Islamic Private Equity and Venture Finance
Islamic Private Equity and Venture Finance
Why is there growth in this industry?
Professionals enjoy approximately 20% carry (25% - 30% in the best venture funds) - flock to this industry and provide product to investors
Regional Macro Trends
Economic dis-equilibriums, corporate restructuring, and acceptability of selling assets, rapid technological change, and available financing - all provide private equity opportunities
Investors have an abundance of equity capital - the rise in public markets has ironically provided more capital for private equity (percentage allocation might stay same - but base is larger)
Returns are consistently better than other investment opportunities. With public returns expected to go down in the coming years, private equity is even more attractive
2. Islamic Private Equity Outgrowing Conventional Private Equity
Islamic finance has witnessed tremendous growth over the past years, both in terms of the growth of the entire industry and in terms of the development of new and more sophisticated products that meet the increasing yet unmatched demand for structured products and comply with the principles of Shariah law. The global Islamic finance industry is valued today at approximately US$800 billion. Furthermore, there are a number of additional factors such as growth in the Muslim population (estimated to grow by over 20% within the next 8-10 years, to reach 1.6 billion, which represents 21% of the global population, against 19% as of today), an enormous increase in the wealth of this population (the wealth of high net worth individuals in the Middle East is estimated to grow at 8% per annum, to reach US$1.8 trillion by 2010), as well as a sharp rise in interest by international (non-Muslim) investors, governments, financial institutions and capital markets to enter the Islamic finance and investment space. This is documented by the value of Sukuk to be issued over the next three years, which is estimated to be worth US$30 billion, with global issuance totaling US$100 billion by 2010.
Islamic private equity focuses on acquiring majority stakes in privately-held Shariah-compliant companies. By doing so it enables investors to maintain control and ensure the company’s adherence to Shariah principles. Islamic private equity provides investors with an ethical investment product offering high performance, portfolio diversification, superior risk-adjusted returns and diverse investment opportunities. Private equity and Islamic investment share a lot of common principles: both of them are based on investment in the real economy, and on the principle of sharing risks and rewards through partnership. Private equity takes a long-term view on investments and aligns the interests of stakeholders, which are also among the key principles of Islamic investment.
Islamic finance has been widely acclaimed as the fastest growing sector within the financial arena. Much of this development has occurred within the debt and related capital markets sectors – sukuk, commodity murabaha, and so on. In the mainstream financial world, a parallel area which has also witnessed incredible growth levels in recent years is the private equity (PE) sector. Now accounting for nearly a quarter of the UK workforce, the meteoric rise of the PE players has not gone unnoticed. Omar Shaikh of Ernst & Young’s Private Equity Transaction Advisory Services practice, explores some of the interesting parallels between these two previously obscure, but now high profile, mainstream alternative financial products.
2.2. The importance of equity-based solutions to the Islamic finance industry
While growing rapidly, the Islamic finance industry today faces a number of challenges. This is unsurprising, perhaps, given its age. Academics and industry practitioners alike have identified a number of issues, ranging from an absence of secondary markets, a lack of consistency and uniformity of standards within Shari’ah compliance to the shortage of qualified professionals with an adequate understanding of both the Islamic and the conventional sides of the equation.
A key challenge, increasingly cited, is the perception of Islamic financial products as being overly engineered and mimicking conventional products. Previously unaccepted products, such as derivatives and hedge funds are coming to the fore. In addition, the extensive use of tawaruq and other structuring methods to create cash loans is raising the question as to the authenticity and direction of the industry. Many analysts are referring to the phenomenon of ‘Shari’ah arbitrage’, class-ing Islamic products as another series of structured products, which create ‘wrappers’ to overcome restrictions.Indeed, grass root opinion in the UK struggles to deal with the bench-marking of Islamic home financing against LIBOR.
The argument that Islamic home financing charges a ‘profit or rent rate’ not an interest rate begins to lose credibility when users realize that the ‘profit or rent rate’ is benchmark against interest rates.
A number of industry practitioners, such as Iqbal Khan (founder and ex-CEO of HSBC Amanah), believe that a change in mindset is called for, by which Islamic products would become ‘Shari’ah-based’ as opposed to ‘Shari’ah-compliant’. Similarly, Tariq Sheikh (founder of RHT Partners) comments that ‘in essence Islamic finance is an equity-based, not debt-based system, and we need to develop Islamic products which are more in line with the “spirit” of the law, as much as they currently are with the letter of the law.’
A banking system based on faith and credibility (and more importantly the perception of it as being so based) is critical to the sustainability and differentiation of the Islamic finance industry.
2.3. Private equity – the elusive musharakah solution?
As in certain forms of the conventional private equity market, the concept of risk/profit and loss sharing is an important fundamental principle of Islamic finance – the principle of musharakah. The Arabic term musharakah is not actually found in classical Islamic texts on fiqh (jurisprudence) and was coined later within texts relating to Islamic financing modes. Fiqh texts refer to the concept of ‘shirkah’ which is translated as meaning ‘sharing’ and is sub-divided into two categories: shirkatulmilk (the joint ownership of a particular property by two or more people); and shirkatulaqd (joint commercial enterprise).
Whilst the principles of Shari’ah require that loss must be shared in proportion to the capital invested, whereas profit share can be set at agreed levels, in general the Islamic model for business financing encourages profit and loss sharing through equitable financial and contractual arrangements. On the face of it, the private equity model seems to provide a natural musharakah-based solution with a proven track record of success within the conventional system.
3. Islamic Private Equity – Criteria for Investment
The demand for Shari’ah compliant investments and financing sources as a whole grows ever more important and may well be on its way to becoming mainstream. As part of this development, Shari'ah compliant private equity funds are increasingly coming to the attention of private equity fund managers, keen to tap a market of investors not only from the booming Gulf States, but from over a billion Muslims worldwide. Those investors who prefer investing in a Shari'ah compliant fashion, also seek an asset class that represents socially responsible investments and view fund investments much like conventional investors. Although the first Islamic equity fund was established as far back as 1986, it is only fairly recently that the sector has started to expand rapidly, with more than 150 such funds currently available on the market.
Legal Structures and Documentation
The lack of standard legal documentation in the Islamic finance space is a major concern for the sector. It gives rise to duplication of processes and inevitably to increased transaction costs.
Bankers rue the fact that there are no standardized legal documentation or templates for internationally-accepted Islamic instruments such as Murabaha, Ijarah and Istisna.
Legal documentation also encompasses other issues in the Islamic finance transaction process. These include the relationship with the Shariah governance process, especially the compiling of the document to reflect the Shariah provisions; the Shariah review of the documentation; the time taken for this review; the quality of this review; the potential areas of conflict and disagreement and how these could be reconciled to satisfy both the law of the land and Islamic financial principles; and issues relating to the etiquette of conducting this legal documentation review process.
The sharing of profit and loss in business is another facet of that same mirror and one which the foundations of the Islamic economy and finance is built upon.
Venture Capital can briefly be described as capital that is made available for newly established to middle sized businesses that have a significant growth potential. Sometimes it is also accompanied by the contribution of additional human resources and networking aid made available by the investors (or their management team).
Mostly, the investment is designed to exit once the growth targets have been reached. The investors aim to generate a return, typically through an IPO or merger of the company. It is a full risk project where profit and loss is shared by both parties concerned during the growth phase and intended capital gains are reaped at the exit thereof. Both mudaraba and musharaka principles can be fully applied so there is therefore no better compliant way of investment possible.
3.1. Investment criteria
Any portfolio manager will confirm that it is advisable to spread the risk of failure of a Target Company over several investors and over a larger portfolio of investments.
It also makes sense to pool the investors in larger investment structures. The benefit thereof 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 public stock exchange has its advantages. The concerned companies usually have had a reasonable life span, sufficient publicly available information, controlled governance, supervision by Capital Markets Board or Stock Exchange Regulators, financial track records and dividend policy.
Companies that are in their early or mid stages or even in their start up stage for that matter, lack all that and by consequence pose more risks to the investor. On the other hand, they also offer more growth prospects and profit returns.
As far as the Target Companies are concerned, Shari'ah imposes some restrictions to the ethical selection criteria to make sure that the investments stay halal (lawfull). In general activities are considered to be haram (unlawfull) when::
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 which should be avoided. We give here an example of the FTSE Shari'ah Global Equity Index Series guidelines which can be roughly be summarized as follows :
Excludes investments when total debt on total assets exceeds (or is equal to) 33%.
Total interest bearing securities and cash
Excludes investments when total cash and interest bearing securities on total assets exceeds (or is equal to) 33%.
Excludes investments in Target Companies if account receivables on total assets are greater than (or equal to) 50 %.
Threshold haram income
Any haram income of a non-compliant Target Company that does not exceed 5 % of overall gross income is considered marginal or accidental. The Target Company will still be acceptable, provided that sufficient cleansingis made according to the guidelines set forth by the Shari'ah Adviser (isolated and given to charity ).
Of course, the nominative contracts such as the mudaraba and musharaka 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 be more lenient in this respect than some of their Gulf based counterparts.
Introduction of Venture Capital
Thus, venture capital may be described as a form of equity financing in which the investor actively participates in the venture being financed. The objective is to add value to the venture company during the financing period, so that the investor (the venture capitalist) can sell its share.
Comparison of Venture Capital and Islamic Finance
The Establishment of the VC Sector in the Islamic World
The introduction of the venture capital industry into a country encourages and supports entrepreneurs, creates jobs and tax revenue and makes possible the development of high technology. This being the case, no government would want to oppose it and there is no reason why Islamic countries should not benefit from it as much as the West has done.
Equity investments in permissible sectors are allowed in Islam (Siddiqi, 1985; Chapra, 1992), as are investments in companies having a zero conventional debt capital structure (Khan, 1989; Khan, 1995). The provision of equity- based capital for
Small and Medium Enterprises (SMEs) also accords with the Islamic desire for wider economic development and a more equal distribution of wealth. Islamic banks have a special role to play in the establishment of the VC sector in Islamic countries. This is because the structure of the two organisations is basically the same. They are both involved in profit-and-loss-sharing (PLS) and have a common history.
Their history started with the Islamic mudarabah, a form of partnership used even before Islam by Arab traders. Later the mudarabah was formalised and embodied in the Shari’ah law by the Muslim jurists. As Islamic culture spread across the world, the mudarabah went with it and continued to be used by Islamic businessmen until the 19th century. In about the 1970s, a kind of quantum leap happened and the concept of the modern Islamic bank emerged from these roots.
But there was another branch in this history. In the 10th century, the Italians took up the mudarabah and it spread through Europe. But while in Islam this partnership form remained undeveloped, in Europe, ever-increasing numbers of entrepreneurs were financed by them, so that the organisations became larger and larger. They became, in effect, what we now call VC companies.
So Islamic banks and VC companies have these common roots and that is why they are structurally similar. The similarities are briefly discussed below. The first level can be said to be the collection of funds. In Islamic banks, the investment account holders are people who participate in the bank’s investments in order to share in the resulting profits under mudarabah. This is called profit-and-losssharing (PLS) and the profits are shared according to an agreed ratio. In Turkey, for example, the ratio used to be 20/80, that is, the bank retains 20% of the net profits and 80% is distributed to the account holders.
In the VC sector, also, those who invest are taking part in a profit-sharing process. A ratio similar to that of the banks is used. On the second level, too, both Islamic banks and VC companies play the same role, that of mudarib or agent. Acting as an agent for their investors, they invest the investors’ funds in a multitude of entrepreneurial companies and pass a proportion of the profits back to the investors, along with capital and gain where appropriate.
It may be argued that conventional Western banks play essentially the same role of agent between their depositors and the businesses they invest in. That is true, but there is a difference, which has important implications for the depositors. Instead of sharing in the profit or loss of the companies they invest in, conventional banks charge these companies a fixed rate of interest and give their depositors also a fixed, but lower, rate of interest. Making their profits from the difference between the two levels of interest, the banks are not participating in any real sense in the fortunes of the businesses they invest in. Nor are their depositors. Indeed, it is as though the bank had erected a wall between the two.
The similarity between Islamic banks and VC companies is closest when they use these PLS partnerships (either mudarabah or musharakah) with businesses. But the Islamic banks also use other forms of financing such as murabaha (renting equipment on a cost-plus basis) and there they differ from VC companies.
In other words, the similarity between Islamic banks and VC companies lies in the fact that they have the same philosophy of financing, that of sharing in the profit and loss of their investments and passing the results on to their depositors. For this reason, they use the same criteria in evaluating projects to invest in, namely, the ability of the entrepreneur and the profit potential of his project. As against this, conventional banks use the criteria of past performance, balance sheets and the credit-worthiness of the entrepreneur.
In case of loss, the Islamic banks have the same attitude as VC companies in that the capital loss is borne by the lender, the entrepreneur losing only to the extent that his labour has been lost.
Unfortunately, in practice, Islamic banks, in order to compete in fund mobilising with the West, have tended to show a preference for murabaha (cost-plus) financing, which is, of course, less risky than PLS. In order to introduce VC into Islamic countries, therefore, an effort will have to be made to persuade the Islamic banks to change their investment policies towards having more PLS contracts.
These are several reasons why Islamic banks tend to be reluctant to resort to PLS. First, the senior people now in Islamic banks mostly learned their trade in conventional banks and so tended to use those Islamic instruments which were nearest to the ones they were familiar with. Since risk minimisation is one of the basic principles of conventional banks, the more risky PLS partnerships, particularly the mudaraba, where no money is contributed by the entrepreneur, were avoided.
Secondly, Islamic banks found themselves in fierce competition with conventional banks and felt that they could only attract funds by paying their depositors a profit share commensurate with the rate of interest paid by conventional banks. This was another reason for avoiding the more risky PLS investments.
Thirdly, in an economic environment dominated by inflation as well as high rates of interest, the Islamic banks did not want to venture into the long-term investments required by PLS, but felt forced to design their portfolios on a short-term basis.
Fourthly, PLS involves close and continuing contact with the entrepreneurs financed and involvement in their problems, a situation the Islamic banks do not usually have the time or resources to cope with.
For all these reasons, conditions must change before a VC sector can be established in Islamic countries. To change them, a comprehensive reform package must be designed. Let us now look at what such a reform package must contain.
Models and acceptable structures for Islamic Venture Capital
Theoretical Models and Acceptable Structures
The basic theoretical model of an Islamic bank, according to Iqbal and Molyneux (2005), was developed on the lines of the Two-Tier Mudarabah (TTM) model. The rate of interest brings the asset and liability sides of conventional banking intoequilibrium, whereas mudarabah is the primary profit and loss sharing (PLS) vehicle of asset and liability creation in Islamic banking. The bank is positioned between surplus groups (investors/depositors) and deficit groups (borrowers/beneficiaries).
The TTM is an equity-based structure. On the liability side, the Islamic bank is assumed to play the role of Mudarib for the suppliers of capital (Rabb al-mals), while on the asset side it acts as the equity financier (Rahb al-ma!) for entrepreneurs (Miidaribs). The bank’s return is therefore determined by a share of the profits on both sides of the TTM; banks share profits with their depositors and also with their beneficiaries. If a business venture fails, the capital provider (bank) loses its capital and labour provider (entrepreneur) loses his/her time and efforts.
Another prominent form of Islamic finance is musharakah; in this equity-based structure, two or more partners with a given amount of capital come together in a business venture. They share profit in a predetermined ratio (Siddiqi, 1985). Entrepreneurs are permitted to contribute to the total funds requirement, but it is only in musharakah that the partners may incur a financial loss, strictly in proportion to their capital contribution.
Both mudarabah and musharakah are equity -based, profit sharing structures, although there are some key differences between the two forms of funding. The main difference is that the entrepreneur offers no capital contribution in mudarabah, and therefore s/he is not liable to incur any financial loss apart from losing his/her effort (cost of labour) if the venture fails. Moreover, the bank is not authorized to participate in the management of a mudarabah project hence this form of financing carries a greater degree of risk. In a project financed by musharakah, the bank has right to participate in management unless it deliberately waives the right to do so. The key question is where the contemporary practice of VC financing fits within the PLS techniques of Islamic finance. Two alternative approaches that might be used for Islamic VC are now explored in greater depth.
In an effort to overcome the problems described above, mudarabah has been combined with another financial structure, wakalah, whereby clients authorise a bank or fund manager to invest funds on their behalf, in return for a predetermined fee. This structure is widely used by Islamic mutual funds (Iqbal and Molyneux, 2005) and a combined TTM-Wakalah structure could offer a suitable model for an Islamic VC initiative.
However, there is a major problem to be addressed in mudarabah, deals. In the mudarabah structure, both the financial institution and the recipient can agree on any covenants at the time of the disbursement of the funds. If the project does not proceed as originally planned, then covenants cannot subsequently be changed unless both parties agree. It would be difficult for investor and entrepreneur to resolve disputes on (say) product development, replacing the CEO and so on. The Islamic resistance to changing the terms of the deal stems from the principle that the outcome of the entrepreneur’s efforts should not be at the mercy of the capital provider. In rnudarabah structures, therefore, all possible outcomes and their consequences have to be agreed upfront. This arrangement could present problems for the way in which venture capitalists structure the contracts with their investee companies.
The second option for the development of Islamic VC stems from the shiir’ka al-man financial structure (Siddiqi, 1985). In the OttomanState, the manufacture and tradeof fabrics, the production of pillows and shoes were funded in this way (Cizacka,1996). In shir’ka al-man, two or more members invest a certain amount of capital andshare the benefits on a pre-agreed basis. This approach permits the capital providerto place any number of restrictive covenants on the functioning of fund managersand/or entrepreneurs (Fethi, 2000). In the VC context, shir’ka aI-inam is a genuinepartnership hence both parties are equally involved in any decision to change thestrategy of the investee company, even after the disbursement of funds.
The analysis above demonstrates that a hybrid of mudarabah and shir’ka al-man would give capital providers many of the powers available to established venturecapitalists; in particular, the investors can insist upon the inclusion of covenants inthe contract and they can make post-investment adjustments/interventions to ensurethat the investee company stays on course for success. Likewise, mudarabah inconjunction with wakalah provides another option for venture capitalists (albeit lessflexible), because the wakeel (representative) may be allowed to carry out businessactivities within mutually agreed parameters.
The critical question is whether Islamic profit-sharing contracts (musharakah or mudarabah) can provide the required flexibility for efficient risk management. This question can be explored in relation to two fundamental dimensions of the structuring process: contractual structuring (the covenants included in shareholders’ agreements and any staging agreements); and, the selection of financial products, namely the choice between equity, debt or hybrids.
In Islamic jurisprudence, parties are free to structure a contract to achieve their mutual economic interests, provided that basic Islamic principles are not violated (Ahmed, 2004). The commonly used covenants in VC shareholders’ agreements and/or the conditions tot investment staging could he applied to mudarabah and musharakah structures, provided that such instruments were used in conjunction with shir’ka al-inan or wakalah.
The idea of differential or disproportionate revenue sharing between two classes of ‘equity’ investors has already been approved in Islamic jurisprudence (Ahmed, 2004). This concession applies provided that the party offering finance also contributes to the management of the project. A modified version of preferred stock could create two classes of shares, with each being entitled to different percentages of profit beyond a defined threshold (Zarqa, 1992). Another financial product that meets the needs of entrepreneurs while simultaneously limiting investment risk is ‘diminishing musharakah,’ (Bendjijali and Khan, 1985). This structure can be fully secured by using company assets as collateral, thus protecting the original capital to some extent until the project achieves profitability. From cash generated through profits, the entrepreneur can begin to repurchase the equity issued to the venture capitalists. (This arrangement resembles the option in VC deals that gives the entrepreneur the right of first refusal to ‘buyback’ equity held by outside investors.) Overall, the venture capitalists’ return varies according to the investee company’s profitability. This gain plus a gradual redemption of part of the invested capital appears Islamically acceptable.
Shari’ah View of Some Key Practices in Venture Capital Financing (Ahmed, H. (2004)
Conventional Venture Capital Practice Shari’ah View
Limited partnership structure Acceptable
Long terms contracts Acceptable
Contracts can be nullified Acceptable
Restrictions placed on the activities of fund managers Acceptable
Equity ratchets to entrepreneurs Acceptable
Investments in equity, fully convertible bonds (zero coupon) Acceptable
Preferred stocks, preference shares of convertible debt Not acceptable
Greater control rights through restrictive covenants Acceptable
Board Seat Acceptable
Staged Financing Acceptable
Replacement of management (CEO) Acceptable
Liquidation rights Acceptable
Provision of non-financial services (strategic advice, etc.) Acceptable
Application of discount rate for valuation Acceptable
Even though investing in a venture is an acceptable financial transaction, some aspects of the conventional venture capital structure are not in line with Shari’ah rulings. These aspects are mainly related to preferred stocks and shares that act like a debt instruments. A Shari’ah compliant structure aims to balance the risk/reward benefits to all parties involved in a deal. As such, any financial instrument that acts like a debt security, where the investor can get a ‘riskless’ reward is prohibited. However, if the burden of risk is placed unevenly on the investor, the investor will not have the incentive to participate in a high risk venture. Two factors aspects are discussed briefly below:
(a) Preferred Stock
In order to minimise the downside risk to Islamic investors, workable preferred stock has been suggested. This ‘Islamic’ preferred stock acts like a pure preference share with pre-determined varying profit ratios. There can be no accumulation of profits and no liquidity preference to one investor over another in case of sale or liquidation of the venture. Thus it is more like common stock with pre-determined profit rates.
Since private equity deals are by nature risky transactions, true valuation of the deal is vital to achieve the target rate of return which is bench-marked against some risk free security, such as US Treasury bonds. Such benchmarks are performance goals against which a company's success is measured, and does not necessarily involve the actual application of riba to a transaction. However, Islamic investors tend to value a company based on two important factors for Shari’ah compliance:
• Returns on a project with a similar risk profile
• The average return on a well diversified equity portfolio
Celanese Performance between 2003 and 2006
Item (USD m)
Revenue Growth Rate
R & D Expenditure
Expenditure on Plant and Equipment
Productivity Per Employee