Investment restrictions are outweighed by funding opportunities
There is growing demand from investors domiciled in the Gulf Co-operative Council (GCC) region for investment portfolios that include Shariah compliant instruments. Although many sovereign wealth funds may invest in other noncompliant products, a growing part of their diverse portfolios is Shariah compliant.
Some very significant institutions and wealthy families in the region will invest only in Shariah compliant instruments. The wealth in the region continues to grow, making GCC investor participation increasingly attractive.
As a result of the continuing credit crunch, LP defaults in other jurisdictions and other factors that have emerged from the global financial turmoil, there is a strong desire on the part of borrowers to establish relationships with investors in the Gulf.
Many of the potential investors seek Shariah compliant investments, which, among other things, require the fund to comply with certain tenets of Shariah law. This article discusses both business opportunities and technical restrictions applicable to establishing and successfully marketing a Shariah compliant fund, based on the thesis that prudent business objectives can be attained through careful structuring of Shariah compliant offerings.
There are a number of considerations to be aware of in order to enter and attract this fast-growing market, including proscribed investments; the necessity of appointing and receiving the approval of a Shariah board and carrying out annual audits; purification of income; asset screening and custody arrangements and trading agreements. None of these considerations are insurmountable.
In fact, some of the basic tenets of Shariah financing promote both religious/ethical objectives and investment safety. It is notable that Shariah compliant borrowers with the necessary underlying tangible assets and limited leverage fared much better than other borrowers during the recent financial crisis.
Moreover, given the success of many Shariah compliant institutions and the struggles of fund managers to raise money in the West, progressive institutions are wise to explore creating Shariah compliant products in order to improve their chances of accessing liquidity in the GCC and parts of Asia.
A growing market
Muslims represent over a quarter of the world’s population (anticipated to be 50 per cent by 2040), yet less than 1 per cent of financial assets are Shariah compliant. This disparity is likely to be rectified in the coming years. Indeed, the Islamic fund industry is growing at 15-20 per cent a year already.
This may rise as young Muslim populations and communities start to save for later life and as their investment preferences expand. The impetus for the sector is currently being provided primarily by excess savings from oil and gas reserves, held in both government and private hands, and by increases in productivity and prosperity. Opportunities for innovative asset management companies to serve Muslim clients have rarely been better and the Gulf and Asia present very attractive markets.
The growingly sophisticated investor base, with wealth geographically concentrated in the Middle East, is underserved by current Islamic product providers. Although long-only equity funds predominate, demand is increasing for sukuk (fixed income) and alternative assets (hedge funds). Global Islamic assets stood at $1.2 trillion at the end of 2011, and are sustaining a growth of 20 per cent per annum.
Because Islamic asset management is still fragmented and primarily devoted to regional offerings, the market is open for new entrants. The assets being and eligible to be managed varies broadly, covering investment classes such as real estate, infrastructure, halal public and private equities, commodities, and other alternative investments. These investments can be managed and/or located not only in the Middle East, but also in both the primary and developing worldwide markets.
Shariah principles prohibit the following types of activities:
The payment or receipt of interest is considered usury, and therefore unjust. Excessive debt is also prohibited, making investments in highly leveraged companies unacceptable. Funds cannot pay a fixed or guaranteed return on capital. Instead of borrowing and lending, Islamic finance relies on sharing the ownership of underlying assets and all risk and profit/loss associated therewith.
Haram – certain restricted activities
Companies involved in prohibited business activities cannot be part of a Shariah fund strategy. Prohibited business activities include the production and sales of alcoholic beverages, including pubs and restaurants, pork products, tobacco; gambling (casinos, online gambling, betting, lottery schemes); and adult-oriented (video, magazines, online material, strip clubs), dubious, immoral and illicit trades (prostitution, drugs).
Maisir – gambling
Islam forbids gambling in any form. Consequentially, with certain exceptions, derivatives, forwards, options and futures are prohibited. Other forbidden practices include short selling, day trading, margin, and scalping trading.
One of the fundamental principles of Shariah is that any loss by the fund be borne by the investors proportionally to their invested capital regardless of whether the investors hold different classes of shares in the fund. In addition, the common practice of negotiating side letters with investors in funds needs to be reviewed from a Shariah law perspective to assure that necessary investor equality is preserved.
Shariah law imposes certain requirements which, along with local tax and other legal requirements, dictate a fund’s structure. While the economic arrangements commonly found in conventional funds are generally adaptable to Shariah, the structural arrangements often need to be quite different.
Shariah prohibits the issuance of preference shares, which limits one’s ability to use a corporation for the fund vehicle when establishing a hedge fund (since most hedge funds needs to issue different classes of shares in order to reflect the interests of management and special deals entered into with particular investors). Shariah also prohibits the payment of interest, which means that fund managers must give additional thought to the structuring of carried interest and performance fees.
However, it is possible to have a properly Shariah compliant fund structured as a mudaraba in which profits are not shared proportionally to invested capital, but rather pursuant to the agreement of the parties, and fund managers may earn a management fee similar to a form of carried interest. A mudaraba is a kind of “limited partnership” arrangement whereby one partner provides capital to the partnership, while the other partner manages the capital in consideration for a percentage of generated profit. Under such structure, those payments are not tied to capital invested by the fund manager (a common method employed for tax purposes in the US and other jurisdictions).
It is also generally accepted by most Shariah scholars that any haram income of a non-compliant target company or activity that does not exceed 5 per cent of overall gross income may be considered marginal or incidental. Therefore, in the private equity context a target company meeting the guidelines would be considered acceptable, provided sufficient cleansing or income purification of the offending income occurs in accordance with the guidelines set forth by the Shariah board.
Set forth below are some particular examples of structuring requirements that need to be accommodated pursuant to Shariah law:
The Shariah advisory board for a Shariah compliant fund may take different forms. The fund may have its own advisor or use the advisor of its fund manager, general partner or sponsor.
Additionally, we have seen the Shariah board range from a single scholar to a group as large as five scholars, who collectively decide matters and may vary in their views.
The Shariah board’s role varies from fund to fund and can range from simple oversight to involvement in management and operations.
However, the fundamental role of the Shariah board is to be an independent regulator initially to approve the fund’s structure and governing documents and to ensure that the fund is conducting its activities in a Shariah compliant manner.
Potential investors in a Shariah compliant fund must be informed as to the names and background of the members of the Shariah board. They will also need to see a fatwa from the Shariah board certifying that the offering documents, as well as operations, acquisitions and financings, are Shariah compliant.
It is necessary that the fund undergo annual audits to assure that Shariah laws have been complied with and that the financial statements have been reviewed and approved by the Shariah advisory board.
The level of Shariah board protection expected by investors varies by market and specific investors’ needs, with the UAE/Dubai market being somewhat more liberal and the Saudi market being more conservative. Therefore a careful due diligence and undertaking of investor expectations is necessary to avoid unnecessary costs and optimise the Board structure and marketability of the fund.
If it is determined that a percentage of a portfolio company’s income is acquired from non-Shariah compliant sources, this revenue must be removed from the profits of the Shariah compliant fund and the Shariah board likely will require that such a percentage of the income be donated to a charity, under the supervision of the Shariah board, through a process known as “income purification”. Sometimes the aggregate amount of all “impure” income earned can be distributed to the investors, who will engage in such purification on an individual basis.
If an investment fund intends to use leverage as part of its investment strategy, it must consider whether Shariah compliant financing is available, given the nature and geographic location of the fund’s target investments. Although the Islamic finance industry has made significant gains, it often will cost more than conventional financing.
Also, with respect to private equity, although portfolio companies generally may be acquired utilising existing debt up to 33 per cent, the debt must typically be reduced to acceptable levels (20 per cent of invested capital) within two or three years after the acquisition. Moreover, accounts receivable of target companies generally may not exceed 33 per cent, and cash and marketable securities may generally not exceed 33 per cent of market cap.
There are a growing number of service providers that offer Shariah compliance package service offerings, from providing access to Shariah boards to Shariah compliant custody and brokerage services using recognised brand name entities. This type of arrangement can add to a fund’s marketability and reduce costs, but no one size fits all well and custom solutions and structures are often preferable.
Please note that it is possible to include “opt out” and “side car” provisions in the fund documents to provide additional flexibility in addressing specific investor concerns.
Benefits and long term opportunities
GCC market variances
Based on our long-standing experience doing business in the GCC, with offices in Abu Dhabi, Dubai, Doha and Riyadh, we note the following general market characteristics. Of course, a fund may be designed to be sold in some or all of these (and other) markets, depending on the size and scope of the offerings.
UAE – a progressive and growing market centred in Dubai and Abu Dhabi with a broad variety of Islamic and other investors that are relatively flexible regarding structuring of investment vehicles.
Saudi Arabia – the most closed and controlled Islamic finance market where Shariah compliance is a legal requirement. Although there is a significant amount of capital available, careful structuring and marketing are critical to market penetration.
Bahrain – historically a progressive leader in Islamic fund-raising in the region, but Bahrain is currently undergoing considerable pressure and shrinkage due to political concerns.
Qatar – like the UAE, Qatar is seeking to position itself as a primary progressive market that can both attract Western capital and accommodate conservative Shariah-driven investors.
Oman – a relatively recent entry into the Islamic finance market, Oman is rapidly becoming a major “player” in this market.
Doing good and doing well (safe and ethical returns)
In many ways, Shariah funds are similar to socially responsible funds in the West, with other intangible benefits. Some of the restrictions imposed by Shariah law not only provide ethical/religious satisfaction, but also help to mitigate risk. In particular, the prohibitions on gambling and excessive leverage help to ensure the safety and stability of investments, and the oversight of a Shariah board helps to assure that proper corporate governance is in place.
Reaching out to establish relationships that will grow over time with Middle Eastern Investors
Shariah-compliant products create the opportunity to gain access to many wealthy investors in the GCC. The extra effort and cultural/religious sensitivity necessary to establish such products provide an opportunity to earn trust and develop long-term relationships in the GCC region which over time will prove rewarding and well worth the effort.