Basic Notions on Islamic Private Equity Funds
To earn money is commendable for any Muslim. It enables one to support oneself, family and loved ones. It also allows one to pay the zakat (welfare contribution) and sadaqah (charity). However, there is also the obligation to use the money wisely and spend it in a way that allows the whole community to benefit. Together with the broad Islamic inheritance rules, the repartition of wealth is an important factor in Muslim society.
The sharing of profit and loss in business is another facet and one on which the foundations of the Islamic economy and finance is built upon.
However, until recently, all of the attention seemed to be focused on the development of the sukuk market. This market was pressured into developing into a fixed income strategy that, while trying to attract investors, mimicked the conventional bond market as much as possible, rather than going its own way.
After the first strong wave of the sukuk market and in the full aftermath of the sub-prime crisis, the recent reminder by the Accounting and Auditing Organisation for Islamic Finance Institutions (AAIOIFI) may cause some short-lived dips in the growth trend but will ultimately lead to further growth in a more apt direction.
The large amounts of money involved in the sukuk issuances by nature always attract more attention and publicity than the strong and steady but quiet growth of the Islamic financial institutions themselves.
The sukuk did help to give the industry as a whole a global brand and even enticed the conventional market to participate eagerly. Its overall value, therefore, must not be underestimated. Besides these instruments, trade finance contracts such as murabahah and ijarah form the main body of contemporary Islamic banking.
Strangely enough, the so-called ‘private equity’ investments have been under-developed so far. Venture capital can briefly be described as capital that is made available for newly established to middle sized businesses that have significant growth potential. Sometimes this is also accompanied by the contribution of additional human resources and networking aid made available by the investors (or their management teams).
Mostly, the investment is designed to exit once the growth targets have been reached. The investors aim to generate a return, typically through an initial public offer (IPO) or merger of the company. It is a full risk project where profit and loss are shared by both parties concerned during the growth phase and intended capital gains are reaped at the exit. Both mudarabah and musharakah principles can be fully applied, so there is therefore no better way of investing compliantly.
Any portfolio manager will confirm that it is advisable to spread the failure risk of a target company among several investors and over a larger portfolio of investments. It also makes sense to pool the investors in larger investment structures. The benefit is that more money is available which in turn enables increased stakes in different target companies to be acquired (further spreading the risk). The pooling also allows special fund managers to be hired to manage the business professionally.
Investing money on the stock exchanges has its advantages. The companies concerned usually have had a reasonable life span, sufficient publicly available information, controlled governance, supervision by capital markets or stock exchange regulators, financial track records and dividend policy.
Companies that are in early or mid stages, or even in a start-up stage, lack all that and hence pose more risks to the investor. On the other hand, they also offer better growth prospects and profit returns.
As far as the target companies are concerned, shariah imposes some restriction on the ethical selection criteria to make sure that the investment remain halal (lawful) when a company:
Immediately, it is clear that the available investment environment is considerable and almost unrestricted. Industries, services, retail, information technology – name it and it can be done. Most of the existing businesses, however, are not yet aware of the ethical-financial restrictions related to interest (riba) and are entangled in interest-based lending in different ways. The willing investor should avoid getting into such an undesirable environment.
In the present economic circumstances, it is extremely difficult to find target companies that are completely ‘interest free’ (in terms of loans) and not too ‘liquid’ (cash receivables). The shariah scholars have accepted this reality and have allowed co-operation for the general benefit. Partial ‘contamination’ of the target companies therefore does not pose any insurmountable hindrance to investment.
A number of ‘rules of thumb’ have been developed and are largely accepted in order to help discern which investment targets are acceptable and those that should be avoided. Here are some roughly summarised examples of the FTSE Shariah Global Equity Index Series’ guidelines:
These guidelines are sound and safe. They basically exclude companies that are too exposed to credit and lending (and interest-based debt), which is what makes them prone to problems or even failure. When most Islamic portfolios yield better results than their likely structured conventional opponents, then the application of such guidelines, even from the preliminary stages, may be one of the reasons for the lower rate of failures.
Of course, the nominative contracts, such as the mudarabah and musharakah partnerships, can be used to structure such consortia of investors. But more contemporary limited partnerships, trusts, funds or corporate structures also have been accepted to be compliant. Southeast Asian scholars in general tend to more lenient in this respect than some of their Gulf counterparts. The choice of the precise structure will depend on the legal vehicles that are available in the jurisdictions involved, tax and foreign direct investment regulations and shariah restraints.
The use of legal counsel on both shariah and conventional consulting is beyond question. It facilitates the communication between the shariah adviser, the investors, the management team and the target company and its initial shareholders. In order to assure full compliance with the shariah, it is compulsory to involve a shariah adviser. Since that adviser cannot be available all the time, they should be assisted on a daily basis by the function of the shariah compliance officer whenever possible.
The shariah adviser will:
Besides tax implication in jurisdiction that are not apposite to receiving Islamic structuring, focus is streamed into aligning contracts, partnership structures and conventional regulations with the Islamic principles. Moreover, in most cases, the expectations of the lawyers and consultants involved – and possibly the other conventional investors or even the target company – do not fit the shariah framework. The conventional mindset indeed is directed to minimising risk (and sometimes even excluding) and optimising profit on an interest-based basis.
Other Topics to Consider