Equate Introduction

In August 1994, Union Carbide Corporation (UIC) & Petrochemical

Industries Company (PIC) began building a $2 billion petrochemical plant
in Kuwait known as Equate Petrochemicals Company (Equate)
$450 million was financed through bridge loan
Sponsors hoped to raise $1.2 billion of permanent debt financing backed
by guarantees from the US Export-Import bank (US Exim)
After one year of failed attempts, sponsors began exploring alternative
financing structure without Export Credit Agency (ECA) involvement
Sponsors wanted inclusion of a tranche of Islamic finance in the new
financing structure
Islamic finance are the funds that are invested in accordance with Islamic
sharia principle (Islamic Law)
Sponsors awarded a mandate to underwrite the Islamic tranche to Kuwait
Finance House (KFH), which, in tern had come to The International Investor
(TII), an Islamic investment bank, for assistance in placing the Islamic
tranche
TII started analysing the project to find out whether the proposed ijara
structure made sense and whether its sharia committee was likely to
accept it, if yes, then how much should they commit
Petrochemical Industry Company (PIC)
PIC was established in 1963, by the government in the state of Kuwait to
manufacture petrochemical products like fertilizer, salt and chlorine
In 1990, PIC received approval from KPC to build a large petrochemical
project
This project was delayed repeated till 1990 because of continuous
interruption of Iraq in the internal matters of Kuwait
By the help US, Kuwait got liberation on 25 th February 1991
After liberation Kuwaits economy recovered rapidly , but still it faced
several problems.
The government was running deficit due the huge reconstruction
cost of $20 billion
Countrys economy continued to depend on oil
Government took the following steps
Government purchased $20 billion of bank loans to prop up the
ailing banking system
Reiterated its goal of diversifying the countrys economic base
PIC also implemented the above policy by establishing a joint venture with
Union carbide Company (UPC)
Partnership with UPC gave PIC access to its state- of-the-art technology,
access to foreign market and training for Kuwaiti personnel
Union Carbide Corporation (UCC)
One of the worlds largest basic chemicals company with operations in 40
countries and 11,500 employees as of 1995
Generated $2 billion in revenue and $200 million in net income
Had two main business units: Basic Chemicals & polymers (BC&P) and
Specialties & Intermediates (S&I)
BC&P unit specialized in the conversion of hydrocarbon feedstock into
polyethylene, ethylene, ethylene oxide and ethylene glycol for sale to third
parties and use in S&I unit
S&I unit took basic chemical to produce polymer products for industrial
customers

UCC developed this joint venture so that it can use its proprietary
technologies in overseas market and could source low-cost inputs for its
S&I division

Equate Petrochemical Project

PIC and Union Carbide officially formed Equate in July 1995, more than two
years after signing their initial agreement
The project consisted of three separate plantsone each for producing
ethylene, polyethylene, and ethylene glycolbuilt in the Shuaiba
Industrial Area near Kuwait City.
Each plant had its own engineering, procurement, and construction (EPC)
contractor.
All three companies had significant construction and management
experience with Middle Eastern projects

The contractors signed lump sum, turnkey contracts requiring them to

deliver fully operational plants for a set price on a given date.

Lump sum contracts included bonuses for early completion and penalties
for late completion
PIC and Union Carbide hired Fluor Daniel, a well-known international
contractor, to manage the entire project
The sponsors began construction in August 1994, financed through a
combination of equity and debt from a $450 million bridge loan." At the
time, they estimated that construction costs would total nearly $2 billion
Market for petrochemicals
Equate would sell 75% of its output in the Middle and Far East, and the
remaining 25% in Europe, virtually all of which would be in dollardenominated transactions.
Union Carbide agreed to purchase a minimum level of output at market
prices as a form of project support
The petrochemical market could be very volatile in the short-run due to
temporary supply and demand imbalances.
In the longer run, industry experts predicted that world demand for
Equate's products would grow between 4% and 6% per year
Growing demand would necessitate as many as 25-40 new ethylene
plants, assuming an average size of 500,000 MTY, and an equal number of
polyethylene plants of somewhat smaller size.

Although experts expected ethylene capacity to keep pace with demand,

they expected polyethylene and ethylene glycol demand to exceed
capacity expansion thereby causing utilization rates to rise
Equate would be a low-cost producer because of its access to cheap
ethane feedstock
Financing the project
PIC wanted to facilitate the involvement of a foreign partner , even
though it could have financed the deal on its own
Union Carbide , wanted to use project finance to limit its Kuwait
exposure
Agreement for 40% of funding from equity or other subordinated debt .
Of this , PIC provide 45 % , Union Carbide 45 % and Boubyan
Petrochemical Company 10% ( it was public traded company formed in
1995 to give chance to Kuwaiti people invest in project.)

Debt required completion guarantees from the sponsors which they

agreed but not on joint basis.
The advisors also recommended on-going guarantees from export credit
agencies. ECAs were government-owned entities established to promote
exports.
ECA guarantees would protect lenders against both political (i.e.,
expropriation, currency inconvertibility, and war) and commercial risks of
non-payment for terms ranging from 7 to 12 years.
US Exim , Hermes of Germany and Sace of Italy were approached
due to contractors nationalities and equipment.
With no constructive negotiations there was a hunt for an alternative
without credit agency.

Islamic Financing
PIC wanted to use Islamic funds. First and foremost, it would give the
sponsors an alternative source of funds. Secondly, the deal's "optics" were
important. The project was in an Islamic country with a government-owned
entity as one of the sponsors
It was difficult to integrate Islamic and conventional funds in a
single project

the first major co-financing was the $1.8 billion Hub River Power project in
Pakistan' This project used a $92 million istisna' during the construction
phase
This Hub river project proved the feasibility of co-financing as a financial
structure.
The sponsors awarded the mandate to underwrite islamic tranche to
Kuwait Finance House
The sponsors wanted to use an Islamic tranche alongside ECA-guaranteed
bank debt. But after negotiating with the ECAs for more than a year
without an agreement, they were frustrated with the process.
The International Investor(TII)
The sponsors awarded the mandate to underwrite islamic tranche to
Kuwait Finance House but KFH approached TII for assistance
TII had two main businesses: Structured Finance and Asset Management
The Structured Finance Group helped governments, corporations, and
projects raise Islamic funds while the Asset Management Group structured
financial products for investors who wished to invest in accordance with
Sharia principals.
It was a flat organization where no one had titles and everyone shared in
effort and compensation.
they shared a common workspace known as the "kitchen" (where projects
and products were "cooked")
The Structured Finance Group completed its first major transaction, a $450
million airplane leasing deal for Kuwait Airways, in 1993.
The deal illustrated the growing strength of the Islamic capital market
along with Tll's ability to underwrite major transactions. In this deal, TII
had the dual challenge of educating both foreign and local investors on
implications of Sharia principles
Alternate Financing Structure
National Bank of Kuwait (NBK) stepped forward to raise the entire amount
without ECA involvement

There would be two tranches of conventional debt, one for international

banks led by Citicorp and one for local and regional banks led by NBK.
Although the tranche for international-banks would be bigger, it would
have a shorter maturityperhaps eight or nine years rather than 10 or 11
to limit banks long term Kuwaiti exposure.
To reduce Kuwait exposure sponsors maintained debt service reserve
account containing 6 months of principal and interest to cover any
shortfall
In order to determine a spread for the loan reflecting the perceived
sovereign and project risks recent deals were used as benchmark.
Hub River Power project $ 686 million, 12 years commercial loan was
priced at 200 bps over LIBOR in 1994
Saudi Petrochemical Company $ 700 million , 8 and half years
commercial loan at 125 bps over LIBOR for its Sadaf plant in 1995
Reason for differences
Hub river was new borrower as Saudi was established credit.
Saudi Arabia as an investment grade country, Pakistan was B+/B1
Equate was given a band of 160 bps -200 bps over six month LIBOR.
bank charging 50 bp commitment fee for making funds available and
50bp-100bps as participation fee for disbursing funds

Structuring the Islamic Tranche

The distinguishing feature of Islamic finance was that returns had to be
based on profit not Interest because Shari prohibited the payment of
interest or fiba (technically, Sharia forbids making money on money).

Profits were considered the just return for those who accepted the risks of
ownership.
The sharia structure also promoted equality among investors. Because
Islamic investors had to own the assets they financed, the bankers would
have to Identify specific assets for the Islamic tranche
Ijarah

Islamic bank would purchase a specific asset and then lease it to

the project for specified period of time.

For this asset has to be separable and should have economic value
unto themselves.

It is a variable-rate instrument that required periodical payments.

Following payment date for fixed at each payment date.

The leasing asset will be taken back by the bank at end of the lease
for nominal value thus it can be amortized fully with no residual value.
Murbaha

Used for post construction financing

Islamic bank purchases an asset and re-sells it to the project

company at a higher price (cost -plus)

Deferred sale price is decided in advance

bank collects payments at maturity or installments

Dollar dominated contract lasts for 1 -3 years with and average of

2 year

Dinar dominated lasts longer period if acceptable risk

Istisna
Product is manufactured for another party according to the detailed time
and product specification

Payment can be in advance , completion or over time based

Customer agrees to buy an asset from Islamic Bank upon completion
Islamic bank would agree to pay the manufacturer to build an asset in
question
Maturity is equal to the construction period and fixed rates that were on
the day contracts were signed

Issues
Investors would own the assets and would bear ownership risk. For a
petrochemical plant, there were equally serious environmental and third
party risks.
To minimize these risks, KFH could place the assets in a special purpose
vehicle (SPV) with limited liability. Thus 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.
Some countries believed their 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. The separation
of asset ownership and use could create incentive problems much the
same way that drivers are less careful with rental cars than they are with
their own carsthis problem is known as moral hazard.

Islamic investors knew nothing about running a petrochemical plant but

have responsibility of maintaining the assets in working order and insuring
them against loss.

One way to solve this problem was to sign a service management

contract with the sponsors, thereby obligating them to pay for insurance
and maintenance.
There were also complications in integrating Islamic and conventional
funds in a single deal.

Most of these Issues had to be addressed In the Inter-creditor agreement

that specified entitlements to cash flows as well as creditor rights in the
event of default.

There were the "simple" problems such as which law would govern the
contractsIslamic 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?

Mother 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 Sheriff principles.
Actual events of default introduced is even more complicated. Because the
Islamic investors would own specific assets, they would have claims on
those assets in a default situation