1. A case study of Islamic project finance The Equate project
This section is largely based on the article “The Equate Project: An Introduction To Islamic Project Finance”, by Benjamin C. Esty, Institutional Investor, Winter 2000, Volume 5, Number 4.
A case study of Islamic project finance
The Equate project
Kuwait, 1996
The Equate Petrochemical Company project involved the construction of a $2 billion petrochemical plant in Kuwait, for which the financing was closed in September The project was a joint venture between Union Carbide Corporation and Petrochemical Industries Company (PIC), a subsidiary of Kuwait's national oil company (Kuwait Petroleum Company, KPC). The plant was financed with $800 million of equity and subordinated debt, $600 million of term debt from international banks with an 8.5-year maturity, $400 million of term debt from regional banks with a 10.5-year maturity, and $200 million of Islamic funds in the form of an Ijara, or leasing, facility ($100 million was allocated to each portion of term debt). This case study focuses on these Ijara facilities and the way they related to the other parts of the financing.

2. The Equate project: an overview
After the Gulf War, the Government of Kuwait started an ambitious programme for economic reconstruction. Contrary to its policy before the Gulf War, it actively looked for foreign partners for the major projects. One of such projects was the construction of a new petrochemical complex, which would help the country to reduce its dependence on crude oil exports. In July 1995, PIC and Union Carbide (one of the world's largest basic-chemicals companies) officially formed the Equate Petrochemical Company to finance, construct and operate a group of new plants. Work on the project had already started prior to that.
The project consists of three separate plants and is located in the Shuaiba Industrial Area near Kuwait City.
One plant, an ethylene cracker, processes ethane gas fuel from a nearby PIC plant into 650,000 metric tons per year (MTY) of ethylene, which is used as the primary input for both the polyethylene and ethylene glycol plants.
The polyethylene plant produces 450,000 MTY of polyethylene, the most widely used plastic in the world, utilizing Union Carbide's UNIPOL process technology.
The ethylene glycol plant produces 340,000 MTY of ethylene glycol used in the production of polyester fiber, automotive antifreeze and engine coolants using Union Carbide's Meteor' process technology.

3. The Equate project: an overview (2)
Work on the project had already started in Construction began in August 1994 financed through a combination of equity and debt from a $450 million bridge loan. By late 1995 the sponsors needed to replace the bridge loan with more permanent financing.
PIC could have afforded to cover the investment from its cash flow, or given that the company had no debts (and neither had its parent, KPC), could have raised corporate loans. But Union Carbide did not want a large exposure to Kuwait country risk. Hence, the sponsors agreed to a project finance structure with most of the funds to come from loans.
Still, the project was not highly leveraged: equity and sub-ordinate debt made up 40% of the funding. PIC and Union Carbide each provided 45%, a publicly traded company formed in June 1995, called Boubyan, would provide the remaining 10%. This would enable Kuwaiti citizens a chance to invest in the project.
There were different options to distribute debt:
bank debt with completion guarantees from the sponsors and with, or without export credit agency (ECA) guarantees (ECAs would normally require sovereign guarantees, which the Government of Kuwait was unwilling to give)
“traditional” securitization
Islamic finance

4. The Equate project: an overview (3)
It was decided to raise most funds through traditional term loans, but to include a relatively small (200 million US$) Islamic portion - given the still relatively new character of Islamic finance, it was felt that it would be difficult to raise much more than this.
It was not yet clear what form this Islamic finance would take. The project sponsors gave a mandate to Kuwait Finance House (KFH), Kuwait's only Islamic Bank, to explore the options.
An earlier large Islamic/non-Islamic co-financing project, the Hub power project in Pakistan, had included an istisna facility. However, Istisna requires full repayment by, at the latest, the completion date of the structure. At that time, if further financing is necessary, a different arrangement must be used. For example, the billion US$ Kuala Lumpur Light Rail Transit 2 Project included a four-year fixed rate istisna facility for construction. It was later converted into an eleven-year floating-rate Ijara facility.
Istisna
Murabaha
Murabaha, like ijara, requires the bank to acquire existing assets. As construction had already started in 1994, such assets were available. The main problem with Murabaha is that, unless when some complex financial engineering is used, it is fixed rate financing, and banks were not keen to take longer-term fixed rate exposure.
Ijara
Unlike murabaha, ijara is a variable-rate instrument that requires periodic, typically semi-annual, payments with the payment for the next period determined at each payment date. The standard contract sets the lease profit rate based on a benchmark interest rate such as the six-month LIBOR (plus a fixed spread).

5. The Equate project: structuring the ijara financings
The sponsors chose the ijara structure as the most appropriate for the project, and fitting best with the appetite of banks. Now, they had to deal with the complications of using Islamic funds, both in terms of finding willing “Islamic financiers”, and in terms of fitting the Islamic financing into the overall financing structure.
The Islamic investors would own petrochemical assets with environmental and third-party risks. One way to minimize these risks was to place the assets in a special purpose vehicle (SPV) with limited liability. But this had not been tested in court yet, and given the prevalence of Civil Code (which does not recognize “trusts”) in the Middle East it was not clear whether financiers can effectively deny liability through use of such a structure.
Ownership
risks
Giving up
ownership
Are the sponsors willing to relinquish ownership over their assets? In particular, if the Islamic financiers are not from Kuwait, would PIC/KPC be willing to give up ownership over “strategic assets” to foreigners? If not, financiers might be difficult to find.
Owners are normally responsible for the payment of insurance and maintenance expenses associated with their assets; and the sponsors might not have the incentives to take proper care of the assets. One way to solve this problem, though not used here, is to sign a service management contract that obligates the sponsors to pay insurance and maintenance expenses in a timely fashion.
Costs of
ownership

6. Costs of
ownership
Under Islamic law, the “mortgage” of the project facilities is only deemed effective (and thus, enforceable in the case of a default) if during the financing, the financiers take responsibility for all the expenses of preserving the mortgaged property. It is, of course, not practical for the financiers to do this directly. Instead, they have the following possibilities:
to build into the contractual obligations for the project company various covenants relating to this preservation of property.
to appoint the project company as the agent for the financiers in maintaining the facilities.
to arrange, to the extent possible, to pay directly for the outside services undertaken to preserve the property - for example, if an outside security agency is used, expenses can be paid directly by the financiers and the appropriate deductions made through the project’s escrow account.

7. Ownership
risks
Under an ijara agreement, contrary to western leases, the “owners” (that is to say, the Islamic investors) retain responsibility for many of the risks associated with the lease, and in particular:
environmental liabilities
unforeseen circumstances regarding the leased facilities/property.
eventual costs arising from unlawful use of the leased facilities
eventual costs arising from unlawful conditions on a leased site
payment of the taxes on the leased facilities/property.
These risks normally have to be dealt with through a variety of means, including through payment structures (the “owners” have to arrange to make certain payments directly, and then recuperate them from the lessee); covenants in the contract with the lessee with respect to compliance with environmental law, and use of the site; and the provision by the lessee of indemnities for eventual damages.

8. The Equate project: structuring the ijara financings (2)
The Islamic financing tranches also had to fit with the non-Islamic tranches. These issues had to be addressed in the inter-creditor agreement that specified entitlements to cash flows as well as creditor rights in the event of default. Some of the complications:
What
law?
Islamic religious law or English law? And if English law is chosen to govern the transaction, would a commercial court recognize, understand, and respect Shariah principles? In practice, different parts of the financing can be governed under different laws.
In the case of payment delays, Islamic investors cannot charge penalty
interest. This could be very costly if there are significant delays. To solve this problem, liquidated damages were included in the Islamic tranches to ensure equal treatment across the various kinds of debt and to deter payment delinquency.
Penalty
clauses
In case of a bankruptcy, the Islamic investors could claim “their” assets. This would destroy most of the project’s “going concern” value. In a standard intercreditor agreement, such preferential treatment is not permitted. The standard solution is for the Islamic investors to
forego their rights in the event of liquidation or default. To minimize priority issues outside of default situations, the bankers then have to ensure that the drawdown and repayment of Islamic funds occurs simultaneously with the flow of conventional funds.
Events of
default

9. What
law?
In a project financing, financiers generally try to take some form of control over both the assets on the ground and offshore receivables. If the offshore receivables are in western countries, then English law or New York law can be used to govern the various security arrangements (e.g., with respect to offshore accounts, letters of credit, performance bonds, receivables, cash). It should be noted that, as long as the underlying contracts is clear, English law does recognize and respect the Shariah principles laid down in such contracts.
But western law is not likely to be effective for the assets on the ground - an award by a western court can be difficult to enforce in an Islamic country. Thus, it is preferable to ensure that the various security arrangements covering local assets - land, leases, facilities, equipment, approvals and permits, intellectual property, technology licenses - are government by Islamic law.
In practice, this would require financiers to use two Special Purpose Vehicles (or “adl”, agent, in the Islamic terminology). One to deal with the offshore parts of the security arrangements and another to deal with the local parts.

10. The Equate project: concluding the transaction
The financing took one year to put together and structuring the deal was not easy. Nevertheless, it was successful. Bank term loans were eventually raised without ECA guarantees - in effect, the negotiations on this aspect were responsible for much of the delay in the financing. The Islamic financing tranches were successfully placed by two Islamic banks with Islamic investors, in private placements. The transaction was hailed as a blueprint for future “co-financing structures”.
In 2001, Equate refinanced the loan with a new 900 million US$ corporate loan facility. This corporate loan also contained an Islamic tranche.
This section was largely based on the article “The Equate Project: An Introduction To Islamic Project Finance”, by Benjamin C. Esty, Institutional Investor, Winter 2000, Volume 5, Number 4.