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Case Assignment:
(HBS) The International Investor: Islamic Finance and the Equate Project

Instructor: Dr. David Reeb

Submitted by: Anna Chif Julian Tang Raghav Fatehpuria Tan Pei Zhi


Before evaluating whether an Islamic tranche should be included in the Equate project deal, we first explore the risks and returns associated with the project to determine if the returns are adequate. Once we can determine the appropriateness of the returns, we then move on to discuss the implications of co-financing with Islamic finance, and whether it should be included or not. Risks associated with the Equate Project Default Risk: The total amount to be raised is $1.2 billion. Interest expense is likely to be substantial on such a large amount, and Equate might face difficulties in repaying this loan. Moreover, all parties have decided to go ahead with the loan without securing any ongoing guarantees from the export credit agencies. This means that lenders would not be protected against any commercial risks of non-payment for terms ranging from 7 to 12 years. To exacerbate matters, the prices of petrochemical products are highly volatile as they are dependent on demand and supply. Thus, in the event that demand fall shorts of the 4 6% as expected, prices may fall due to excess supply which will ultimately affect profits and Equates ability to pay off its interest payments. Mitigating Factor: To reduce the default risk, sponsors included a debt service reserve account containing 6 months of principal and interest to cover any payment shortfalls. On top of that, Equate has access to cheap ethane feedstocks guaranteed by the Kuwait government while KPC agreed to subsidize its price in the early years. This helps Equate to keep its costs low and thus allow it to better absorb any adverse change in petrochemical prices. Lastly, Equate can also hedge against the price fluctuations by entering into a futures contract. Unstable Political Situation: The political situation in Kuwait is highly unstable as the war ended only a few years ago. Also, Kuwaits close proximity with Iraq and Iran makes it highly vulnerable to any political unrest within these countries. Moreover, without the guarantees from export credit agencies, this project is subjected to political risks for terms ranging from 7 to 12 years. Furthermore, Kuwait government has been running budget deficits. Despite their attempts to diversify the countrys source of revenue, it is still largely dependent on oil. Separation of Asset Ownership and Usage: The separation of asset ownership and use can cause moral hazard incentive problem, where people take less care of rented assets than if they were to own that asset, causing an operating risk. Since Islamic investors need to own the assets that they are investing in, they would have the ownership of the assets. Thus, they are technically responsible for maintaining the assets in working order and insuring them against loss, even though the user of these assets is Equate. Mitigating Factor: To prevent this incentive problem, Kuwait Finance House (KFH) can sign a service management contract with the sponsors, thereby obligating them to pay for insurance and maintenance. Exchange Rate Risk: Virtually all of Equates products sold would be in dollar-denominated transactions, so movements in the exchange rate would affect Equates profits. Mitigating factor: This risk can be hedged by entering into a futures contract in the forex market.

Interest rate risk: Since interest rates are based on LIBOR, fluctuations in this rate will lead to fluctuations in the interest rate, which can put the firm into financial difficulties should the LIBOR rise to a relatively high rate such as 16% in 1990. Late Payment Risk: Conventional lenders could charge penalty fees, but the Islamic investors could not. Instead, they would have to donate the penalty interest to charity or risk violating the Sharia principles. In the event the project experienced significant delays, this inability to collect penalty interest would be very costly to the Islamic investors, as they would be losing the time value of money. Laws to govern (English vs. Islamic laws): Since it has not yet been decided which laws would govern the contract, it might create an issue if problems arise. If English law is used, Islamic investors might incur risks of the settlement not taking into account Sharia principles. If Islamic law is used, a similar risk will be carried by Western investors. Appropriate Returns for the Equate Project In order to determine the appropriate returns for the project, we did a comparable analysis to evaluate if 7 10% was an appropriate return for the term loan investors. Our starting point was the U.S. Long-term Industrial Bonds in Exhibit 8a as an appropriate benchmark for a similar project such as Equate in the U.S. According to Exhibit 2, it was stated that Kuwait had a credit rating of 53.4 while Saudi Arabia had a credit rating of 55.6. Given that the credit scores were similar and Saudi Arabia was perceived to be investment grade, we infer that Kuwait would also be of investment grade. Thus, given the interest that the Kuwait government had in Equate, we assumed that the credit rating of Equate would be equal to the countrys credit rating. To be conservative in our estimates, we take the lowest investment grade of BBB and the yield corresponding to that would be 7.451%. Next we factor in the risk that entails the Equate project and according to the case, which would be a premium of 160 200 basis points (bp). Our assumption here is that the 160 200 bp does in fact account for all the risks mentioned above. Adding that to our benchmark, we get an estimate of 9.05 9.45%. This is towards the higher end of the 7 10% mentioned in the case. From the case, we know that the interests on the term loans would be 160 - 200 bp over LIBOR. Looking at Libor over the past 10 years, it averages around 10%. Thus the yield that investors will expect to receive would be 11.6 12.0%. Since investors are likely to receive more than the 7 10% mentioned as well as our estimate of 9.05 9.45%, we conclude that the returns on the Equate project are appropriate and even in excess of the risk undertaken. Decision on the Islamic Tranche The inclusion of an Islamic tranche in the capital structure of the project involves various benefits as well as disadvantages. After evaluating both sides of the argument, we feel that there should be an Islamic tranche included in the project. Let us first analyze difficulties related to including an Islamic tranche. First, there would be a potential conflict of governance if an Islamic tranche was included. This conflict of governance would stem from the attempt to integrate Islamic and conventional funds into a single, co-financed deal. There would also be problems with deciding on the positioning of the tranche to tackle the issue of interest payments and deciding on which assets are to be held by the Islamic investors. The project would also become more complex if an Islamic tranche was included. One of these complexities is dealing with payment delays. Islamic investors could not charge interest as it was in violation of the Sharia principles. Thus, in the event that the project

experienced significant delays, the implicit cost of not earning on the time value of money would be costly to Islamic investors. On top of that, in an event of a default, the presence of an Islamic tranche would pose a problem for the other investors as the Islamic investors have ownership over specific assets of the project. The sale of these assets would be beneficial to the Islamic investors but would jeopardize the projects ability to continue as a going concern. On the other hand, we feel that there should be an Islamic tranche included because we have to keep in mind that the project is taking place in Kuwait, a place where it would be more socially acceptable to investors if the project was financed using Islamic financing. Also, the Equate project is a government led project, and hence, it would be advisable to add an Islamic tranche to generate more popularity and acceptance. Furthermore, the Equate project is of a substantial size and if co-financing is successfully carried out, it would send a message to the investment community that Islamic finance is a viable source of finance for large projects. It would also assure Islamic investors who are looking to invest in projects that they would be able to do so in accordance to the Sharia principles. These factors would constitute the deal optics as mentioned in the case. Despite the challenges which co-financing brings about, we argue that the long term benefits for Islamic finance would outweigh the short term challenges of this particular deal especially if they are dealt with properly (e.g. signing a service management contract with the sponsors obligating them to pay for insurance and maintenance thus overcoming the issue of moral hazard). Having concluded the need to include an Islamic tranche, we now have to decide on which kind of tranche would be advisable. Since construction has only just begun, it would be difficult to identify assets that would be separable and their economic value. Since there are no assets that could be identified clearly, the sponsors would not be able to use the Murabaha or Ijara contract to finance the construction phase of the project. Thus, we suggest adopting the Istisna contract to finance the construction of the plant itself. Upon completion, Equate would have to purchase the completed asset from the bank. Following this, Ijara or Murabaha would be appropriate to finance the equipment that Equate would need to purchase for production of the petrochemical products. At first glance over Exhibit 7b, it seems to suggest that the Ijara structure is not as popular as the Murabaha structure since it trails by the Murabaha structure by 50% in KFH and 36% in Average Islamic banks in GCC Countries, in terms of the various financing methods used. This would suggest that there is not much familiarity with using this method of financing. However, while deciding on the financing of this project, we need to take into consideration the requirements of various stakeholder groups. Using the Murahaba contract would mean a fixed income whereas Kuwait Finance House wanted to follow a variable structure as they wanted the Islamic tranche to follow the structure of the commercial loans closely. Since Ijara was variable in nature, it would achieve this goal for Kuwait Finance House. A potential query at this point could be as to what assets these Islamic investors would have claim over. We feel that since the project is a petrochemical plant, these would be instruments such as furnaces and boilers that could be held by these investors. This would comply with the Islamic principles as well since these have a value in themselves.