The death of Islamic Venture Capital?
A new investment scheme that can destroy Shariah compliant private equity
Investors love private equity (PE). In the time of low interest rates, doubtful and inconsistent performance of hedge funds, and increasing popularity of passive index tracking funds, the astute investors flock to private capital placement opportunities. With almost US$1.5 trillion in “dry powder” the industry is feeling rather peachy.
The Middle East is in awe of this continuous money-making exercises — the Abu Dhabi Investment Authority placed US$28.9 billion in PE in 2019, and the top 10 GCC’s institutional investors have more than US$3.7 trillion of combined assets under management.
The Shariah compliant PE is a tiny fraction of its conventional counterpart. Investment professionals often cite the following reasons for the slow the development of Islamic private equity:
· operational difficulties and additional costs related to operating of Shariah supervisory boards;
· lack of personnel properly trained in finance, operations management and Fiqh;
· impossibility of using leverage that drives the potential investment returns down
Contrary to expectations, the prohibition of investment in haram sectors (alcohol, tobacco, gambling, production and distribution of pork, production and sale of weapons) is not a significant factor, as these sectors lack appeal to the most conventional PE funds as well.
In the search of Shariah compliant money, the smart legal brains have developed a limited partner structure that enables Shariah compliant investors to invest in conventional PE funds, if the underlying investment assets do not violate the Shariah prohibitions.
The resulting structure is fairly easy to implement — it involves combining a Murabahah with Waad (a unilateral promise) to enter into a Musawamah.
Murabahah is a widely used transaction that involves a deferred payment for an asset that justifies a trade margin. Musawamah involves the sale and purchase of certain assets for spot delivery and sport payment. The price payable may be small and the nominal profit can be significant. The underlying assets for the commodity Murabahah are the usual suspects — the LME-traded metals.
At first, two special purpose vehicles are established — SPV 1 and SPV 2. Shariah compliant investors invest in SPV 1 and obtain its participation papers. With the received funds SPV 1 buys commodities (metals) on the LME via a commodity Broker 1 and sells them via a Murabahah contract (with deferred payment terms) to SPV 2. Via this Murabahah contract SPV 1 and its Islamic investors will receive distributions from the conventional PE fund.
SPV 2 sells the commodities to Broker 2 for cash and the funds are invested into a conventional PE participation paper. Thus SPV 2 would act as the Fund’s limited partner which in turn works on instructions from Islamic investors.
SPV 1 enters into a Musawamah contract with SPV 2 to purchase commodities at the Musawamah price. This step assures the possibility of realization and accounting of investment losses (if any), since the Murabahah price must be paid in full over the time of the contract.
Musawamah price = the value of realized loss by the fund.
The mutual obligations between SPV 1 and SPV 2 under the Murabahah and the Musawamah are squared off. The net return is paid out to SPV 1.
Chart: A scheme of Shariah compliant investment in a conventional fund
Source: Author’s own
Are there any Shariah issues? Well, the source of income is the asset in which the proceeds of Murabaha are invested. The leverage on the PE fund are not appraised by Shariah scholars. So, the fund can use leverage and avoid employing the Shariah board.
As a rule Shariah compliant investors would not make the majority of investors in a conventional PE fund that uses Murabahah/Musawamah model. This way, if any of the “impure” revenue is created (from sales at a hotel bar, or conventional bank’s property rental fee), it can be allocated to non-Islamic limited partners.
This tool is Shariah compliant on the surface and at least two of the major US PE houses will be offering it to the Middle East investors in 2021. It will either kill the Shariah compliant PE industry or just, perhaps, In Sha Allah, make it more viable by adopting new investment techniques — like adopting Sukuk issuance by PE funds in lieu of leverage.
