The Counsel

Banking & Finance

Structured Islamic Finance

by Shaharyar Nashat

Solicitor & Advocate

Structuring a financing in a way which is compliant with Islamic law (or Shariah) allows corporate and financial institutions with a Shariah oriented investment policy to invest in that transaction.

The current market for Shariah compliant products is valued at approximately US $500 billion but growth rates are expected to grow at15% per annum over the next 10 years.1
Further evidence of the global impact of Islamic finance has been highlighted in a statement by the International Islamic Finance Forum, which stated that there are approximately 270 Islamic banks worldwide in 75 countries, holding financial investments in excess of US $400 billion. 2 Given the nature of their business and investment strategies few Islamic banks (if any) were directly affected by the subprime crisis.3
According to the Director of Islamic anking at the State Bank of Pakistan (SBP), the Islamic finance industry in Pakistan has shown tremendous progress over the last ten years. The market share of Islamic banks in Pakistan grew tenfold to 5% from a mere 0.5% in 2003. With the execution of various expansion measures laid out for the industry, the central bank expects to see the market share increase further to 12% by 2012.4 This target may not be too far away as the country’s Islamic banking assets have increased on an average of 30% in the past four years to Rs. 411 billion according to SBP estimates.

Recent years saw Gulf corporates on the acquisition trail. Awash with liquidity, a number of leveraged deals were undertaken by Gulf investors in Europe and further afield. Several of the acquisitions were financed, in whole or in part, by the application of Islamic finance.
In this article, we will consider two such deals: the acquisition of Aston Martin Lagonda by a consortium principally of Gulf investors and the purchase of the Egyptian Fertiliser Company by two funds managed by Dubai based private equity house and Abraaj Capital.

The Deals

Aston Martin Lagonda
In the spring of 2007, The Investment Dar and Adeem Investment Wealth Management, both from Kuwait, led a consortium of investors in the acquisition from Ford Motor Company of the iconic Aston Martin Lagonda Group.
The financing package for this acquisition arranged by WestLB AG, London branch was ground-breaking as it represented the first leveraged buy-out in the UK, wholly financed in a Shariah compliant manner.

Egyptian Fertiliser Company
The US $1.41 billion acquisition of the Egyptian Fertiliser Company (EFC) represents the largest private equity deal in the Middle East and North African region. The acquisition was undertaken by the Infrastructure and Growth Capital Fund and Buy-out Fund II LP, both managed by the leading Dubai based private equity house, Abraaj Capital, together with other investors.

The financing package, led by Deutsche Bank initially, comprised a US $850 million senior and a US $400 million subordinated bridge facilities with an investment of US $675 million of equity. The senior facility was subsequently partially refinanced by a long term Islamic facility.

Islamic Finance: the basics

  • The faith of Islam encompasses all aspects of a Muslim’s life, providing a moral and behavioural code to be followed in daily life.

  • Islamic law or Shariah is based on the teachings of the Quran and Sunnah and governs the social and economic dealings of all Muslims.

  • The principles and values of the Islamic financial model have been developed over time and are based on both explicit rulings of Shariah and from Shariah scholars’ interpretations and understanding of the law (fiqh) set out in the Quran. Interpretations differ between different Shariah scholars and can lead to the terms of an Islamic financing being approved as valid by one scholar and from one school of fiqh, whilst not being acceptable to scholars from another school. This dynamic impacts on the development of new Islamic finance products. Islamic financial institutions enlist the guidance of retained scholars to approve the terms of proposed financing structures.

  • The main guiding principles of Shariah relevant to financing are set out below.

» Whilst Islam encourages and promotes the ability of individuals to prosper, certain commercial activities are forbidden for Muslims, including, gambling, pork related products, armaments and other activities considered to be socially detrimental.

» Muslims must avoid taking excessive risk-taking and / or uncertainty in transactions, including uncertainty as to amount of payment.

» Muslims cannot receive or pay interest (Riba). Accordingly, they are unable to conduct business with conventional financial institutions which base their business model on interest payments. Islamic financial institutions were created to serve the Muslim market and have developed products which comply with Shariah law and yet provide the same value as conventional bank products. This is broadly done by replacing interest with cash flows from productive sources, such as returns on investment activities and businesses.

» The reason behind these guiding principles of Islamic Finance is that society should flourish by co-operation and mutual help and although Islam encourages trading and investment, it prohibits non-productive activities (e.g. creation of money by money or charging interest).

The Structuring Challenge
As in any leveraged buy-out, the deal timetable is challenging and the time is not always available to put in place a structured Islamic solution. Local law, tax and Shariah related considerations will have an impact on the Islamic structure which is to be applied.

Aston Martin
For the Aston Martin acquisition, in addition to the 60% equity contributions made by the Kuwaiti investors, the primary syndicated financing facility was structured as a £225million commodity murabaha facility. This commodity murabaha involves the purchase by the facility agent (acting on behalf of the syndicate) of London Metal Exchange (LME) warrants for an amount equal to the financing, the purchase price being the ‘cost price’. Having acquired title to the commodities, the facility agent then sells them immediately to the borrower at a deferred sale price, comprising the cost price plus profit (calculated pursuant to a formula comprising cost price x LIBOR + margin x number of days/365).

The syndicate members are a mix of European banks, Gulf Co-operation Council (GCC) banks and Asian banks who funded the Investment Agent, WestLB AG, London branch, under the Murabaha. The facility used in the Aston Martin transaction consisted of two tranches: a £200 million term murabaha facility and £25 million revolving murabaha facility. The facility had an eight-year maturity period with a ‘put’ option at the end of the fifth year, allowing participants to demand repayment of the facility. This option was incorporated to satisfy the desire of some GCC investors for a tenor of not more than five years. The pricing of the facility has a profit rate of 295 bps over LIBOR for the initial five years, then 345 bps over LIBOR for the remaining three years. The leverage on the Aston Martin loan is approximately 4.5 times earnings before interest, tax and depreciation, which, when compared to comparable European leveraged buy outs closed in the summer of 2006 is low but in line with Islamic finance guiding principles.

Egyptian Fertilisers
To meet the acquisition timetable, the Egyptian Fertiliser acquisition was initially financed by way of a conventional senior loan. This was later partially refinanced with US $424 million Islamic financing structured around the forward sale of fertiliser urea arrange by Deutsche Bank.

So we have three very different deals, each using a different Islamic structure. The commodity murabaha structured applied in the Aston Martin financing is the simplest and most portable of the Islamic structures that can be applied. That said, this structure is the subject of debate amongst some Shariah scholars and some of the more conservative Islamic banks may refuse to accept a financing on this basis. Whilst the initial Aston Martin financing was structured using a commodity murabaha, the application of a musharaka structure for a refinancing was carefully considered. Whilst the UK has implemented certain measures to facilitate Islamic financing in the UK (e.g. tax treatment of profit element of an Islamic financing equal to interest), there are still problems with the application of capital gains tax (on revaluation of those assets which, in order that they meet the Shariah requirement that a minimum of 30% of assets in a musharaka, must be in non-cash form) together with issues relating to the musharaka being treated as a collective investment scheme. There were perhaps even concerns from pension’s regulator in connection with Aston Martin’s final salary pension scheme. Put together these issues meant that a structured musharaka solution was not available for the refinancing. Consequently the refinancing applied a similar commodity murabaha financing to that used to finance the acquisition initially.

The Infrastructure and Growth Capital Fund managed by the Abraaj Capital is a Shariah compliant fund. As such any acquisitions it makes and financing it obtains must be Shariah compliant. With the Shariah Board of the Fund not prepared to accept a commodity murabaha structure, an Islamic leasing (Ijarah) structure (essentially involving a sale and leaseback of the borrower’s assets) was carefully considered. However, Egyptian law considerations and the impact of tax on an Ijarah in Egypt meant that this option was not available. With the borrower generating supplies of urea, a forward sale financing structure (Bai Salam) involving the purchase by the financiers of a future supply of urea was agreed. The borrower would then be appointed by the financiers to sell the supplies of urea on their behalf and the financing would be rendered pursuant to these sales.

These examples illustrate that the Islamic structuring of any buy-out very much depends upon tax and local law considerations as well as the nature of the target’s business and assets available against which to structure an Islamic financing. If available, the commodity murabaha provides for a relatively vanilla and portable structure which is generally widely accepted and tax efficient. But for a widely acceptable syndication amongst Islamic financial institutions, other structures must also be considered.

The Future
The above acquisitions point to a high potential for future buy-outs applying Islamic finance. They each show the flexibility of Islamic structures to be able to take account of the legal, tax and asset availability in order to put together an aggregate financing between the two deals in excess of US $2 billion. As for Pakistan, there are reports of the Government of Pakistan’s plans of offering debt worth PKR 80 billion (approximately US$934 million) via 3-year Ijarah Sukuk and are being seen as another boost to the global Islamic finance industry. This comes after a suspension of 14-month suspension of sales in the country. According to Abdullah Ahmed, the treasurer at Al Meezan Bank Ltd., the government will pay a premium of 50 basis points or 0.50 percentage point, more than benchmark six-month T bills. It is expected that the Government will use the money raised from the sale to meet its current expenditure, which is on the rise due to the recent devastating floods in the country and shortfall in revenue collection. This would be the second issue of Ijarah Sukuk after the successful launch of the first 3-year Ijarah Sukuk in September 2008, through which the Government had raised PKR 42.2 billion. Total value of the assets under the present issuance program of the Government of Pakistan’s Ijarah Sukuk is PKR 191.43 billion.

Going forward, in order for Islamic finance to reach its full growth potential in a country such as Pakistan, the State Bank needs to encourage diversification and innovation of financial structures. This would involve either applying innovative Islamic products on a stand-alone basis or applying a combination of Islamic instruments to suit project finance needs. In attempting the latter, it needs to be ensured that vanilla Islamic products such as Murabaha, Ijarah and diminishing Musharaka, etc., are implemented with their necessary preconditions, consistent with Shariah principles, to promote modes that can be used to finance commercial and project finance activity.

According to Dr. Shamshad Akhtar, former Governor State Bank of Pakistan, the future of Islamic financing is in incorporating the same within a multi-sourced project finance offering, alongside conventional project financing structures. Creation of a standard legal structure for establishing and operating with ease Islamic SPVs as the financing vehicle would greatly facilitate this process. However, there is a great need for harmonization of these alternate and multi-financing legal and regulatory structures.
As Islamic finance will continue to be an integral part of the global financial system, it is important to have an integrated initiative, both for conventional lending and Islamic finance. Aside from standard application of conventional banking regulations, Islamic financial institutions must consider adopting IFSB (Islamic Finance Services Board) and AAOIFI (Accounting and Auditing of Islamic Financial Institutions) standards with appropriate tailoring to suit domestic requirements. Also, issues such as bank liquidation and insolvency issues arising from Shariah compliant financial transactions, for example, in terms of the priority of claims of depositors and shareholders during liquidation of an institution offering Islamic financial services pose legal challenges that must be resolved in a consistent manner across jurisdictions. Such an institution would also be exposed to a number of risks in jurisdictions with established insolvency rules that are not tailored to deal with insolvency issues in Islamic financial transactions. These legal risks, amongst others, have been highlighted in an IFSB paper, Islamic Finance: Global Legal Issues and Challenges, which was published in 2008. It is therefore important that policy actions be expedited with cross-border consensus to develop a Shariah compliant framework for crisis management and resolution in order for structured Islamic finance to continue its expansion.

Two commonly applied Islamic structures


In its simplest form a Murabaha is a form of sales contract, which will factor in a cost plus, or mark-up, based on the financing. The murabaha transforms the lending activity into a sale and purchase agreement under which the finance house acting as seller (Seller) buys raw materials, goods or equipment required by the borrower (Buyer) for resale to the Buyer at a higher price agreed by both parties. This allows the Seller to be viewed in the role of a business entity, giving services or sale of goods to customers with the aim of profit making. The Seller can do this because trading is not prohibited by Islamic law and therefore, the Seller can sell the goods at cost plus profit margin. The Seller is obliged by Shariah law to tell the Buyer his cost price and the profit that he is making. The transaction is completed in two stages (as in the case of the Aston Martin transaction).

The term Musharaka is normally translated to mean ‘partnership’. Literally, Musharaka means a joint venture agreement between two parties to engage in a specific business activity with the aim of making a profit. The partners will contribute funds and not necessarily in equal amounts. They can also contribute labour, goodwill, commodities and shares. All assets of Musharaka are jointly owned in proportion to the contribution of each partner. The ratio of profit distribution may differ from the ratio of investment in capital but the loss must be divided exactly in accordance with the ratio of capital invested by each of the partners.

The author is a gradute of University of London (LLB) and university of Oxford (LPC). He also completed the Islamic Finance Qualification course from the Securite Insititute Internationale in London. He is an Advocate and a member of the Junior Lawyers Division of the Law Society of England Wales and is currently Legal Counsel to ICI Pakistan Ltd.
Prior to this possition, the author worked at Lovells LLP, London and at Orr, Diagnam & Co., Karachi

1 Islamic Finance News:
2 The Bankers’ Magazine Survey 2009
3 Standard and Poor Report on Islamic Finance in 2009
4 Interview of Pervez Said, Director of Islamic Banking at the State Bank of Pakistan with Anna Marie Samsudin