Project Finance

There are many definitions for project finance.

Finnerty (1996, p. 2) defines project finance as:
. . . the raising of funds to finance an economically separable capital investment project in which the providers of the funds look primarily to the cash flow from the project as the source of funds to service their loans and provide the return of and a return on their equity invested in the project.

Nevitt and Fabozzi (2000, p. 1) define it as:
A financing of a particular economic unit in which a lender is satisfied to look initially to the cash flow and earnings of that economic unit as the source of funds from which a loan will be repaid and to the assets of the economic unit as collateral for the loan.

The International Project Finance Association (IPFA) defines project finance as:
...the financing of long-term infrastructure, industrial projects and public services based upon a non-recourse or limited recourse financial structure where project debt and equity used to finance the project are paid back from the cash flow generated by the project.

The above definitions mainly describe project finance from the debt perspective i.e. as a loan transaction.

Mechanics of a Shariah based project finance:

If a project is financed under the contract of Istisna, the project sponsor or initiator shall award the construction job to a contractor and the contractor will be paid according to the agreed terms, be it progressively, periodically or bullet payment at satisfactory completion etc. The price paid will include the contractor’s profit margin.

The project sponsor/initiator may raise the funding for the project via a Mudharabah or Musharakah arrangement whereby investors are invited to participate in the project. The returns from the Mudharabah or Musharakah venture cannot be predetermined and it shall be sourced from the cash flow or revenue of the project. It is therefore acceptable that no returns will be earned during the construction and pre-operating period. The project is owned by the Mudharabah or Musharakah investors/venture and upon completion; they may lease the asset for rental income or sell the asset for profit.

Ijarah Mausufah Fi Dhimmah is an arrangement whereby the financiers of a project are able to earn the lease rental during the construction period in the form of advanced lease. The setback of this arrangement is that should the project stall or fail, the owners will have to repay the Lessee(s) the advance lease paid.

There is always a completion risk in project financing. Should the project fail to be completed, the contractors should be paid what is due to them based on the work done. The Mudharabah or Musharakah investors will then share, according to their respective rights; the proceeds form the disposal of the project. The investors have no recourse to claim the full amount of their investment unless fraud or negligence on the part of the contractor or project manager is proven.

The main difference between Shariah based PF and conventional PF are;

(1) Ownership of assets (project)
Under conventional financing the project is held as collateral and the financers can claim from project sponsors for any shortfall in repayment.
Under Shariah financing, the asset/project is owned by the financiers and therefore they can only claim up to the value of the asset/project or the outstanding lease rental and nothing more.

(2) Returns from financing
Conventional financiers are repaid a fixed, predetermined payment over a specified period regardless of the profitability of the project. Any overdue payment will be charged a penalty and a default will force the asset to be forced-sold to recover the debt. Any shortfall will be met by the project sponsor.
Under Shariah financing, the investors are paid returns only when the project has positive cashflow. They can only claim for payment if fraud or negligence on the part of the contractor/project manager is proven.

(3) Risk
Conventional project financing places the construction, completion, market risks on the borrower and the bank (financier) only assumes the credit risk of the borrower.
Shariah financing distributes the risks amongst all the parties involved in the project. No one party can be insulated from the risk, unless fraud and negligence is proven.


Having being so used to earning predetermined returns with some recourse, banks would naturally be hesitant to finance projects the Shariah way. To overcome this, Shariah based project financing has to be marketed differently, highlighting the merits of risk-reward sharing and equitable distribution of income.

Vulnerability of Islamic finance exposed?

Sukuk defaults expose vulnerability of Islamic finance

MANAMA/KUALA LUMPUR: First defaults of Sukuk are set to expose the vulnerabilities of Islamic finance, with most investors expected to have no better legal redress than conventional bondholders as underlying assets have not been truly transferred to them.

The current financial and economic crisis is a first for the $1 trillion Islamic finance industry, which over the past few years has been spoilt by cheap oil money, and legal provisions and protection clauses in Sukuk worth billions of dollars are being tested for the first time.

Islamic bonds, or Sukuk, are structured as profit-sharing or rental agreements and their returns are derived from underlying assets. Islamic finance caters to investors who would like to avoid paying or earning interest, prohibited by Islamic law.

Kuwait’s Investment Dar said in May it had defaulted on a $100 million Sukuk registered in Bahrain and in the United States a court case is ongoing on the East Cameron Partners Sukuk by bankrupt Texas-based East Cameron Gas Company.

Despite its earlier billing as a safer alternative to traditional banking due to its requirement for assets to underpin deals, Islamic bondholders may not have any more legal safeguards than conventional counterparts in case of default.

With rare exceptions, Sukuk issuers have created special purpose vehicles (SPV) to pool assets underlying the issue, but they have not been securitized for a true sale to investors.

“Secular, non-Shariah courts upholding those structures are more likely to consider Sukuk holders to have contractual rights as opposed to proprietary rights and as a result rank them as creditors rather than equity holders,” said Muneer Khan, partner and head of Islamic finance at law firm Simmons and Simmons.

A $650 million Sukuk issued by troubled Saudi group Saad, which is undergoing debt restructuring, for example is seen as an asset-based, rather than an asset-backed, Sukuk. Yields of the Sukuk jumped to above 70 percent in mid-June, as investors feared a default of the issue.

Most Sukuk are structured as asset-based instruments, rather than asset-backed securitization where “you always have a claim for that particular asset that has been sold to you as the investor”, said Megat Hizaini Hassan, an Islamic banking lawyer in Kuala Lumpur.

“Everybody is chasing the same assets if they have not been transferred to the name of the Sukuk holders,” said Samer Amro, senior associate at law firm Dewey LeBoef. Other uncertainties are likely to arise from Sukuk defaults, including a debate about how courts will interpret repurchase clauses which are structured to follow a controversial ruling by prominent jurist Sheikh Muhammad Taqi Usmani in late 2007. Taqi had ruled that repurchase guarantees found in most Sukuk contradict Islamic laws, as they violate the principle of sharing risks and returns.

“If you’re looking at the newer structures where the repurchase obligations are left to be determined at the time of repurchase, there may be some issues there,” said Megat Hizaini. “You don’t really know how the courts will treat it in the situation,” he said.

Islamic finance is governed by scholars’ rulings, national regulators and its own standard-settings bodies such as Bahrain-based AAOIFI, the Accounting and Auditing Organization for Islamic Financial Institutions.

“In the Middle East, it’s going to put to the test many of the legal protections that were originally built into the Sukuk,” said Mohammad Faiz Azmi, global Islamic finance leader at PriceWaterhouseCoopers, adding that countries in the region typically do not have bankruptcy laws as sophisticated as in Europe.

“When these Sukuk start to default, it would be very apparent which jurisdiction has a more robust system than others,” he said.

Corporates with perceived higher risks that are facing high borrowing costs and a sluggish regional IPO (initial public offering) market could use true Sukuk sales with full ownership transfers as an avenue to the capital markets.

“It adds some credit-enhancement, it adds credit-worthiness,” said Rizwan Khan, a senior associate at law firm Norton Rose.

But the paperwork involved in registering ownership transfers in the Gulf Arab region and restrictions on foreign ownership of land make true Sukuk sales difficult.

Issuers have to register the SPVs, to which asset ownership would have to be transferred, in Bahrain or the Cayman Islands, as regulatory frameworks in other Gulf countries like Saudi Arabia and Kuwait do not fully cover Sukuk structures. This turns the SPV into a foreign buyer, limiting the pool of assets.

“This is not going to change unless laws are enacted, in particular on the ownership issues,” Khan said.

Source: Reuters, Monday 20 July 2009 (27 Rajab 1430)


The article above highlights and proves how identical the Sukuk is with conventional bonds as most investors are not expected to have better legal redress than conventional bondholders as underlying assets have not been truly transferred to them. This will lead to Islamic bondholders not having any more legal safeguards than conventional counterparts in case of default because their structure is merely asset-based and not asset-backed where they have a claim for that particular asset that has been “sold” to them. To make it worse, the courts may regard the Sukukholders as mere creditors instead of equity holders.

A good way to address this issue is to ensure that future Sukuk issuances be done in the true Shariah spirit, especially when it comes to asset ownership. The transfer of assets in such transaction must not be done just for the purpose of making it “Shariah compliant”. In a Shariah based structure, the equity element is always present, the debt element comes later. It is not possible to structure a debt based Sukuk without having equity ownership first.

Standardisation of Shariah Rulings

Bank Negara Malaysia introduced the “Shariah Parameters” with the objective of providing a comprehensive understanding of the principles and basis of adopting Shariah contracts for Islamic finance products in order to standardise the Islamic finance practices. The parameters are designed to clarify concepts, principles and conditions of Shariah contracts and provide the basis for decisions on matters relating to conditions, mechanisms and implementation of Shariah contracts.

Standardisation does not mean restrictions. It simply means things are done in a more consistent manner, avoiding confusion and disputes. I would think reaching a consensus on Shariah rulings would not be such a big problem as many scholars are already sitting on committees in different “Shariah jurisdictions”,* which often come up with different fatwas/rulings.

Standardisation will also enable a better understanding of Shariah based finance among the newcomers to the industry. It will eliminate confusion and make it easier to grasp the principles that govern the industry. Documentation and structures will be more comprehendible and legal disputes can be settled in a more orderly and consistent manner.

Will standardisation create a straightjacket and stifle creativity? I doubt so. In fact it will enable creativity to be undertaken more systematically in the presence of consistent guidelines and parameters.

With this standardisation, a Shariah decision made in Bahrain, Abu Dhabi, Kuala Lumpur or even London will be understood, accepted and applicable globally. This will enhance the efficiency and effectiveness of the industry and hopefully will open up more avenues for innovation and growth.

Standardisation will eliminate the Malaysian standard, GCC standard etc. It will create just one global standard and that bodes well for the industry.

*By Shariah jurisdictions I mean Malaysia, GCC and Europe/North America where the fatwas tend to be different depending on the Mazhab and the scholars’ individual interpretation.

Asset Based vs. Asset Backed

A brief definition of the two forms of financing:

Asset Based:
Methods of financing in which investors look to the cash flow from an asset or a pool of assets for a return on, and the return of their investment.

Asset Backed:
A term used to describe a security which is backed or secured by a pool of assets such as leases or receivables, but not real estate. The security shall be serviced by the cash flow derived from the pool of assets.


Given the definitions, which would be the preferred structure for Shariah based financing?

The important thing to consider is the ownership of the (real) asset and not just the rights to the earnings or cash flow. For example, an Ijarah structure requires full ownership before one can lease out and earn lease rental from an asset. Therefore, in order to make it comply with Shariah, the structure must define the ownership of the asset as well as the rights and responsibilities of the owners and the counterparties.

There is nothing wrong with a security that derives its cashflow or income from a pool of assets. But in a partnership based structure, the rights to income from an asset is derived from the ownership of the asset and full ownership means legal ownership and not merely beneficial ownership. There must be a true sale of the assets and not merely an artificial beneficial sale.

Whether we call it asset based or asset backed, we must ensure that the assets and the rights associated with ownership belong to the rightful parties.

Training Islamic Banking and Finance Professionals

Any discussion on Islamic banking and finance is never complete without lamenting on the shortage of skilled IBF professionals. This lack of expert human resources is due to so much demand chasing so few talents. But before we dwell further on the matter, we should first define what an IBF professional is.

To be an IBF professional as a person must first;

• Appreciate the values promoted by Islam;
• Understands why Islam forbids certain things and/or activities; and
• Must never think/behave/act like a conventional banker.

How do we achieve this? How do we mould such a banker?

We should start form the very basics. These professionals must be told and reminded from the very beginning that Islamic and conventional banking are two distinctly different financial models. They should not in any circumstances apply conventional banking practices into Islamic banking. These professionals must be trained to look at Islamic banking from the Islamic banking angle and not from the perspective of conventional banking.

The Shariah based financial model, as the name suggests, is guided by the rules of Shariah and what can or cannot be done is determined by Islamic law. Therefore, in order to effectively promote Islamic banking and finance, the promoter must understand and acknowledge the governing rules. One need not be a Muslim to understand and appreciate Islamic law; the only thing needed is an open mind.

Understanding Islamic law would also mean understanding the mechanics of Islamic financial transactions, why certain activities are prohibited and why certain things need to be done in a certain way.

For the industry to prosper, all its components must be equipped with the necessary expertise. Therefore, when talking about IBF professionals, we should not be just looking at the bankers. The scope must be expanded to include the solicitors, accountants, rating agencies, trustees, media, investors and the regulators.

Shariah based finance is actually very simple and straight forward. We will complicate things every time we practice Islamic banking the conventional way.

Islamic Hedge Funds?

"Hedge fund" is a term that was originally used to describe a type of investment pool that uses sophisticated hedging and arbitrage tools to trade in the equity markets and explicitly pursues absolute returns on their underlying investments. The most widely-accepted definition of a hedge fund is that it is a fund that uses leverage, shorting and options to achieve its investment goals, beginning with the protection of investor capital.

The first hedge fund was set up by Alfred W. Jones in 1949, the first to use short sales and leverage techniques in combination. In 1966, a "hedge fund" run A. W. Jones shocked the investment community because it outperformed all the mutual funds of its time, despite their huge 20% fee.

According to some experts, hedge funds are believed to be highly speculative and thus may run contrary to the Shariah prohibition of gharar. At an even more fundamental level, however, hedge funds use short sales to neutralise the influence of market forces; and short sales involve the sale of what one does not really own, which is haram.

Toby Birch of Birch Assets Ltd doubts whether hedge funds could in principle be Shariah-compliant, calling Islamic hedge funds "something of an oxymoron," being an area of controversy, where such structuring might obey the letter of Shariah, it is not compatible with the spirit.

Often, in structuring Shariah compliant instruments, a number of contracts are combined to achieve the desired result, a solution that meets the financial or investment needs. On the surface, combines two or more Shariah concepts may sound perfectly acceptable but indiscriminately doing so may lead to what Tarek Diwany describes as “contractum trinius”. Ahmed Abbas, of Bahrain’s Liquidity Management Centre, criticised such mechanisms as false to the spirit of Shariah. “I don’t care, if you take 20 Islamic steps in order to short sell, you cannot sell what you don’t own. “Islamic banking is not about drawing an Islamic veil over something un-Islamic.”

There have been many opinions and views as well as fatwas on whether hedge funds are Shariah compliant or not. We should be looking at the purpose of a hedge fund rather than the mechanics of the fund. This way hopefully we can up with a solution to the problem rather than modifying an existing (probably incompatible) instrument to solve the problem.

To "hedge" means to manage risk. The key word here is risk management. Our objective is to manage risk in a Shariah compliant manner. We shouldn’t be talking about Islamising hedge funds to manage risk, we should be finding means to manage risk which do not contravene Islamic laws. We should not be finding ways to Islamise hedge funds just for the sake of creating or adding to market liquidity and to enhance rice discovery.

Managing risk is permissible in Shariah based finance provided the means of managing that risk complies with the rules of Shariah. Managing risk can come in the form of full transparency, honouring contractual obligations, being accountable and acting in a professional way. Shariah based financial transactions are after all partnership and risk/reward sharing arrangements. Actions undertaken to manage and/or minimise risk should be directly related to the business venture by ensuring that it is undertaken in the proper manner.