Five years ago, Islamic instruments would have barely merited a mention in a report on the region’s project financing. Today, not only do a growing number of deals include a sharia-compliant finance tranche, but projects are being funded on an exclusively Islamic basis.
Vast increases in local wealth and capital investment capacity are permitting project customers to push for a substantial Islamic element in financing packages, in the knowledge that the money and technical and legal structures to provide it in sharia-compliant form are now available.
Moreover, at a time of credit squeeze in Western markets, the reliance on such funding seems likely to increase. MEED has identified at least six major transactions that were concluded in 2007 with a significant Islamic financing element. In most cases, it was the sole or principal form of financing used (see table, page 45).
Still, the trend should not be overstated. There were just six deals in the region, five of which were in Saudi Arabia and one in Kuwait. The move towards substantial reliance on sharia-compliant project funding is therefore fairly concentrated, in geographical terms.
The largest purely Islamic deal was a $575m package put together by banks, which included ABC, Saudi Fransi and Riyad Bank, for Saudi Polyolefins to extend its operations and refinance the debt originally incurred to fund the building of the company’s propylene and polypropylene plants.
The package, comprising a $400m ijara lease and a $175m murabaha contract – under which the client buys items first purchased on their behalf by the financiers – was most notable for the 10-year tenor of its facilities.
This transaction is also interesting because it illustrates the scope for the Middle East’s Islamic investment capacity to be tapped as a tool for refinancing projects, which, in some cases, may have initially been funded on conventional terms.
Not long ago, specialist project lawyers were warning that Islamic institutions were mostly limited to taking on short-to-medium-term exposures, and that this could limit them to secondary supporting roles in project financing, rather than acting as the principal participants. But nine banks proved willing to join the Saudi polyolefins deal.
This was not a one-off. In December 2007, agreements were signed for a $450m (SR1.7bn) Islamic financing of Jeddah’s third container terminal, Tusdeer, which is being developed on a build-operate-transfer basis by a Saudi-Malaysian joint venture, Red Sea Gateway Terminal (RGST). In this case, the deal is structured as an ijara with a 16-year tenor.
“This is a forward lease structure, repaying from port revenues,” says Ziyaad Sarang, director of project finance at South African financial adviser Standard Bank.
It proved entirely possible to raise sufficient long-term funding. “There are a lot of banks and project sponsors that want to move towards Islamic financing and if they structure [a deal] right, there is no problem in mobilising the finance,” he says.
Indeed, it may be that the nature of Islamic instruments fits well with the way a project is put together. “As long as the facility is used to finance assets, this is sharia-compliant,” says Sarang.
“The owner of the assets is the provider of the finance and the lessor is the port operator, who repays this financing over the operating time of the port. The Islamic finance does not change the basic way in which a project financing operates.”
In the case of Jeddah’s container terminal, the decision to opt for sharia-compliant instruments was driven by two factors: the desire of the project sponsor, Xenel Industries, to fund it through Islamic finance; and the fact that the bank that won the competitive bid to finance it, Al-Rajhi, is an Islamic institution – although it bid in partnership with Standard Bank and subsequently decided to syndicate a slice of the deal to Saudi Fransi.
There was some speculation that the use of Islamic finance in larger project deals would be held back by questions of technical cost, because banks and law firms would need to produce two structures and sets of legal documentation: one conventional and one Islamic.
But of course, this issue does not arise when the structure is totally Islamic – which means there is no need for conventional instruments.
Despite the added complexity of combining structures, there has also been growth in the number of blended deals, which include Islamic and conventional elements, although there may be cases where the prospect of added technical costs persuaded project sponsors to opt for one route or the other.
Often, even if the use of Islamic techniques requires some extra technical preparatory work, the added costs are outweighed by the attraction of being able to tap into the con-siderable funding capacity of the Middle East’s sharia-compliant investment and financing market.
The political, social and public relations benefit of ensuring a space in key deals for local investors and key financial institutions that are committed to Islamic finance is another beneficial factor.
In July 2007, the financing for the $2.1bn Kuwait Paraxylene Production Company (KPPC) aromatics project was closed. Kuwait Finance House (KFH) is the only purely Islamic institution out of the 19 mandated lead arrangers.
However, KFH is a major player in the local market. Moreover, the $347m sharia-compliant element of the deal – with Apicorp, ABC, Citibank and ING also participating – represents a significant part of the funding.
An analyst at the lead financial adviser on the deal, Societe Generale (SocGen), says the decision to include an Islamic element was motivated by a desire to diversify funding sources and bring Kuwaiti financial institutions into the deal.
For the plant’s main sponsor, Petrochemical Industries Company, the local dimension is particularly important as it is the first joint venture project it has carried out without foreign partners. Its partners in KPPC are Kuwait National Petroleum Company and Al-Qurain Petrochemical Industries Company.
The instruments used were an ijara and an istisna – under which the financiers develop the project and then deliver it to the client against deferred payment of the sale price.
There have been suggestions that the project business struggles to attract some Islamic institutions because they can earn a better return on their capital in other sectors, notably the booming retail finance market in the Gulf.
SocGen agrees with this analysis to some extent, noting that margins in the Arabian project finance market have been driven down by the influx of competing international banks, whereas this has not happened in the local corporate finance market. However, it points out that project business offers advantages when it comes to risk.
“There have been few if any losses in project finance deals in the Gulf,” says the SocGen analyst. “There are still several Gulf banks that find project finance an attractive business, and more will do so with an increase in margins.”
The extent to which Islamic project finance will grow, however, will vary from country to country. It will also depend on the size of a deal.
The specifics of a transaction will also be crucial. It is perhaps unsurprising that the new $315m Hajj terminal for Jeddah airport has been financed largely on an Islamic basis.
Craig Nethercott, a partner at US law firm White & Case, which is involved in the Hajj terminal scheme, says it is important for the sharia-compliant project finance market because it is one of the first build-transfer-operate concessions. “It provides an Islamic finance product platform from which subsequent infrastructure deals can be done, both in the kingdom and the wider region,” he says.
The specific religious significance of the project can be seen as reinforcing its financial security, as can the fact that the ultimate client is the kingdom’s General Authority for Civil Aviation. However, as a commercial concession, the project will still have to operate on a viable basis, generating an adequate return for its developer, Hajj & Umrah Terminals Construction & Development Company (HTDC), a subsidiary of the Saudi Binladin Group.
Power is another infrastructure sector where Islamic finance is starting to play a significant role. UK-based International Power and CMS Energy of the US were early pioneers in this field, tapping local Islamic institutions to complete the funding package for the Shuweihat power project in the UAE, when concerns after the September 11 attacks in the US made it difficult to raise sufficient money on inter-national markets.
Today, in more favourable circumstances, Islamic banks are being brought in from the outset as part of the core financing plan, and the signs are that this trend will continue.