role of the Islamic Development Bank in Jeddah. As the largest project financing institution in the Islamic world, it has the size of balance sheet and financing capability to take a supranational role in extending development finance to its member countries. Project financing for the fiscal year 1994/1995 amounted to US $415 million, approximately 31 per cent of the US $1,351 million extended in financing by the IDB during the year. At the IDB’s 20th Annual Meeting in Jakarta, it was announced infrastructure financing should, in time, have a beneficial impact for the poorer member countries that have little or no alternative source of development funding.
The IDB plans to focus on the development of public utilities and power projects. US $153 million was extended to the energy sector last year, mainly as individual tranches of multi-sourced financings for the extension of existing plant. From a structural perspective, Ijara is the predominant contract, accounting for US $247 million, or nearly 60 per cent of all project financing.
Last year, the IDB established the Islamic Corporation for the Insurance of Investment and Export Credit (ICIIEC). The Corporation’s objective is to provide export credit insurance initially, and to provide investment insurance against the relevant country, political and exchange control risks in the future. The effectiveness of this organisation as compared to the other ECAs remains to be seen, but its potential and ability to develop an appetite for project finance is obviously immense.
Contractual Issues in Multi-sourced Project Finance
We know, from experience, that there are inter-creditor issues encountered in multi-sourced project financing. Recently, Kleinwort Benson participated in term financing arranged by the Islamic Investment Company of the Gulf for the infrastructural development of the holy sites at Arafat and Muzdalifah in the Kingdom of Saudi Arabia.
Our involvement was an invaluable learning process as we, along with the United Bank of Kuwait, were in the minority as conventional participants and this project funding was provided predominantly by Islamic financial institutions. Once we had satisfied our credit committee as to the commercial viability of our investment, we were able to accept the decisions of the Islamic participants regarding the ethical nature of the project and its financing structure.
Reversing positions, however, in multi-billion-dollar development projects, we may find an Islamic investor co-financing alongside a greater number of providers of conventional funds. The majority of financiers will prioritise the commercial risk and viability of the investment and the Islamic financier will, of course, give precedence to Sharia considerations.
Governing Law
International financings are normally determined by English law as there is an element of certainty in interpretation. Historical relationship has resulted in a number of similarities between English law and the local law of a large number of countries, including Malaysia, and, so far as it does not directly conflict with the Sharia, English law generally prevails in Islamically financed contracts.
Title and Ownership
Previous co-financings have usually allowed for the identification of specific assets within the project that might be suitable for Islamic financing. Any financing under terms of Ijara or a deferred sale concept will necessitate ownership of the underlying asset by the Islamic investor. This can present a number of problems:
i) Firstly, unless the Islamic bank has an equity position in the project, the sponsor may be reluctant to relinquish control of major assets in a manner that will enable the financier to comply with its own Sharia stipulations;
ii) When the investor holds the asset for a term (say in the case of a lease-based transaction), as opposed to contracting for immediate onward sale, he will be exposed to local legislation regarding owners’ liability in the event of damage or destruction;
iii) Additionally, under English law, third parties harmed by an asset may seek compensation from its owner. As owner of the asset, the Islamic financier may also be impacted by the costs of maintenance and insurance that are his responsibility.
iv) Due care and attention will also need to be paid to the impact of local taxation on the cost of acquisition and, particularly, the profit upon sale.
These issues are real concerns for Islamic financiers in term investments, but not considerations for providers of conventional funding.
To address some of these concerns, Islamic project finance has sometimes been provided through a Special Purpose Company (SPC) incorporated with limited liability status in the relevant jurisdiction. In the case of Ijara, the SPC acquires tide to assets as lessor and ownership liability rests with the SPC rather than the financing institution. Although Sharia Advisors to some Islamic institutions in the Middle East have raised concerns about this technique, it has been used fairly extensively for Ijara transactions and has particular relevance for securitised issues.
Warranties
The supplier of goods under the terms of a Murabaha contract must also ensure that additional responsibility is not being assumed under local liability law. A proper contract of assignment of warranties between original supplier and ultimate purchaser must be drawn up to ensure that the Islamic financier (interposed as vendor) does not assume liability through severing the direct contract between manufacturer and end-user.
Certainly, the London law firm Freshfield believes that this issue is often not adequately addressed in Islamic financing contracts and that the commonly documented blanket liability exclusion clause may not actually be effective. Once again, the Islamic financier is obliged to research local law liability that is not applicable to conventional loan provision.
Manufacturing/Production Delay
the conventional financier lends directly to the borrower, whereas the Islamic investor provides finance for acquisition of assets or their manufacture. If production delays occur, consideration must be given to the Islamic bank’s capability to perform under the terms of his contract with the user of the asset and the impact that that will have on the project in its entirety.
Events of Default and Inter-Creditor Issues
i) In the event of default, conventional co-financiers may call for repayment and levy appropriate interest charges for non-performance. The Islamic bank must give a great deal more consideration as to how it might proceed in the event of non-performance and, indeed, how compensation may be sought.
One solution in a long-term project is for the financier to offer beneficial terms for early and even prompt repayment. In any event, and whatever the mode of funding, it is obviously not possible for an Islamic financier to claim interest on late payment. Action cannot be taken until a sufficient amount of time has been afforded for arrears to be addressed.
ii) Generally, in the event of directional decisions within a group financing, the relevant parties will have rights of decision determined by outstanding aggregate loans. Unless the Islamic institution’s participation is determined by outstanding credit risk, the Islamic financing tranche may need to be separated from the core financing to ensure that the financier enjoys the same benefits of decision, or conversely, is not affected by a majority ruling that directly conflicts with the Sharia. Although certainly worth addressing, practically speaking, we have generally found that voting rights can be satisfactorily solved.
iii) Segregated financings are often preferred by conventional co-financiers, who raise concerns about disbursal of proceeds of asset sales in the event of default, given the Islamic bank’s requirement for direct ownership of those assets and, accordingly, their preferential right to the proceeds in the event of sale.
Islamic Finance and Infrastructure Development
Not surprisingly, perhaps, many of the initial forays into term project finance by the Arab Islamic banks have been in domestic markets and those with interest-free economies, such as Sudan and Pakistan.
Most (although not all) of the project involvement has related to individual, shorterterm, start-up and working capital tranches but we perceive a desire amongst our clients for more substantial involvement, and see the provision of term facilities as the next step. Our appointment as advisor to the UK’s National Grid Company for a major infrastructure development in Pakistan has enabled us to invite Islamic financial involvement in both a two-year start-up facility and the seven-year term finance.
Traditionally, Middle Eastern governments have considered the domestic provision of infrastructure to be their own responsibility. Lately, it has become increasingly difficult to fund the heightening demand because of the growing deficit in government revenues.
Although this is a common problem to other geographical areas, it is unlikely that the Middle Eastern governments will resort in the immediate future to large-scale privatisation of businesses and infrastructure that they already own.
Secondly, it is unlikely that they can attract sufficient investment from abroad to satisfy outstanding demand, even in the event of significant relaxation of foreign ownership and investment restrictions. There is, indeed, some evidence that the desire to raise external finance for build-own-operate projects is prompting several Gulf governments to review existing foreign investment laws.
The common preference is therefore to develop new projects on a joint venture basis between, typically, a local company, a government entity and a foreign technician, and that is one that finds favour with the governments and, liquidity aside, has structural appeal for an Islamic financing institution.
Admittedly, Malaysia does not face the same disadvantages as the governments of the Middle East and has promoted, particularly successfully, the application of its domestic, conventional capital markets to finance the new-build, private infrastructure, including Kuala Lumpur’s new light rail system and large sections of toll roads and power projects.
Although we have already established that, on a global scale, the international debt capital markets are not well suited to start-up ventures, there are a couple of exceptions at national level. The domestic capital markets in Malaysia almost certainly lead the pack in their comprehension of start-up project risk and the Islamic system is actively demonstrating that the understanding extends to both financial sectors.
Earlier we considered the increasing momentum of the Islamic capital market and the application of IPDS to local infrastructure finance. Recently, a consortium whose shareholders include Tabung Haji Technology, YTL Corporation Berhad and ABRAR Group International, with Siemens AG of Germany as the major technical partner, have been awarded the mandate to finance the Express Rail Link project. It will be the first time that a Malaysian infrastructure development is extensively financed through Islamic products.
Still looking specifically at mandates within the Malaysian market, one of the most sizeable examples of multi-sourced project financing relates to the RM 8.8 billion financing for KL International Airport.
In addition to an RMI billion Government Equity injection, an RM 1.6 billion bond issue and the equivalent of RM 600 million provided in Yen by a Japanese Government loan, RM 2.2 billion (or 25 per cent of the aggregate project financing costs) will be provided through a securitised Bai Bithaman Ajil syndication allowing for the issue of tradable notes, and arranged by a consortium of local banks led by Bank Islam Malaysia Bhd.
I believe this to be the largest Islamic debt securitisation to date, and the accompanying Guarantee of the Government of Malaysia serves further to appeal to investors who might otherwise be discouraged by the 20- year tenure and risk profile of the transaction.
Typical capital market investors in whichever sector look for very high-quality paper with credit standing that approaches the level of government risk. If we are thinking of specific future opportunities for the Islamic capital market, we should consider the requirements of infrastructure utilities that generally have safe cash flows and predictable performance over the long-term. For those reasons, blue-chip utilities are already viewed by conventional capital market investors as near equivalent to government securities and very-long-term finance is available for their infrastructure related projects.
We have addressed some of the difficulties faced by Islamic institutions with regard to long-term equity participations, but it should be highlighted that infrastructure equity can generate enormous profits, as well as risks, between development and start-up.
The global financing markets are more competitive than ever before and even developing markets are awash with offers of short-term funding. Most financiers are exploring the enhanced rewards available from diversification into provision of long-term funding, and Islamic institutions, more confident now that they have the necessary in-house resources to analyse the complex cash flows and opportunities, are no exception.
There is no shortage of infrastructure development opportunities in markets that are considered to be the traditional domain of Islamic financing. Legislation permitting, there is great value attributed to raising long-term investment from the international markets, where appetite may be negatively impacted by factors including political climate, local legislation and local currency exposure.
From the investment perspective, the enhanced rewards available from term participation in development ventures is one incentive for the Islamic financier balancing the provision of long-term funding against liquidity. The fulfilment of Islamic values through the promotion of development of Muslim economies is a still greater incentive.
The Islamic banks of the Middle East undoubtedly hold the majority of Islamic deposits, but, as we have seen, face considerable barriers to fixed-term participation without recourse to liquidity. This, in turn, impacts negatively on the volume of the assets financed through the Islamic sector and the generation of appropriate outlets for investors.
As we have noted, the implementation of an alternative, interbank system is prioritised, but will need greater Sharia consensus and the support of central regulatory authorities to succeed. Capital market development is high-profile too, but it is only recently that the Gulf markets have tested the viability of raising conventional finance through public debt instruments. Th e presence of recognised rating agencies should assist with the prospects of deepening the regional markets through the provision of detailed information and analysis to prospective investors.
It is worth highlighting a precedent for substantial participation in term financing by high-net-worth individuals and corporates that are less restricted by liquidity and are hungry for diversified investment. We have noted that the sheer scale of domestic development opportunities here will serve to deepen the asset base of the Islamic financial system.
Undoubtedly, investment potential exists in both domestic and international markets where investors are attracted to rated issues that generate competitive and liquid investment outlets. These elements of performance, security and credit quality are crucial to developing the issuance of long-dated paper through the Islamic capital market that satisfies the long-term funding requirement of the underlying project.
Innovation within the capital market is the key to attracting that investor base and a number of institutions here are ensuring that product innovation is a primary focus.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
Comments
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.
John Doe
23/3/2019Lorem ipsum dolor sit amet, consectetur adipisicing elit, sed do eiusmod tempor incididunt ut labore et dolore magna aliqua. Ut enim ad minim veniam, quis nostrud exercitation ullamco laboris nisi ut aliquip ex ea commodo consequat.