Since the beginning of history, the Middle East has always been in the headlines. But for investors, the real significance of the region lies not just in the ongoing drama of geopolitics but in the underlying capital reserves that, if fully utilised, could reshape the way the global private equity investment community procures its funding.
For many Western groups, a stumbling block to accessing Middle Eastern capital has been the fact that Islamic finance is constrained by a unique set of guidelines. These guidelines are established by scholars who make rulings according to the principles of the shari'ah – an organic law common to all Muslims. Shari'ah imposes an explicit moral framework which channels capital away from investments considered haram (sinful).
Shari'ah is derived from a number of overlapping sources: the Quran; the Sunna/Hadiths (examples and sayings of the Prophet Muhammad); qiyas (analytical comparison); ijtehad (reasoning and logic applied by scholars); and ijmaa (a consensus on issues requiring ijtehad).
According to shari'ah, investments in companies that manufacture haram products like alcohol, tobacco or pork products are forbidden. As such, the entertainment industry – hotels, casinos, cinema, music and pornography – is offlimits. Shari'ah investment principals also frown on companies tied to weapons, human cloning, abusive animal testing and abortion.
No making money from money
Most significantly, shari'ah investment principles forbid backing endeavors that depend heavily on riba – the paying or charging of interest. This includes insurance companies and any interest-based banks or financial associations. Bonds and many other fixed-income products are also ruled out, as are preferred shares, which pay guaranteed dividends. However, many investors are not absolutist in their approach to shari'ah compliance, allowing for leeway when assessing whether a certain investment is appropriate.
For example, the Dow Jones Islamic Market Index was launched in 1999 to represent companies that follow shari'ah investment guidelines to a reasonable degree. The FTSE has established a similar index agency.
Dow Jones' Islamic Market Index excludes companies if their ratio of total debt against total assets is equal to or greater than .33; if the ratio of accounts receivables against total assets is equal to or greater than .45; or if the sum of non-operating interest income plus other “impure” income divided by revenues accounts for 5 per cent or more of total income.
Determining whether a company is shari'ah compliant takes some digging. A company that does not generate excessive riba income and is relatively debt free may appear to present an attractive investment opportunity. But it may also employ interest rate swaps, currency swaps, trade the commodities market, and be heavily involved in internal financing of customer receivables, all activities which are considered haram.
Because of the complications involved in assessing the appropriateness of an investment, all Islamic fund managers must abide by the guidance of boards of shari'ah advisors. While these funds avoid haram investments, they often struggle to maintain a balanced, diversified portfolio.
Shari'ah investment strictures put many Middle Eastern investors in a unique situation – their portfolios may not include most forms of fixed-income investments, i.e. securities that are staple ingredients in the bulk of the world's institutional investment portfolio.
Venture versus buyout
Private equity, with some exceptions, lends itself nicely to shari'ah compliant investing. Through private equity, particularly through early stage investing, institutions may participate in, and benefit from, the growth of companies as partners rather than as creditors.
One analyst says venture capital investment allows for greater clarity in decision making and more control over the agenda set by any portfolio company: “You are investing in a company at the early stage of development, and the balance sheet has not been ‘infected’ with bonds and bank loans. From a shari'ah point of view, that is the most pure form of investment.”
Through private equity, institutions may participate in the growth of companies as partners rather than creditors
A venture capital fund can have its own shari'ah board to establish screens, firstly, on what investment can be made, and secondly, the type of securities that can be used to finance companies. For example, convertible or preferred stock options are common in venture capital funds, but are not acceptable in an Islamic context, because they bear interest.
From a shari'ah compliance standpoint, private equity becomes less “pure” as it moves into more mature businesses because at these later stages of development, bank loans are more common source of funding.
Here is where private equity is the subject of some debate among shari'ah scholars. Buyout transactions and recapitalisations obviously involve debt securities. But even a leveraged buyout, if structured properly, can be embraced by Islamic investors. Some investors view coupon-paying securities as allowable so long as their structure cannot be viewed as a straight loan. For example, a company that securitises its cash flow and sells the right to a receive a portion of that flow would not, according to some analysts, be against the rules. “Conceptually, it can work,” says one.
A bright future?
These are, of course, gray areas. The line between a loan that pays interest and a security that channels cash flow is thin. According to shari'ah, making money from money is not permissible. A straight loan treats money as a commodity in its own right, rather than as a measure of value that has no human utility. A securitised cash flow, on the other hand, lays claim to the sale of underlying commodities or services. Therefore, the receiver of the cash flow is actually receiving his or her coupon based on the buying and selling of real commodities rather than as a fee for the “rental” of an intrinsically valueless currency.
Loans are allowed under shari'ah under three circumstances: the lender does not intend to be repaid in full; the lender is simply parking money with the borrower for safekeeping and does not expect interest; or the lender is advancing money to the borrower with the expectation of sharing in profits or losses.
From a fixed income viewpoint, the third circumstance sounds most similar to an unsecured, coupon-bearing note – the buyer may share in a pre-determined cash flow so long the issuer performs at a certain level. Otherwise, both the note-holder and the issuer experience loss.
However, securitisation does create an imbalance between the issuer and the holder, where fixed payments continue independent of the underlying performance of the assets, with the exception of a serious deterioration of the business. Shari'ah frowns on any form of imbalance in business relationship.
It is easy to see why many Islamic investors prefer early stage venture capital, where “pure” equity investing so clearly allows for equal partnership in the capital structure.
The Web site of the Al Rajhi Banking & Investment Corp., the Saudi financial institution, has a comprehensive overview of Islamic banking and investment principals that includes a nice summary of the principal of profit and loss. It reads almost like a primer on the private equity industry: “The basic and foremost characteristic of Islamic financing is that, instead of a fixed rate of interest, it is based on profit and loss sharing. Islam encourages Muslims to invest their money and to become partners in business instead of becoming creditors. This encourages entrepreneurship. In turn, entrepreneurs compete to become the agents for the suppliers of financial capital who, in turn, will closely scrutinise projects and management teams. The objective is that high-risk investments provide a stimulus to the economy and encourage entrepreneurs to maximise their efforts.”
Well argued, and evidence that private equity and Islam may have a bright future together.