Under these structures the Islamic lender purchases an asset from the borrower or a third party, or in the case of a greenfield project contracts with the borrower to develop such assets, paying the borrower on a milestone basis, and then leases it back to the borrower in return for the payment of a pre-determined rent. As required by Sharia the risk is shared between the parties, as the Islamic lender must retain responsibility for insurance and major maintenance, although this may be subcontracted back to the borrower.

Where it is intended that the borrower should take title to the asset on maturity of the lease, the rent can include a fixed element, which essentially relates to repayment of the principal, and a variable profit element. Some Islamic scholars believe that the variable profit element may be linked to floating interest rates such as Libor. The variable element may also include reimbursements by the borrower of insurance and maintenance costs.

It is permissible to transfer investments in ijara financings, such transfers being considered as a Sharia-compliant sale of an interest in the ijara asset. This allows the Islamic lender to syndicate or, as contemplated for recent Abu Dhabi independent water and power projects (IWPPs), issue Islamic securities known as sukuks.

The requirement to accommodate ijara structures within workable co-financing structures has led conventional lenders to address a number of significant legal and commercial issues:

• Sharia law risk: Although ijara facilities for projects in the region have typically been documented under UK or US law with enforcement through the relevant courts, conventional lenders will remain concerned to ensure that Islamic lenders have complied with their internal Sharia committee’s requirements and that there is no credible risk of documentation subsequently being declared non-compliant, leading, possibly, to the Islamic lenders considering a funding default. There is little ability to obtain a separate independent consultant’s sign-off on Sharia compliance. Conventional lenders have typically been required to rely on some form of compliance certificate from a senior officer of the Islamic lender and a perception that in such a situation the Islamic lender would act responsibly to resolve the problem. Any perceived exposure can be further mitigated by restricting transfers of participations during the drawdown phase, requiring the ijara facilities to be fully drawn down before the conventional loans, or transferring risk to sponsors, where a completion guarantee is provided.
• Asset ownership: Ijara financings require Islamic lenders to take legal title to the assets subject to the lease, raising concerns that such assets, typically the turbines in power projects, would fall outside the security package on enforcement, leaving the lender group with an incomplete asset to sell. In jurisdictions with mortgage legislation in place, Islamic lenders have been required to take title to such assets subject to a prior mortgage, give negative pledge and non-disposal covenants and then to mortgage back into the security package their acquired interests in such assets. Transfer of title to project assets may also impact on the validity of construction warranties and other project agreements, requiring thorough legal due diligence to be undertaken.
• Parri passu treatment: Both Islamic and conventional lenders will typically wish to see that their facilities are fully parri passu. To a large extent conditions precedent, drawdown schedules, repayment terms, covenants, representations and warranties and events of default can be conformed across the conventional and ijara facilities. However, the Islamic lenders, through their lessor/lessee relationship with the borrower for example, may have additional rights against the borrower which conventional co-lenders will not wish to see exercised without their affirmative vote.
• Lender voting: As in any other multi-sourced financing, the respective voting rights of the lender groups will be of concern to all parties. Noting that ijara facilities are often in addition to local conventional bank facilities, international lenders will have to resolve concerns as to local control and conflicts of interest. Solutions reached to date deviate widely from the borrower’s optimum of a single vote across all financing tranches.

The regional project finance market has adapted readily to the introduction of Islamic tranches in some significant recent financings, and such tranches remain the focus of innovation, not least the continuing development of structures allowing the issuance of sukuk securities. The issues raised by these co-financing arrangements remain challenging, but market solutions based on working precedents are evolving. Further optimisation for the benefit of all parties, not least borrowers, should continue apace in the coming months.

Nicholas Buckworth is a partner based in London. Tim Pick is a senior associate based in Abu Dhabi. Both work in the international project development and finance field, primarily in the energy sector. n