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The Equate project: An introduction to Islamic Project Finance
Journal of Project Finance, Vol 5, Issue 4; New York; Winter 2000
- By Benjamin C Esty

    Equate Petrochemical Co


With more than one billion Muslims living primarily in regions with enormous infrastructure needs - the Middle East, Asia, and Africa - there is a growing need to understand Islamic culture, financial systems, and commercial practices. Toward that end, this case study is an attempt to explain the basic tenets of Islam finance as they pertain to project finance and infrastructure development. The Equate petrochemical project, a joint venture between Union Carbide and a subsidiary of Kuwait’s national oil company, shows that co-financed structures can work and creates a template for future deals across the Islamic world.

Full Text:

Copyright Institutional Investor Systems, Inc. Winter 2000

Muslims, or followers of Islam, comprise approximately 25% of the world’s population, and Muslim countries control approximately 10% of global GNP (see Exhibit 1). Because most of the countries with large Muslim populations are relatively poor, as shown by their GNP per capital ratios, one of the biggest challenges facing Islamic countries in the next decade is financing infrastructure development. By some estimates, the potential market for private participation in infrastructure projects in the Middle East alone is $45 to $60 billion over the next ten years. In fact, there are now almost 300 infrastructure projects pending in the Middle East - not counting projects in the oil, gas, and petrochemicals sectors. 1 Although local companies will not be able to finance all of these projects by themselves, they will participate as sponsors, sometimes by choice and other times by regulation (i.e., governments often require domestic participation and control of Strategic resources). Increasingly, the executives in charge of projects in Islamic countries want to finance them according to Islamic religious principles (known as Sharia). At the same time, Islamic investors are looking for long-term investments that are religiously acceptable. The challenge, therefore, is to develop project finance structures that are not only consistent with Sharia principles, but also attractive to international capital providers.

Co-financing is one solution. In a cofinanced deal, the sponsors combine conventional “Western” finance with “Islamic” finance. Because Sharia prohibits interestbased financing, investors must use profit based structures that involve asset ownership in one form or another. Although there are advantages to using Islamic finance, the asset ownership requirement generates several potential complications in deal structuring and project management. This article describes some of the permissible structures, the potential complications resulting from co-financing, and some of the generic solutions.

But rather than simply describe the various structures and complications, I illustrate them through a case a study of the Equate Petrochemical Company, a $2 billion petrochemical plant in Kuwait that closed in September 1996 The project is a joint venture between Union Carbide Corporation and petrochemical Industries Company (PIC) a subsidiary of Kuwait’s national oil company. The name Equate is based on the concept of “Ethylene Products from Kuwait” (Ethylene-Kuwait), the letters E and Q also stand for Excellent Quality. The plant was financed with $800 million of equity and subordinated debt, $600 million of tern 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 tranche of tern debt). In this article, I describe not only the Ijara structure and the rationale for its use, but also the two other most commonly used structures - Istisna and Murabaha. After describing the general principles of Islamic finance, the project, and its co-financed structure, I conclude with a brief update on the project since closing and a quick overview of some other recent co-financed deals.


Islam is the world’s third monotheistic religion and comes from the same Semitic heritage as Judaism and Christianity. From the very beginning, Islam acquired its characteristic ethos as a religion uniting both spiritual and temporal aspects of life, seeking to regulate not only an individual’s relationship with God, but also human relationships in a social setting. As a result, Islamic law and secular institutions govern both individual behavior and societal interactions in addition to Islamic religious principles.

The Arabic term Islam, literally “surrender,” illustrates the fundamental religious belief that followers must surrender to the will of God, or Allah. The will of Allah is made known through the Qur’an, the sacred scripture which Allah revealed to his messenger, Mohammed. Mohammed’s sayings and deeds, collectively known as the Sunna, are codified in the Hadith. The Surma provides an interpretation and explanation of the Qur’an. Together these and other sources establish a set of guiding principles for Muslims known as the Sharia (Sharia is derived from the word meaning path.) Rather than a codified body of law, the Sharia is an ever-expanding interpretation of religious law. Only those believers whose lives conform to Sharia will be granted entrance to heaven.

Sharia has three main prohibitions that create distinctions between Islamic finance and ‘Conventional” or “Western” finance.3 One of the most important features of Islamic finance, and probably the only feature known by most people, is the scriptural injunction against interest, or Riba. Interestingly, the Qur’an condemns Riba, but provides little explanation of what the term actually means. In fact, the Arabic term Riba, a noun, means any payment in excess of the original principal, which can be interpreted as any form of interest payment. This prohibition is intended to prevent exploitation and to maximize social benefits; it highlights Islam’s emphasis on social welfare over individual welfare. Instead of interest, profit is the just return for someone who accepts the risks of ownership. The emphasis on asset ownership biases Islamic finance towards equity structures. Despite this orientation, project finance, and hence this article, is largely about debt finance. Sharia also declares uncertainty, or Gharar, in contracts as un-Islamic. Analogies, which are commonly used to explain Sharia principles, illustrate the importance of certainty.

Basically, you cannot sell what you do not own or cannot describe in accurate detail. Thus, you cannot sell fish in the sea prior to catching them because you cannot describe them in sufficient detail (i.e., in terms of type, size, and amount). The subtle difference here is that the former relies on the occurrence of an uncertain event for its fulfillment. Islamic law also declares gambling, or Maisir, as unacceptable because it can lead to immorality (the compulsion to gamble) and other social evils such as poverty. This  restriction has direct implications in the dealings of modern financial instruments such as futures and options, which may be deemed illegal due to their speculative nature.

Given the link between religious principles and secular life, Islamic countries have developed financial institutions that provide Sharia-consistent products and services. Although the history of Islamic banking goes back hundreds of years, it did not begin in its modem form until the middle of the twentieth century. The first Islamic financial institution, a small Egyptian institution named Mit Ghamr Local Savings Bank, was formed in 1963. Early development was slow and did not accelerate until the creation of the oil boom during the 1970s created a larger segment of wealthy citizens looking for ways to invest their savings in accordance with the Sharia. During this period, several Islamic financial institutions were created including the Islamic Development Bank in jeddah, Saudi Arabia in 1974, and the Dubai Islamic Bank in 1975. Renewed interest in fundamental Islamic principles through the 1980s and 1990s further spurred the demand for Islamic financial institutions.

By 1997, there were 176 Islamic financial institutions, with $148 billion of assets, operating in over fifty countries. Although these institutions are often collectively referred to as Islamic banks, this term is somewhat of a MISnomer because it includes commercial, investment, and development banks. Of the total, there are approximately sixty Islamic banks holding $80 billion of assets. Exhibit 2 shows the growth of Islamic financial institutions from 1993 to 1997. While the compound growth rate of assets has been almost 30%, the market is expected to grow at 15% per year for the next several years. Exhibit 3 shows the, geographical distribution of these institutions as of 1997. As one might expect, the majority of the institutions and the assets are in the Middle East. It is interesting to note that the largest institution as of 1997, the $22 billion Bank Melli Iran, was roughly equal to the fiftieth largest U.S. bank holding company at the time.

Islamic banks differ from their Western counterparts in two important ways. First, they conduct business in an interest-free manner to avoid Riba. The relationship between Islamic banks and their customers is not the standard one of creditor and debtor, but rather one of the sharing in financial risks and rewards. A second difference is the fact that profit is not the sole purpose of an Islamic bank. These banks must ensure that funds are invested in accordance with religious principles. A Sharia advisory committee, comprised of Islamic jurists, oversees the operations of each institution. These committees, which range in size from one to seven members, typically meet quarterly to discuss specific products and transactions.4 It is the committee’s job to determine what is permissible, or halal, and what is unlawful, or haram. Like public accounting firms, they provide annual reports in which they assess whether an institution has “acted in compliance with the rules and regulations of the Islamic Sharia.”


Caption : EXHIBIT 1


Caption : EXHIBIT 2


Caption : EXHIBIT 3

Historically, different Sharia committees, or boards, have disagreed on the permissibility of various structures. According to one lawyer:

We have come up with a structure that has been approved by an Islamic institution and its Sharia board and we have tried using the same structure for another client and it is found to be completely unacceptable.5

Recently, there has been an attempt to harmonize Sharia standards and guidelines across institutions. One major step toward this goal was the creation of the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAO1FI) in 1991. This organization has helped build consensus on a number of issues and narrowed the scope of disagreement on others

Despite its global growth, the development of an Islamic financial sector has permeated countries in varying degrees In some countries with Islamic governments (e g Pakistan Iran and Sudan), the entire economic system has aligned with Islamic principles.6 More moderate governments (Bahrain, Brunei, Kuwait, Malaysia, Turkey, and United Arab Emirates) embrace Islamic banking through support of a dual banking system with conventional banks. Other countries such as Egypt, Yemen, Singapore, and possibly Indonesia, neither support nor oppose Islamic banking. And finally, there are countries that actively discourage the creation of a separate Islamic banking sector (Saudi Arabia 7 and Oman).

As of the late l990s, the growth and development of Islamic finance is well underway. Several recent developments support this contention. For example, the Islamic Development Bank recently announced the creation of a $1.5 billion Infrastructure Fund to finance projects in member countries according to Islamic religious principles.8 Recognizing the growing demand for Islamic equities, Dow Jones recently created the Islamic Market Index (PJIM) which tracks 600 companies whose operations conform to Sharia principles. Major financial institutions such as Citibank and HSBC Group, also recognizing the trend, have recently set up Islamic finance divisions to serve this growing market segment. Another manifestation of the growing interest in Islamic finance is the increasing number of trade groups and research organizations dedicated to collecting and disseminating information about Islamic finance. One such example is the Harvard Islamic Finance Information program (HIFIP) which was founded in 1995.9And finally, there have been several billion-dollar projects in recent years, including the Equate Petrochemicals Company and the Thuraya telecommunications project, that have utilized Islamic fluids.


PlC and Union Carbide officially formed Equate in July 1995, to finance, construct, and operate a $2 billion petrochemical plant. The project was part of the Kuwaiti government’s economic strategy in the wake of the Gulf War. Exhibit 4 shows the large decline in real GDP, oil production, population, and perceived credit quality (the Institutional Investor country risk rating) between 1990 and 1991, and the partial recovery by 1995. Following the War, the Kuwaiti government wanted to develop stronger political and commercial ties with coalition countries as a way to express gratitude and ensure future domestic security. This desire to promote foreign investment changed Equate from a PlC-only project into a joint venture with Union Carbide. But the project had other benefits. Kuwait wanted to limit its dependence on oil production and refining, and it wanted to attract foreign capital given the deficits created by government expenditures on reconstruction. Consistent with the countries economic strategies, PlC chose Union Carbide, one of the world’s largest basic-chemicals companies with joint ventures around the world, as the project’s other sponsor because of its technology and access to world Petrochemical markets. From Union Carbide’s perspective, it saw the Equate project as an opportunity to use its proprietary processing technologies and to source low-cost inputs.

The project consists of three separate plants - one each for producing ethylene, polyethylene, and ethylene glycol - and is located in the Shuaiba Industrial Area near Kuwait City. Exhibit 5 provides an overview of the project. The first plant, an ethylene cracker, processes ethane gas fuel from a nearby PlC plant into 650,000 metric tons per year (MTY) of ethylene, which then 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.

The sponsors hired Fluor Daniel to manage the entire project and to construct necessary utilities and related infrastructure. They began construction in August 1994, financed through a combination of equity and debt from a $450 million bridge loan. By late 1995, they needed to replace the bridge loan with more permanent financing.


Union Carbide and PIC resolved two major issues regarding the permanent financing relatively quickly. Both wanted to use project finance, but for different reasons. PlC wanted to facilitate the involvement of a foreign partner even though it could have financed the deal on its own balance sheet - neither PlC nor its parent KPC had any debt. Union Carbide, on the other hand, wanted to use project finance to lin-Lit its Kuwaiti exposure, especially given the Gulf War. The sponsors also reached early agreement on the project’s capital structure: 40% of the funding would come in the form of equity or subordinated debt (including subordinated debt, the project had a debt to total-capital ratio of 85%). PlC and Union Carbide each provided 45% of the equity. Boubyan Petrochemical Company (Boubyan), a publicly traded company formed in June 1995 to give Kuwaiti citizens a chance to invest in the project, provided the remaining 10%. Exhibit 6 describes the project’s sources and uses of cash. .

A more difficult question was what kind of debt to use. The project’s financial advisors, Chase Manhattan, J.P Morgan, and Chemical Bank, argued for bank debt with completion guarantees from the sponsors and export credit agency (ECA) guarantees from organizations like the United States Export-Import Bank (US Exim), Hermes, and SACE. In addition to term loans, PlC wanted use $100 to $500 million of Islamic funds, assuming it could be raised on competitive terms. On the one hand, tapping the Islamic capital market would provide an alternative source of funds, albeit a relatively small one given the current size of the Islamic banking market. A second, and more important reason for using Islamic finds was, to quote a banker who worked on the project, the deal’s “optics”. After all, this project was in an Islamic country with a government-owned entity as one of the sponsors. Structuring the deal Islamically (at least in part) would make it more socially acceptable to Kuwaiti citizens and investors.

At the time, however, there were few precedents for Integrating Islamic and conventional funds in a single, project-financed deal. In fact, the first major co-financed transaction was the $1.8 billion Hub River power project in Pakistan. This project used a $92 million Istisna’ facility during the construction phase provided by Al-Rajhi Banking and Investment Corporation. An istisna is a commissioned or pre-manufacture finance facility; see below.” When asked why they decided to use the Istisna’, a banker replied, “The Islamic facility was available quickly ... it was competitively priced and was responsive to the project’s financing needs. “12 Unfortunately, and somewhat unfairly, this deal tarnished co-financing as a financial structure because the closing was delayed by more than four years due to political factors. Nevertheless, Euromoney named it “Deal of the Year” in 1994, in part because it proved the feasibility of co-financing as a financial structure. Based on this and other smaller deals, PlC wanted to include a tranche of Islamic funds. It awarded a mandate to arrange the funds to Kuwait Finance House (KFH), Kuwait’s only Islamic Bank.

In structuring the Islamic tranche, KFH could have chosen one of three main structures: Istisna’, Murabaha, or Ijara. While each had advantages and disadvantages depending on the application, KFH’s job was to select the most appropriate structure and to resolve any complications resulting from the use of Islamic funds. In the words of an Islamic investment banker who worked on placing the Islamic funds with investors:

The way to understand Islamic finance is to replace the word Islamic with the word structured. Like an structured finance deals, you have constraints that must be overcome with creativity and innovation. Here, the constraints are based on the principles of Sharia. The question is how to structure the deal given these constraints.

The first approach would be to follow Hub River and use an Istisna’ contract in which one party contracts to manufacture an asset for another party according to detailed time and product specifications. To avoid prohibitions against Gharar (uncertainty), the assets involved had to be describable in great detail. The most common structure for construction finance is known as a ‘back-to-back” Istisna’, which placed a financial intermediary such as an Islamic bank in the middle of the transaction. Under the first Istisna’ (the sale contract), a customer agrees to purchase an asset from the Islamic bank upon completion. The purchaser can pay the bank in advance, at completion, or over time based on a set of pre-determined completion milestones. Under the second Istisna’ (the “hire to produce” contract), the Islamic bank agrees to pay the manufacturer to build the asset in question. As an intermediary, the Islamic bank accepts the manufacturer’s performance risk and the buyer’s payment risk. The major advantage of an Istisna’ facility is that it is a fixed-rate contract with the profit margin set at signing. The major disadvantage with an Istisna’ structure is that it is for construction financing, not permanent financing and would expose the project to refinancing risk. Thus, it was not appropriate in this case because the sponsors needed permanent financing.

For post-construction financing, the sponsors could have used either a Murabaha (cost-plus financing) or an Ijara (leasing) contract. Both structures require ownership of dedicated assets. Because construction was well underway by the time the sponsors were looking for permanent financing, there were assets available to “ring fence” for the Islamic tranche. In a Murabaha contract, an Islamic bank purchases an asset and re-sells it for a higher price at a later date - hence the term “cost-plus financing.” While the parties negotiate the deferred sale price in advance, the Islamic bank typically collects the actual payment as a bullet at maturity or on an installment basis depending on the contract. Murabahas are fixed rate instruments, which is an advantage from a borrower’s perspective). From an investor’s perspective, however, a Murabaha contract is like investing in a risky, fixed-rate, zero-coupon bond; they are exposed to ownership risk between the time they buy and sell the asset. Dollar denominated Murabaha contracts typically have maturities ranging from one to three years while Kuwaiti dinar-denominated contracts can have longer maturities as long as investors are willing to assume interest-rate risk.

Although short-maturity structures were indicative of lending conditions in Kuwait in 1996, they are still quite common in most Islamic financial markets. In fact, at the time the deal was financed, 90% of the Kuwaiti Central Bank’s bills and bonds had maturities of less than two years; none had a maturity of more than three years.

Banks, too, were reluctant to make long-term investments in part because there was no Islamic Central Bank (the Central Bank did not follow Sharia principles explicitly) and in part because they had few long-term liabilities to offset the assets. A quick look at KFH’s asset liability mix, as an example, illustrates several important features of Islamic banks (see Exhibit 7). As of 1995, a large fraction of its assets and liabilities would mature within one year. Even the assets that matured after one year were really not long-term assets as a western banker might think of them. Most had maturities of less than four years. 13 That said, not all the short-term liabilities were really short term even though they were classified as such. They are more like rate insensitive core deposits.” Second, KFH was able to reconfigure its maturity structure in a relatively short amount of time. Between 1993 and 1995, the percentage of liabilities maturing within one year decreased from 70% to 34% as concerns over the Gulf War began to fade. Third, KFH had a potentially serious mismatch problem: the fraction of short-term assets was growing while the fraction of short-term liabilities was shrinking. While these changes reduced its liquidity risk, they exacerbated its interest-rate risk. From this perspective, KF.H should have been interested in booking long-term assets such as a long-term Murabaha or Ijara. The choice between the two depend on whether it had fixed- or variable rate liabilities. Its reluctance to book long-term assets stemmed from a combination of not wanting to book fixed-rate assets (Murabahas) or extend long-term credit given the country’s political, and economic fragility following the Gulf War.

The final option was to use an Ijara contract, or financial lease, In an Ijara facility, the Islamic purchases specific assets and then leases them to the project company for a period of time. To qualify for an Ijara contract, the assets had to be separable and have economic value unto themselves. Here, Islamic scholars use the analogy of bicycle tires. You cannot lease finance the construction of bicycle tires using an Ijara contract because the tires are not useful by themselves. In contrast, you could finance the construction of bicycles using an Ijara. However, identifying specific assets with economic value in a large, integrated project like Equate is not always easy.


Caption: EXHIBIT 4


Caption : EXHIBIT 5


Caption: EXHIBIT 6

Unlike the Murabaha structure, the Ijara s is a variable-rate instrument that requires periodic, typically semi-annual, payments. According to the contract, the payment for the following period is determined at each payment date. The standard contract sets the lease profit rate based on a benchmark interest rate such as six month LIBOR (plus a fixed spread). As with a conventional financial or capital lease, the project company treats the leased assets as if it had purchased the asset itself. The lease obligation appears on its balance sheet as a long-term liability offset by a depreciating fixed asset. At the end of the Ijara, the project company takes ownership of the leased asset for a. nominal charge. While the Ijara described here - a fully amortizing lease with leases residual value is the most common structure, there are other kinds of leases (operating leases, leases with residual value, etc.). While all three structures - Istisna’, Murabaha, and Ijara - could have been used to finance Equate, the sponsors chose the Ijara structure as the best compromise between what they wanted and what investors were willing to provide. They selected several furnaces, boilers, and other related equipment as the basis of the lease.

The sponsors’ decision to use Islamic funds created a number of complications, particularly with regard to managing the project and structuring the intercreditor agreement. For example, because the Islamic investors would own the assets, they would bear ownership risk. In some cases, the ownership risk could be substantial. The common example given by lenders was, ‘‘What would happen if you owned an airplane that crashed n a major city?” For a petrochemical plant, there were equally serious 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. Because such a structure had not yet been tested in a major litigation, it was unclear whether a court might “pierce the corporate veil” and assert liability on the deal’s Islamic investors.

A second issue involved the selection of assets for the Islamic tranche. The sponsors had to be willing to relinquish asset ownership In certain circumstances, this decision was not easy. Some countries believed that natural resources were strategic assets and were unwilling to permit foreign ownership of those assets. If Kuwait imposed such a restriction, the pool of available investors would shrink considerably.

A third issue involved the payment of insurance and maintenance expenses associated with the Islamically financed assets. 14 The separation of asset ownership and use or control creates incentive problems in the same way that drivers are less careful with rental cars than they are with their own cars - a problem known as moral hazard. In fact, even though the Islamic investors knew nothing about running a petrochemical plant, they technically would be


Caption : EXHIBIT 7

responsible for maintaining the assets in working order and insuring them against loss. One way to solve this problem, though it was not the solution here, is to sign a service management contract that obligates the sponsors to pay insurance and maintenance expenses in a timely fashion.

There were also complications associated with trying to integrate Islamic and conventional funds in a single, co-financed deal. Most of these issues had to be addressed in the intercreditor agreement that specified entitlements to cash flows as well as creditor rights in the event of default. There were the “simple” problems such as which law would govern the contracts - Islamic religious law or english law? Even if they chose English law to govern the transaction, would a commercial court recognize, understand, and respect Sharia principles? Another problem was how to deal with payment delays. Conventional lenders could charge penalty interest, but the Islamic investors could not. Instead, they would have to donate the penalty interest to charity or risk violating Sharia principles. In the event the project experienced significant delays, this inability to collect penalty interest is very costly to Islamic investors. Nevertheless, liquidated damages are regularly included in the Islamic tranches to ensure equal treatment across the various kinds of debt and to deter delinquency.

Actual events of default introduced even more complicated issues. The standard procedure for resolving bankruptcies in the United States is to enforce an automatic stay. A judge then supervises a liquidation in the case of Chapter 7 or a reorganization in the case of Chapter 11. In both cases, the goal is to maintain a common pool of assets to ensure maximum liquidation or going-concern value. For an integrated production facility like Equate, the assets would be virtually worthless if they were liquidated piecemeal. Because the Islamic investors would own specific assets, they could claim those assets in a default situation. While they might come out whole, they could destroy the project’s going-concern value in the process. This kind of preferential treatment violated the standard pari passu treatment in most intercreditor agreements. Yet other structures that lumped the Islamic and conventional lenders together as a single entity ran the risk of tainting the Islamic tranche. The standard solution was 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 had to ensure that the drawdown and repayment of Islamic funds occurred simultaneously with the flow of conventional funds.

The complexity of co-financed deals makes them potentially more costly to structure and more unwieldy to operate post-completion One Islamic banker complained, “Using Islamic finance is like trying to do something with one hand tied behind your back.” A lawyer from Clifford Chance, echoed a similar sentiment, “If there’s no [specific tax or balance sheet] need for Islamic cash, then people won’t hunt it down because of the added complexity of structuring transactions.” 15


The sponsors closed financing on September 15, 1996. Although they originally had envisioned using an Islamic tranche alongside ECA-guaranteed bank debt, they abandoned the idea of using ECA guaranteed debt after more than a year of negotiations. One of the key sticking points was the ECAs demand for a sovereign guarantee, something the sponsors in general and PIC in particular objected to based on its belief that the project was strong enough to stand on its own. As a result, the sponsors began considering alternative financial structures without ECA involvement, and eventually closed the deal without ECA support. The final deal included two term loans, a $400 million regional bank tranche and a $600 million international bank tranche. Each tranche also included a $100 million Islamic Ijara facility for a total of $1.2 billion of term debt priced initially at 175 basis points (bp) over LIBOR. The International Investor (TII), a leading Islamic investment bank located in Kuwait, and KFH placed $120 and $80 million of the Islamic facility, respectively. While KFH booked some of the Islamic tranche on its balance sheet, both KFW and TH placed funds with investors holding custodial accounts with them.

When the deal closed, it was heralded in the press for many reasons. It was the first project in Kuwait between local and international investors, the first heavy industrial project financed in part by a public share offering, and the first major project since the end of the Gulf War.16 The leading project finance journals commented:

[Equate is] ... the most ambitious effort at blending Islamic and conventional financing .... [it] not only proves the viability of Islamic financing, it also demonstrates that Islamic banks are capable of arranging and funding large regional projects. 17 The Equate deal may prove to be the turning point for Islamic project finance.., it should provide a template for future Islamic-financed projects.18

The Amir of Kuwait officially opened the plant on November 12, 1997. The following month, the sponsors refinanced the project due to declining interest rates and successful completion. The new terms extended repayment on the international tranche from eight to ten years and cut the interest rate to 80 bp over LIBOR, but left the Islamic facility in place though it, too, was repriced.

In its first full year of operations ending June 1999, Equate unexpectedly lost $210 million because of falling crude prices and a subsequent downturn in the petrochemical market - ethylene glycol and polyethylene prices fell 40% and 24%, respectively, in 1998.19 On the positive side, sales volumes were close to projections. The sponsors responded in August 1999 by injecting an additional $710 million into the company bringing total capital up from $277 million to $987 million (KD 86 million to KID 306 million). The recapitalization reduced the leverage ratio to 44% based on the term loans only and 63% based on total debt (term loans plus subordinated debt). The sponsors provided the following rationale for the recapitalization:

The re-capitalization ... is being undertaken to strengthen the capital structure to improve its profitability, which had been negatively affected by the length, depth, and timing of the current trough in the petrochemicals market.20

One measure of the project success, though not necessarily a reflection of the project financial strategy overall, is Boubyan’s stock price. The public subscription or sale of stock took place at 100 fils (1000 fils equals one Kuwaiti Dinar, which equals approximately US$3.26 under current exchange rates). Public trading began in June 1997 at a price of 400 fils, rose to as high as 480 fils, and then fell to 160 fils by September 1999.21 Compared to Equate’s 60% decline from the public offering, the Kuwaiti market index fell 37%. One can attribute the market’s decline, and a large fraction of Equate’s decline, to falling oil and petrochemical prices over the past two years. Interestingly, neither the index nor Equate have re-gained much ground since oil prices have shot up in late 1999.

Despite Equate’s recapitalization and Boubyan’s poor post-issuance returns, KPC has announced plans to construct a second olefins plant, a $1.2 billion aromatics plant, and a $50 million methanol plant by the year 2002 .22 Whether these projects will proceed and whether they will be co-financed remains to be seen.


With more than one billion Muslims living primarily in regions with enormous infrastructure needs the Middle East, Asia, and Africa - there is a growing need to understand Islamic culture, financial systems, and commercial practices. Toward that end, this case study is an attempt to explain the basic tenets of Islamic finance as they pertain to project finance and infrastructure development.

The Equate project showed that co-financed structures can work and created a template for future deals across the Islamic world. In fact, there have been several more co-financed deals since the Equate project closed in 1996. The Kuala Lumpur Light Rail Transit 2 Project, a $1.8 billion infrastructure project in Malaysia, closed in October 1996. It included a four-year, fixed rate Istisna’ facility for construction, which was converted into an eleven-year floating-rate Ijara facility. 23 More recently, Thuraya Space Telecommunications Company, a $1.1 billion joint venture company formed to provide satellite telecommunications services in the Middle-East, closed in July 1999 with a $100 million Islamic tranche as part of a $600 million debt package. Other smaller projects such as the Shuaiba power plant in Saudi Arabia, the TAG and Mersin motorways in Turkey, and the Kuala Lumpur International Airport in Malaysia - have used Islamic financing, but do not fall in the same league as the mega-projects like Equate and Thuraya.

Although the number of co-financed mega-projects is increasing, the pace has been more of a trickle than a flood. The question of how common co-financed deals or totally Islamic-financed deals will become is hotly debated among Islamic bankers. Iqbal Khan, Head of Global Islamic Finance at HSBC in London, commented:

We are clearly seeing new opportunities arising out of Islamic financial institutions’ ability to originate, structure, and document the increasingly complex transactions... (recent developments) give increasing relevance to Islamic finance in the field of project finance. 24

Yet even proponents of Islamic structures have their doubts. A banker from Kuwait Finance House commented:

Islamic finance capital markets are still in the developmental stage. There may be important domestic projects where local Islamic institutions may play a major role but expecting this to happen on a consistent basis or a global or even regional level would be difficult.25

While it is too early to tell which view is right, an improved understanding of Islamic finance in general and Islamic project finance in particular will undoubtedly help the market develop.




The author thanks Mathew Mateo Millett and Fuaad Qureshi for research assistance; Issam Al-Tawari, members of The International Investor, and Iqbal Khan of HSBC Group for helpful comments; The Harvard Islamic Finance Information


Program for data; and the Division of Research at the Harvard Business School for financial support.


1 See Canzi [1999]


2 Much of the background material on Islamic finance comes from Vogel and Hayes [1999]. See also “An Introduction to Islamic Finance,” Harvard Business School.


3 See Allen and Overy [1993]


4. See Vogel and Hayes, p. 49.


5. See Khalill [1997]


6. See Vogel and Hayes, p. 11.


7. The Saudi Arabian government believes that by


declaring certain financial Institutions as Islamic, they would be implicitly branding other institutions as un-Islamic. For this reason, it does not distinguish Islamic banks in the chartering process.


8. The $1.5 billion 1DB Infrastructure Fund L.P. will be managed by the Emerging Markets Partnership, an international private equity firm headquartered in Washington, D.C. (http://www.empwdc.com/).


9. HIFIP can be reached at http://www.hifip.harvard.edu.


10. This information is based on the Harvard Business School case study, “The International Investor: Islamic Finance and the Equate Project” and the corresponding teaching note. Both the case and the teaching note were prepared using public information only.


11. Technically, the Hub River project used two Istisnas. Because the dosing was delayed, the Islamic Investment Corporation f the Gulf (IICG), the Investment banking subsidiary of Dar Al-Maal Al-Islan-il Group (DMI), provided a second istisna to replace the first one.


12. See Khalill [19971.


13. Aggarwal and Yousef [1999] provide additional evi


14. Defence on the short-term nature of assets in Islamic banks.


14. Sharia prohibits conventional insurance because insurance contracts are uncertain. An alternative is to use a mutual insurance structure, or takafol. Under takafol, participants pay a defined amount into a common pool. In the event of an insured event, the participants then donate compensation to the damaged party.


15. “Newcomers Flock to the Market,” Middle East Economic Digest, December 19, 1997, p. 7.


16. “Equate Kick Starts New Era In Kuwait Industry,” Middle East Economic Digest, December 5, 1997, p. 6.


17. Infrastructure Finance,-Aprll 1997, p. 9.


18. “Equate Signals Turning Point,” Project & Trade Finance, July 1996, p. 29.


19. “Equate Losses US $210 m,” Project Finance International, June 2, 1999, p. 5.


20. “Equate to Raise Capital to $987 Million,” Middle East Economic Digest, August 13, 1999, p. 24.


21. Prices are from Bloomberg under the ticker symbol BBPC.


22. “Kuwait to Build Second Olefins Plant,” Deutsche Press-Agentur, April 3, 1999.


23 “Project Financing: Infrastructure Offers Opportunities to Combine Conventional and Islamic Finance,” Middle East Executive Reports, July 1998, Vol. 21, #7, p. 9.


24. Project Finance, October 1998, p. 40.


25. See endnote 24.



Aggarwal, R.K., and T. Yousef ‘Islamic Banks and Investment Financing.’ Journal of Money, Credit and Banking, 1999.


“An Introduction to Islamic Finance” Harvard Business School, Case study #200-002.


Canzl, German. “You Cannot Afford to Walt. Project Finance, July 1999, pp. 18, 20.


Esty, Benjamin C., and Mathew A Millett. “The International Investor: Islamic Finance and the Equate Project.” Harvard Business School case #200-012, 1999.


Islamic Banking and Finance: Memorandum to Clients and Professional Contact of Clifford Chance.” Clifford Chance, London, October 1992.


“Islamic Finance.” Allen & Overy, Dubal, October 1993.


Khalili, Sara, “Unlocking Islamic Finance.” Infrastructure Finance, April 1997, p. 9


Vogel, Frank, and Samuel Hayes, Islamlc Law and Finance: Religion, Risk, and Return. The Netherlands: Kluwer Law International, 1998.

[Author note]

BENJAMIN C. ESTY is an associate professor at Harvard Business School



Muslim Population Statistics 1996


Muslim Population
































Total for top 15 countries


Total Muslim Population


Total World Population


Muslim Percentage of Total


Source http://islamicweb.com/ ,author’s estimates.



Islamic Banking Market – 1993-1997







4-Year Compound Annual Growth Rate

Number of Banks







Financial Statistics($000)

Total Assets







Total Capital







Net Profits







Source “Directory of Islamic Banks and Financial Institutions – 1997.” The International Association of Islamic Banks, Jeddah.



Geographic Distribution of Islamic Banks — 1997


Number of Banks a

Percent of1997

Asset                       Capital

South Asia b








Southeast Asia c




Middle East




Gulf Cooperation Council d




Europe and America




Asia e












Source “Directory of Islamic Banks and Financial Institutions- 1997.” The Internet Islamic Bank, Jeddah

a Includes other Islamic financial institutions such as Islamic investment banks.

b South Asia includes Bangladesh, India and Pakistan.

c Southern Asia includes Brunei, Indonesia, Malaysia and the Philippines.

d The Gulf Cooperation Council is a political, economic, social and regional organization 1981 by UAE, Bahrain, Saudi Arabia, Oman, Qatar, and Kuwait.

e Asia includes Russia and Kazakhstan



Kuwait Economic indicators 1986-1995


Real GDP

(KD billions)

Government Budget Surplus (Deficit)

(KD billions)

Oil Production (millions oil barrels per day)









































Source Economist Intelligence Unit Country Reports, International Monetary



Overview of the Equate Projects



Source Based on published sources and company reports.

Dashed lines signify ownership: bold solid lines indicate product flow.

MTY is metric tons per year. A metric ton equals 1,000 kilograms (kg), or approximately 2,200 pounds (lb).



Sources and Uses of Capital



($ millions)

Percent of Total


Uses of Capital

Construction engineering, materials and equipment



Capitalized interest, closing/financing costs, and other costs



Licensed technology



Preliminary operating expenses



Total Users of Capital



Sources of Capital

Petrochemical Industries Company (PIC):

Equity Capital



Subordinated debt



Total PIC Contribution



Union Carbide Corporation:

Equity Capital



Licensed technology and subordinated debt



Total Union Carbide Contribution



Boubyan Petrochemical Company

Equity Capital



Subordinated debt



Total Boubyan Contribution



Total Shareholder findings



Term Loan Facilities

International Banks



Regional Banks



Islamic tranche

$1,200  60.8%



Total Sources of Capital



Source Author’s estimates based on published sources.



Asset/Liability Management in an Islamic Bank (Kuwait Finance House)



Total Assets

($ millions)

% of Assets Maturing Within One Year

% of Liabilities Maturing Within One Year













Source Kuwait Finance House Annual Reports, 1993-1995

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