Islamic and project finance would seem to be ideal bedfellows but for a variety of reasons the match has never been perfect. Now, however, with expectations much lower, some genuine progress can be made. By Rod Morrison.
Project finance involves providing debt for significant capital expenditure schemes, usually in the energy and infrastructure spheres. Unlike other asset classes in the capital markets, it is genuinely asset-backed – the debt is serviced solely from the cashflows of the project, a physical asset.
As such, marrying project finance with Islamic finance, which relies on real assets too, should be a natural. There are differences, of course. Project finance is traditional debt, for a start, while Islamic finance requires a profit-sharing mechanism. And – importantly – the security required on a project financing is different than on an Islamic deal. Simply put, project finance needs security over the cashflows of a project while Islamic finance needs physical security on the asset itself.
Notwithstanding the differences, the two concepts have plenty in common. And given that project finance has played an important role in the development of the GCC economies and its mega projects over the last decade, the two concepts share a common home in the Middle East. Therefore it was logical that earlier in the decade, Islamic finance came to play an important role in financing projects in the region and indeed, the two concepts seemed to merge into one.
But then the bandwagon stopped – for reasons explained below. Now, with the hype from those days have being truly extinguished, we could start to see the emergence of a genuine role for Islamic finance projects – based on cost of capital and availability, ie real need and value, rather than on slightly artificial constructs.
In the aftermath of 9/11, when global capital market liquidity was low – particularly for financings in the Middle East – Islamic finance was seen as a vital source of funding for major projects in the Gulf. A classic example was the Shuweihat independent water and power project (IWPP) financing in Abu Dhabi.
The US$1.235bn deal was launched into syndication on September 10 2001 as a 20-year loan for sponsors CMS and International Power and the state utility ADWEA. The events of 9/11 and the general downturn in the world economy at the time meant the deal quickly hit the buffers and had to be tweaked to sell. The loan pricing was upped a little and a US$250m Islamic tranche – secured on lease payments on the turbines – was introduced with Abu Dhabi Islamic Bank (ADIB) as the lead.
The success of the deal led to Islamic tranches on project financing deals becoming commonplace. On the next ADWEA IWPP – Umm al Nar – there was a US$232m Islamic tranche alongside a US$855m senior loan. Half of the US$440m equity bridge loan was Islamic. On the US$1bn Alba aluminium smelter upgrade in Bahrain, there was a US$250m Islamic tranche. The US$540m refinancing of the ADWEA A2 IWPP in 2004 had a US$150m Islamic tranche.
By 2004, the Islamic boom was running out of puff. ADIB had taken on some significant long-term project finance positions, too big given the size of the bank. All Islamic institutions were struggling to compete with the much larger international banks, which were now roaring back into the lending market in the run-up to the credit crisis. However, Islamic finance as a concept remained in vogue and what happened next was that the concept was then taken over by the international banks.
A prime example occurred in 2005 when the bridge loan on the US$3bn Dolphin pipeline scheme between Qatar and UAE was refinanced by a US$2bn loan and a US$1bn Islamic tranche. The pricing of the facilities was ultra cheap at 35bp to 45bp and only the big international banks could justify taking a piece.
The Islamic tranche was arranged and sold solely to Islamic arms of international banks, with the exception of Dubai Islamic Bank. This raised concerns about whether deals were actually Islamic or not and – reflecting these concerns – I wrote a commentary in Project Finance International under the headline, "Islamic – To be or not to be" stating: "There seems little business need for Islamic pari passu tranches on project financings right now. Deals should either by Islamically structured or not."
2009
There are similarities between 2001 and 2009 and once again Islamic finance is being put forward as an important source of liquidity for projects in a credit-crunched world. But this time, there are differences. Islamic finance is being viewed in a more realistic way. There are now two rationales for it – providing finance, where appropriate, and allowing Islamic sponsors of projects to remain Sharia-compliant, a key consideration as more aspects of the Islamic economies move to Sharia compliance.
Two deals transacted this summer illustrate the new market for Islamic project finance – the Rabigh independent power project (IPP) and the Kuwait Energy Company (KEC) oil field financing.
There has been a dearth of Islamic project finance financing since 2005 – aside from Saudi deals such as the US$2.8bn Marafiq IWPP transaction in 2007 – which had a US$600m Islamic tranche – and the US$200m Hajj airport deal in Jeddah in 2008. The rationale behind these two was to take advantage of local Saudi bank liquidity and this theme has continued into 2009. Saudi banks remain liquid, despite some well published local corporate headaches.
With international bank liquidity dire in the earlier part of this year, Rabigh IPP sponsors ACWA Power and Kepco opted for a mix of Saudi and international debt for their US$1.9bn financing, with 70% coming from the local funders. The international tranche had to be covered for political and commercial risks by South Korean export credit agency KEIC.
The Saudi funders stepped up to the plate on this deal and, given the Islamisation of the Saudi economy and its banks, this will be repeated on other major deals in the Kingdom. In addition, for local sponsor Acwapower, arranging a Sharia-compliant financing was very beneficial. The company is planning an IPO in the medium term and will want to attract Islamic equity investors. Acwapower International chief financial officer (CFO) Rajit Nanda said the financing structure was aimed at "maximising pools of liquidity and doing it on a Sharia-compliant basis".
The deal itself is described in full in the Global Energy supplement produced by PFI on October 7. From an Islamic prospective, the key is that the Islamic facility was split into two tranches – one for Sharia banks and the other for non-Sharia banks. The Sharia banks – Alinma, Al Rajhi and NCB – took 65% of the Islamic facilities. Their tranche was a wakala ijara deal based on lease payments and providing fixed-rate funding. The non-Sharia bank tranche – for Samba, Saudi British and Saudi Fransi – was a "procurement facility", providing floating-rate funds on an ijara basis.
Putting the deal together with competitive 20-year plus finance costing around 250bp to 300bp was some achievement in the first half of 2009. In addition, the scheme was not backed by a sovereign guarantee on the project payments from the government, which is usually key in Saudi power deals, and the contractor will be Chinese – a concern for international lenders.
The KEC deal is much smaller but in some ways just as interesting. Islamic finance for exploration and production (E&P) oil and gas companies is virtually unheard of in the Gulf as the E&P companies are massive state-owned majors. KEC is one of the few independent E&P companies in the Gulf and is headed by local notable Ms Sara Akbar. Like Acwapower, it too is planning an IPO, perhaps as early as next year. To maximise the take-up of Islamic investors of its IPO, it wanted to arrange its 2009 financing on an Islamic basis.
Initially, it secured a term sheet from Standard Bank for a US$75m funding last autumn for its assets in Egypt and Yemen but as global finance conditions worsened Standard had to pull out as it could not sell down the loan. Standard has structured a conventional oil loan and was going to flip this into an Islamic structure.
KEC then approached multilateral IFC earlier this year. It drew up plans for a conventional US$50m deal – split between a five-year US$35m base case return senior tranche and a six-year mezzanine base case return plus profit share tranche – and then flipped it into an Islamic deal. Ajay Goyal, financial controller at KEC, said that opting for the Islamic deal added two months to the transaction timetable and about 20% to the legal bill but the pricing was actually the same.
KEC used the reserve based borrowing technique common to the E&P sector. The deal is secured on the reserves in the ground, which are valued. The reserve base value can move up and down during the life of the facility. But Goyal said co-opting Islamic finance to reserved based financing provided no real problems, aside from legal documentation.
Nevertheless it was the first time the two concepts had been matched. The deal has a commodity-sales linked murabaha structure based on buying and selling palladium. The fact that the reserve base value can go up or down during the life of the facility was said to present no challenges to Islamic finance. KEC, and indeed the IFC, which is part of the World Bank, expect more reserve based Islamic deals. For local lenders, one plus is that the tenors on these deals are short.