The recent global economic crisis, the consequent reduction in the availability of bank financing to fund infrastructure, and shareholder pressure has refocused attention on Islamic project finance.
There is a pressing need in the Middle East for new infrastructure, be it roads and bridges or airports and rail, but most Islamic project financings to date have been in the energy sector.
However, recent trends demonstrate an interesting shift towards airport construction (and other non-energy assets) increasingly being financed on an Islamic basis.
Both the Kuala Lumpur International Airport and the International Terminal at Istanbul’s Atatürk involved large Islamic financing tranches.
Perhaps the largest such involvement was in 2012 when the Saudi Arabian General Authority of Civil Aviation (GACA) issued a 15 billion Saudi Arabian Riyal sukuk (an asset-backed or asset based certificate). The proceeds of which are intended to finance, at least in part, the construction of a new $7.23 billion airport in Jeddah.
GACA subsequently awarded a contract to a consortium of TAV Airports, Al Rajhi Holding Group, and Saudi Oger to build the new $1.2 billion airport in Medina under a public-private partnership agreement involving a build-operate-transfer (BOT) structure.
This financing comprised of Islamic equity participation, forward financing facilities provided by the National Commercial Bank of Saudi Arabia, and, a $750 million syndicated Islamic facility arranged by Sumitomo Mitsui Banking Corporation.
Islamic finance overview
Contemporary Islamic finance is a burgeoning subsector of the international financial markets. The industry is young and hence conclusive data about its growth and assets under management is difficult to obtain, although improvements continue to be made in this regard.
Reliable estimates indicate that the industry is somewhere in the neighbourhood of $1.3 trillion of assets under management with several hundred institutions globally participating.
To properly understand Islamic finance, one must first understand that rules surrounding trade and finance are part and parcel of the religion by which Muslims are to conduct their lives and organise their finances and businesses.
These rules are part of the Sharia, from which Islamic law (and other aspects of Islam) are derived. This derivative process, along with interpretation and subsequent application, is performed by trained Muslim jurists. Islamic finance utilises a structure whereby jurists provide ethical-legal advice.
Islamic finance is in many respects akin to socially responsible investing (SRI). There are what may be termed, substantive principles, that speak to the substance of an investment or, in other words, the purpose for which the capital provided will be utilised.
In practice, the substantive principles are applied to a target company’s line of business, to the assets involved, and to specific activities which the capital may advance. Industries such as gambling or pornography are typically prohibited under these rules.
Perhaps the most conspicuous feature of Islamic finance – and where it differs from SRI – is that the mechanism of financing must also comply with what may be termed as ‘procedural principles’. These include prohibitions against riba (commonly, but incompletely, translated as ‘interest’) and gharar (inappropriate uncertainty).
The rules derived from these two control the manner in which a financing takes place. Here, Islamic law is less concerned with the purposes for which money will be utilised and more so with how, and on what terms, capital is provided.
It should be mentioned that the substantive overlap somewhat with the procedural principles in governing, for instance, how income is generated and how profit and loss (simply speaking)
In its modern, and perhaps most relevant form, the prohibition against riba disallows the earning or paying of any benefit, monetary or otherwise, on a loan of money.
Loans appear to be countenanced by Islam as charitable activities, not as profit-making ventures. This prohibition extends to trading involving certain other commodities, such as gold, silver and foodstuffs.
When these commodities are traded, one for another, the trades must be made in equal measure and without deferral. Because earning a profit without assuming a market or asset risk is unlawful, equity arrangements lend themselves more readily to Islamic finance.
Islamic law demands that entitlement to a return on capital be tied to the successor performance of the subject asset or project.
As for gharar, Muslim jurists generally hold that Islamic law prohibits transactions involving excessive uncertainty. Broadly speaking, this encompasses transactions in which the
asset consideration or other key terms are non-existent or insufficiently specified.
By way of example, it is also deemed to apply to instances of trading in risk, such as derivative instruments, and some conventional insurance policies where there is deemed to be (excessive) uncertainty regarding the aggregate premium to be paid and the amount paid upon realisation of the insured risk.
These concepts of riba and gharar drive the structuring of transactions away from conventional arrangements, such as interest-bearing loans, and call for creativity.
The use of sales and leases is common in contemporary Islamic finance.
Moreover, the presence of an asset is a virtual necessity, and contemporary Islamic finance transactions often present with what is often considered as greater ‘proximity’ to the asset as compared to their conventional counterparts.
Airport and other project transactions can thus be much easier to structure and document than, for instance, the construction of a mere financial product. However, such financings must exist and succeed within a conventional framework.
Islamic financing tranches are usually integrated within a much wider, multi-sourced financing arrangement. This typically involves the Islamic financiers coming in alongside conventional lenders, multi-national development institutions, and credit agencies.
Integrating Islamic financing solutions typically requires the Islamic banks to assume a pro rata and pari passu position with the other, senior conventional lenders while at the same time trying to adhere to Sharia principles.
Islamic construction contracts (in Arabic, istisna) have been used for infrastructure projects, requiring the financiers to enter into a construction contract directly with the contractor. This fundamentally changes the risk profile of a conventional project financing.
So this arrangement has been modified such that the financiers contract with the project company which, in turn, serves as the main contractor and possesses the ability to sub contract. The project company agrees thus to the procurement manufacture and delivery of the asset.
The procurement contract itself acts as a funding mechanism whereby periodic payments may be made to the financiers. A forward lease is sometimes also utilised while construction is underway; leasing begins once the subject asset, or sufficient components thereof, have been delivered.
This enables the financiers to generate a return replicating the economics of a conventional financing. There are, of course, a number of additional complexities and nuances beyond the purview of this article which require careful consideration, including taxation and inter-creditor issues.
The challenge is to develop finance structures consistent with Islamic principles and also attractive to international providers and project sponsors. The potential for reward and growth is significant.