Volume13.Issue26

Bye bye Britain, hello Uncle Sam?

The world is still reeling in shock at the outcome of the EU referendum which is sure to cause a seismic shift in the geopolitical and economical landscape of the world. In our last issue, we explored the potential impact of Brexit on the UK’s Islamic finance market; this week, however, we turn our attention to the next likely safe haven for Shariah investment during these uncertain times.

The IFN Editorial team brings you editorial insights from across the world with a look at Islamic liquidity management and boosting initiatives in Bahrain and Pakistan; the rise of residential property funds; and Turkey’s successful US$1 billion sovereign Sukuk. Our analyses focus on Sudan and the private equity and venture capital sector while our IFN Correspondents provide us with updates from Iran and the UAE. Maureen Badjoerie, CEO of Trust Bank which is preparing to launch Islamic banking services in Suriname, writes on how Shariah finance will empower Latin America and the Caribbean while Neale A Downes, a partner at Watson Farley & Williams, walks us through the phenomenon of Islamic funds. Our resident columnist Kavilash Chawla offers us interesting thoughts on a number of catalytic events, including Brexit.

As usual, we wish our readers an informative and insightful read – one that will help provide some direction during these uncertain times.

Company Focus: Shariah compliant Abraham’s River set to unleash further Islamic finance growth in the US

Although growing at a rapid pace, the Islamic finance industry in the US remains relatively small and fragmented compared with other parts of the world. However, incremental changes seem to be taking place, and the recent Shariah compliance certification for new kid on the block Abraham’s River is welcome news for the fledgling industry. DANIAL IDRAKI brings you the story.

The Chicago-based Abraham’s River was established in 2015 by David Loundy, the CEO and chairman of Devon Bank, and describes itself as operating in accordance with “the requirements of the Abrahamic faiths” (Judaism, Christianity and Islam). It aims to expand the provision of religiously compliant financing in the US, and to provide religiously acceptable income-oriented investment options. “Throughout the ‘Great Recession’, we at Devon Bank tried various attempts to create Shariah compliant investment products and to launch a non-interest-based bank. It was the wrong thing at the wrong time, as we could not find the investor support we needed,” Loundy explained to IFN. 

After gaining further experience in deposit management for Islamic banks, the concept for Abraham’s River was born. Launched a year ago, the firm bought its first asset in September 2015, and began operations in January this year. “At the end of May, we received the Fatwa approving the structure, and in June we paid our sixth monthly dividends and finished our private placement memorandum,” Loundy added.

Currently, Abraham’s River’s assets are predominantly in the Ijarah structure, with a few shorter-term Murabahah transactions. It has nine religious institution properties under its commercial real estate portfolio, aside from retail and industrial properties. The institution also provides a small amount of residential property and medical equipment financing. 

“Abraham’s River functions as an Islamic bank, but not in a way that the US regulators would call it a ‘bank’ — no charter, no branches, no employees — sort of a clownfish living in the anemone of Devon Bank, which also means very low overheads,” Loundy noted.

Abraham’s River is based on the dual concepts of Wakalah and Musharakah. Investors pool their funds under a Musharakah agreement and invest into Shariah compliant transactions as approved and endorsed by the Shariah Board of Devon Bank. As part of its investment mandate, no more than 10% of investments may be focused outside of the US. The major focus, although not necessarily exclusive, is on assets that support the payment of a monthly dividend and a stable price for membership units of Abraham’s River. It currently has four unit classes, which include liquid (class L), term (class T), charity (class C) and equity (class E).

Aside from receiving the official Fatwa, Abraham’s River is waiting to hear from the Chicago Rabbinical Council on its documentary review. While barely one year old, Abraham’s River is by no means taking things slow, and sees plenty of opportunities in a country with 3.3 million Muslims (according to Pew Research Center). 

“We are now ready to take the ship out to sea. We will increase business on the financing side, add investments on the other side of the balance sheet in a way we have not been able to so far, and possibly use the company as a warehouse to accumulate assets to generate Sukuk,” Loundy opined.

Sovereign Sukuk: A subdued week

Coming to an end of the first half of the year, the sovereign Sukuk front has been relatively quiet over the past week, with no new issuance. DANIAL IDRAKI takes a look at some of the announcements that keep the momentum going, no matter how miniscule it may seem.

Indonesia
The government of Indonesia is targeting to raise IDR4 trillion (US$296.4 million) via an auction of sovereign Sukuk (SPN-S 29122016 and four project-based Sukuk series) conducted on the 28th June to finance the 2016 State Budget, according to an announcement on the Ministry of Finance’s website.

Iran
The Iranian Mines and Mining Industries Development and Renovation Organization (IMIDRO), a state-owned holding company active in the mining sector, is planning to issue IRR4 trillion (US$132.64 million)-worth of Sukuk Musharakah. Over IRR3.3 trillion (US$109.42 million) of the overall figure will be allocated to the production of titanium pigment from the Kahnouj mine located in Kerman Province, whereas IRR700 billion (US$23.21 million) will be spent on the development of the second phase of West Azerbaijan Province’s Zarshooran gold mine.

Upcoming sovereign Sukuk

Country

Amount

Expected date

Oman

US$2.5 billion

TBA

Hong Kong

TBA

TBA

Egypt

TBA

TBA

Iran

IRR60 trillion

2016

Nigeria

TBA

TBA

Jordan

JOD175 million

TBA

Pakistan

PKR79.1 billion

TBA

Egypt

TBA

2016

Kazakhstan

TBA

2016

Kenya

TBA

2016

South Africa

TBA

2016

Bangladesh

TBA

TBA

Hong Kong

US$500 million to US$1 billion

TBA

Ningxia Hui Autonomous Region

US$1.5 billion

TBA

Senegal

TBA

TBA

Niger

XOF150 billion

TBA

Luxembourg

TBA

TBA

Tunisia

US$500 million

TBA

UAE

TBA

TBA

Shandong Province

CNY30 billion

TBA

Sindh Province

US$200 million

TBA

Kuwait

KWD1 billion

2016

Maldives

TBA

TBA

Sri Lanka

US$1 billion

TBA

Germany

US$1 billion

TBA

 

US commercial real estate market continues to capture Shariah investment despite slowdown

The US commercial real estate market may be showing signs of cooling down, but this has not deterred Islamic investors from jumping into the US property business as global demand for North American real estate continues to surge. VINEETA TAN reports.

Gulf Islamic Investments (GII), based in the UAE, is the latest to join a string of Shariah-inclined financial institutions in capitalizing real estate opportunities in the US. GII recently acquired a Class A Commercial Building in Pennsylvania for US$48 million using a five-year Shariah compliant financing facility. The deal is the firm’s first foray in the US market and certainly not the last as GII intends to expand its portfolio to include assets in the European and US markets. Tapping the US market follows its entry into the UK – both of which were executed in the span of eight months.

International demand for US real estate has been on the upward trend; however, the market is already showing signs of slowing down. According to Moody’s and Real Capital Analytics, prices of commercial properties in major US cities have dropped 3% since April while Cushman & Wakefield projects the New York property market to shrink by as much as 30% in 2016. Pacific Investment Management attributes this slowdown to a stricter regulatory environment and the weaker growth of China among others; the firm expects domestic real estate values to slide as much as 5% over the next 12 months.

Yet, despite the weaker environment, there are encouraging signs from the Islamic investor pool which still sees US real estate as a lucrative asset class. 

“We have plans to acquire high-quality income-yielding real estate assets in the US, the UK, Germany and other parts of Europe and also to invest selectively in attractive value-added development opportunities in these regions,” confirmed Pankaj Gupta, the co-founder and co-CEO of GII. 

GII is not alone. Saudi Arabia’s Islamic investment firm Sidra Capital in April broke into the US market with a SAR350 million (US$93.28 million) purchase of a South Carolina property to kick-start its future US acquisition plans. UK Shariah compliant real estate specialist 90 North in February closed a US$123 million acquisition of Saint Gobain’s North American headquarters outside of Philadelphia. 

More recently, Soho Properties raised US$219 million in Shariah compliant funding from financiers in Malaysia, Kuwait and Saudi Arabia to finance the construction of its Tribeca condominium tower in Manhattan. 

“This transaction aptly demonstrates the increased activity in Islamic financings in the US which has emerged over the past year,” commented Baker & McKenzie partner Mona Dajani, who advised the Saudi Arabian firm, MASIC, involved in the Tribeca transaction.

World nations turn to Islamic arbitration services as Shariah finance goes international

Litigation through the courts may be the most popular choice for Islamic financial commercial disputes; however, VINEETA TAN writes that an increasing number of market participants are gravitating outside the courts to settle transaction disputes as the internationalization of Shariah finance reaches an all-time high.

According to Prof Sundra Rajoo, the director of the Kuala Lumpur Regional Center for Arbitration (KLRCA), there has been a meaningful increase in the number of commercial disputes crossing over to the Islamic arbitration side, although the level of take-up, while on the upward trajectory, could still be improved. 

“It’s hard to proportionate this against dispute resolution cases in the conventional financial industry — that would be similar to comparing apples to oranges. But the demand for a Shariah compliant dispute resolution avenue is at par with the industry’s growth and market share needs at the moment,” Prof Rajoo told IFN, adding that he expects the adoption of the Islamic arbitration services to expand as the Shariah finance market matures.

Very encouraging is that Chinese President Xi Jinping’s ‘One Belt, One Road’ strategic initiative, which has opened the doors for Shariah compliant project funding opportunities, has also cleared the way for third-party commercial dispute resolution services. 

Multiple arbitration centers worldwide, including the KLRCA, are now working together to launch a platform to market their services together; Prof Rajoo confirms that the proposed alliance will approach the government of China once things have been formalized. 

Qatari authorities have also shown interest in possibly utilizing the KLRCA’s set of Shariah compliant arbitration rules — the world’s first to adopt the United Nations Commission on International Trade Law’s Rules for Arbitration.

When the KLRCA’s i-Rules were launched in 2012, industry observers welcomed it as a positive step toward broadening arbitral options and fortifying Malaysia’s position as an international Islamic finance hub, and to a large extent, to enhance standardization across the global Islamic finance industry. 

And while one can hope for that, Prof Rajoo however highlighted: “It is important to remember that [the i-Rules] are a means to an end, and not an end to a means in the larger picture for harmonization in the industry.”

The i-Rules are currently in the process of being updated in tandem with the review of Malaysia’s Arbitration Act which was last revised in 2011. Recommendations to the government, which include recognizing emergency arbitrators, are expected to be made this year, confirms Prof Rajoo.

Property funds: The next big thing for Islamic investors?

The uncertainty surrounding the UK exit from Europe has hit, and hit hard. With property investment up there as the number one asset class for Islamic investors into Britain, LAUREN MCAUGHTRY takes a look at the latest trend likely to hit a sector already under fire — the growing popularity of property funds. 

While Brexit could have a serious impact on the UK investment landscape, industry insiders are pragmatic that the consequences for Islamic investors are unlikely to be too serious (see cover story, Vol 13 Issue 25: ‘The Big Brexit’). Other issues, however, continue to impinge on the real estate market — which could be on the verge of a sea change in the way overseas investors get involved. 

New taxes on UK property, combined with stamp duty changes and a more rigid regulatory approach, have meant that investments must now be structured to take account of the new landscape. And while direct investment has until now been the favored form of investment, a new avenue has emerged that is about to explode onto the Islamic scene. 

“Property funds are becoming increasingly popular and specifically more important to the Middle East[ern] investor,” explained Naomi Heaton, CEO of UK-based property investment firm London Central Portfolio (LCP). “They are Shariah compliant, but in addition the taxes on direct investments are not applicable if you invest through a fund structure.” 

Islamic investors active in the UK market will soon have to pay capital gains tax, inheritance tax and stamp duty, while even offshore companies and holdings are soon to come under scrutiny. “The UK government doesn’t charge tax on property funds which have multiple investors and diverse ownership,” noted Heaton. “Middle Eastern investors don’t feel very comfortable with tax, so that is a major attraction especially given the recent changes in the UK property market.” 

For those investors buying for investment purposes, this approach simply makes more financial sense, and industry insiders are expecting a significant shift toward both residential and commercial funds. But this does not just benefit overseas buyers — it also has an inclusive effect for the domestic market. For UK investors keen to allocate their funds according to their religious principles, these funds are also eligible for inclusion in their Self Invested Personal Pensions and Individual Savings Accounts, two of the most popular tax-efficient savings vehicles — allowing them to access central London investments in a way they might not be able to do on a direct basis, while ensuring they are not penalized on a tax level. 

And while Brexit is expected to have an overall negative effect on the UK economy and inward investment, the small central London segment could in fact benefit from the upheaval. “Prime Central London real estate is expected to benefit from a flight to quality and the security of blue-chip tangible assets, against a background of highly volatile financial markets,” noted LCP on the 24th June. “It is now likely that property prices in Prime Central London will increase…. LCP have received a stream of enquiries from the early hours of this morning.”

As this market strengthens, funds will play a vital role in its development. “Over the next five years, you will find that funds will become significantly more important,” agreed Heaton. “Everything is shifting toward the funds arena. There are huge new dynamics coming into the property market and for people who have an investment strategy, this is going to be a major new trend.” 

Pakistani Islamic banks gain liquidity investment options as country builds infrastructure with Shariah finance

Flush with liquidity, the fast-growing Islamic banking fraternity of Pakistan has always struggled to find suitable avenues to park excess liquidity but VINEETA TAN observes that the landscape is becoming more fluid, thanks to concerted efforts by Prime Minister Nawaz Sharif’s government in creating quality instruments to absorb abundant Shariah liquidity from the system.

The numbers are encouraging. Official central bank data shows that Pakistani Islamic banking institutions have significantly increased their investments: in the first quarter, a total of PKR593.6 billion (US$5.62 billion)-worth of Shariah banking investments were channeled into a variety of asset classes including sovereign securities, shares and Sukuk — a 60.6% surge as compared to the corresponding period in 2015. 

This upswing — which reflects the growing options Islamic banks have to park liquidity — is mainly driven by the stream of investments into federal government securities which swelled by 67.9% year-on-year to PKR417.6 billion (US$3.96 billion) at the end of March 2016. While the exasperated domestic Shariah banking community has for a long time been pushed to a corner with few Islamic-friendly investment avenues, the financial circle has received reprieve: in the first quarter alone, the government printed PKR80.4 billion (US$761.58 million)-worth of Sukuk Ijarah to meet the overflowing demand of Islamic banking institutions which collectively has over PKR200 billion (US$1.89 billion) of excess idle funds, according to some estimates.

The government did not stop there. This week, state-owned Water & Power Development Authority (WAPDA) raised PKR100 billion (US$947.24 million) through Sukuk — the country’s largest-ever fund (both conventional and Islamic) mobilization for a public entity. The private fundraising exercise, conducted to finance the 969 MW Neelum Jhelum hydropower project, was described as a “milestone” in the history of Pakistan by WAPDA Chairman Muhammad Zubair, who also added that this issuance will go a long way in facilitating funds for other hydropower projects. 

More significantly, the 10-year diminishing Musharakah facility will have great implications to the wider Pakistani financial market: Syed Iqbal Ashraf, the president and CEO of the National Bank of Pakistan, which is the single largest subscriber of the landmark debt with a 35% share, believes that the Sukuk, to be listed on the Pakistan Stock Exchange, will pave the way for Islamic banks and Shariah mutual funds to invest their liquid funds.

With a ‘AAA’ rating (JCR-VIS) and a sovereign guarantee, it does not come as a surprise that investment-hungry Islamic banks would clamor for a piece of the Sukuk in an environment where high-quality assets are scarce; and more of such offerings can be expected as Prime Minister Nawaz puts in place a robust infrastructure project pipeline particularly in the China-Pakistan Economic Corridor — as part of the ambitious ‘One Belt, One Road’ initiative — expected to be commissioned in 2018. Already approximately US$1.95 billion of financing involving some of China’s and Pakistan’s largest banks have been raised, part of which is Shariah compliant, and the multibillion-dollar projects will open the door for Islamic banks to participate as the government consciously decides to utilize Shariah compliant financing to make its infrastructure plans a reality.

Table 1: Pakistani Islamic banking investments in PKR billion

 

Period

Growth (%)

 

March 2015

December 2015

March 2016

Year-on-year

Quarter-on-quarter

Federal government securities

248.7

307.4

417.6

67.9

35.8

Fully paid-up ordinary shares

5.8

12

12.4

113.8

3.3

Bonds/PTCs/Sukuk

50.2

56.7

50.6

0.8

(10.8)

Other investments

64.9

62.5

113

74.1

80.8

Total investments

369.6

438.6

593.6

60.6

35.3

Provisions and deficit (surplus)

(1.5)

(6.7)

(6.7)

346.7

0

Net investment

368.1

431.9

586.9

59.4

35.9

Source: State Bank of Pakistan

 

Bahrain’s liquidity fund — will it boost Islamic equities on the bourse?

Bahrain Bourse is set to receive a capital injection with the latest US$100 million Bahrain Liquidity Fund (BLF) that is meant to enhance the depth of the country’s capital markets and provide better liquidity to investors involved with the bourse. DANIAL IDRAKI looks at the situation and how Islamic investors might be able to take full advantage of the new initiative.

“Both Islamic and conventional investors are chasing yield in the current environment that is full of uncertainties and compressed returns,” Najla M Al Shirawi, CEO of Securities and Investment Company (SICO), told IFN recently, in explaining the current investment landscape in the Kingdom. Launched by SICO in collaboration with other market participants, the BLF will act as a market maker by providing two-way quotes on most of the listed stocks with a reasonable spread, to allow investors to actively trade their stocks. Restricted liquidity currently plaguing the stock market in Bahrain causes securities to trade at a discount to their underlying value and regional peers, and the fund aims to reduce that discount over the medium to long term.

The bourse currently has a market capitalization of US$22 billion with over 45 listed companies, out of which 17 comply with Shariah standards. It has made several initiatives in recent times to boost the local Islamic and conventional capital markets, including the introduction of the Bahrain Islamic Index in September 2015, the introduction of rules for REITs and the offering of Bahraini government bonds and treasury bills. Najla said that part of the funds from the BLF will also be used to invest in Shariah compliant equity instruments listed on the Bahrain bourse. 

“The BLF shall endeavor to increase liquidity and free float on the Islamic listed equities, among which there are five banking stocks representing around 11% of the total market cap. [The] BLF will also participate in future Islamic equities primary and secondary offerings to be traded on [the] Bahrain Bourse, encouraging more Islamic capital-raising activities to utilize [the] Bahrain Bourse as a platform that has the sufficient depth to support such activities,” Najla explained. She added that there is plenty of room for improvement since the Bahrain Islamic Index has a liquidity of just US$300,000 on average since its launch.

The timing of the new liquidity fund could not have happened at a more critical moment for the Kingdom, as it braces itself for a challenging economic outlook with lowered energy prices and a reduction in government spending, in line with the overall cutbacks in the wider GCC region. Year to date, the Bahrain All Share Index has declined 8.62% to 1,111.14 points, while the Bahrain Islamic Index also dipped by 12.74% to 714.08 points. Najla commented that general sentiment in the capital markets, including Islamic capital markets, is risk-off sentiment, whereby there is more liquidity in safer instruments such as government Sukuk compared with higher risk instruments such as equities or sub-investment grade corporate Sukuk.

There are 91 Islamic funds with total assets amounting to US$1.3 billion as of March 2016 which dipped slightly from US$1.4 billion a year earlier. The overall assets under management of more than 2,740 mutual funds in the country, meanwhile, stood at approximately US$7 billion. These figures were noted during the Middle East Asset Management Forum 2016 in May by Abdul Rahman Al Baker, the executive director of financial institutions supervision at the Central Bank of Bahrain.

“Certainly, we believe that the liquidity available for investing in Shariah compliant products is far better than the liquidity available for conventional products, specifically in the region, due to the limited number and variety of Shariah compliant investment products. Investors are essentially looking for products that would give sustainable income over a reasonable investment period with very clear risk mitigation tools in place,” Najla affirmed.

It has been a difficult year for Bahrain, as exemplified by the ratings assigned by Moody’s when it downgraded the country’s long-term issuer ratings to ‘Ba2’ from ‘Ba1’ and assigned a negative outlook. Perhaps the BLF will be a turning point to the right direction for the country’s bourse.

Thinking big

By Kavilash Chawla, a partner at boutique management consulting firm Bâton Global and a visiting scholar at Drake University.

In the four weeks since my last column, there has been an opportunity to ‘think big’ about a number of catalytic, world-changing events. Let’s start with the most recent: Brexit. What does Brexit mean for Islamic finance? 

While none of us has a crystal ball, the first casualty is likely to be London itself. Since the city hosted the World Islamic Economic Forum a couple of years ago, outgoing Prime Minister David Cameron had successfully begun to establish London as the hub and gateway for European Islamic finance. Now, it seems likely that it was all for naught. Firstly, part of the attractiveness of London as a hub for Islamic finance was its access to Europe. While the new operating reality is yet to unfold, it is hard to imagine that the UK will be able to retain its passporting privileges to the European market. A second loss to the city’s aspirations to be an Islamic finance hub is talent. While home-grown talent in the UK will likely continue to be strong, the isolationist, anti-immigrant message Brexit sends is very hard to ignore. As organizations think about and evaluate their growth strategies, the implications of Brexit as it relates to accessing world-class talent are certainly going to weaken the prospects of London as a hub.

Another casualty is likely to be the growth and expansion of Islamic finance in western markets like the UK. The engagement between UK financial market regulators and the Islamic finance industry has been very positive over the last decade, and that relationship is often held up as an exemplar of how regulators and industry can work together to find solutions that meet the needs of the local population. As an external observer, it is hard to remain optimistic that the new UK is going to be as engaged. This means a champion and exemplar for integrating Islamic finance into a conventional system has been lost. As the US and other markets may look to attract Islamic finance, and as Islamic finance looks to expand further into non-OIC countries, the potential loss of the UK regulatory authorities as a partner could be costly.

I am, however, an eternal optimist. While we all expect significant turmoil and fallout from Brexit over the coming months (and years), Brexit creates new opportunities. For other European cities, it creates an opportunity to continue to establish themselves as the hub of European Islamic finance. Luxembourg, Switzerland, or perhaps even France, Germany or Belgium could emerge as a hub for the region. While the European political climate still needs to be navigated and poses a formidable barrier, a pivot east from the UK may be where Islamic finance’s European future lies. 

Other than Brexit, this past week also saw the arrival of 1,000 Mandela Fellows from sub-Saharan Africa to 36 elite universities in the US for a six-week leadership program. Does Brexit signal that the move south may be more strategic and prosperous for Islamic finance, at least in the medium term? 

While it ultimately depends on an organization’s capabilities, capacity and resources, Brexit has certainly forced the need to ‘think big’ about the next few years for Islamic finance in Europe, and where the opportunities for growth and success are going to be found over the next five to 10 years. For my own part, I have been very impressed by the Mandela Fellows! 

The phenomenon of Shariah compliant funds

Much of the focus in recent years in the Islamic finance space has been on the explosion in the issuance of Sukuk (or so-called Islamic bonds), the use of Islamic finance or tranches in financing large infrastructure projects and the equally notable growth in the retail market. However, another industry has also been quietly and very successfully developing – the phenomenon of the Shariah compliant fund and with it, the creation of a complementary Islamic fund and asset management market. NEALE DOWNES writes.

In many ways, this is not at all surprising, as Islamic finance structures are, at their heart, far more akin to equity than to debt. Musharakah (joint venture) and Mudarabah (a limited partnership) – perhaps the purest of Islamic finance contracts – are arrangements whose very nature is in the sharing, between the partners therein, of risk and reward or, put another way, of profits and losses. 

Structure
Shariah compliant private equity funds are normally structured as a limited partnership which, as explained previously, to all intents, is the same as a Mudarabah arrangement. As a general rule, Shariah prohibits investments in preference shares, as they go against the principle that all investors or stakeholders should bear losses equally or, at the very least, pro rata to the level of their equity participation. Hence, investing in or through a company which issues different participating classes of shares is generally not allowed, although the use of management shares (for control) is not uncommon. 

One alternative is a closed-ended unit trust structure, whereby a fund company issues units to investors and then delegates management and administration to a third party – usually the fund sponsor or one of its affiliates. For example, this contractual structure is the norm for Middle East-sponsored funds domiciled in Bahrain. Shariah compliant private equity funds with international investors are, however, typically domiciled in traditional offshore jurisdictions familiar to such international investors.

The flat, opening or annual management fee is categorized as an agency arrangement (where the fee is a fixed amount or a percentage of capital commitments or the net asset value) and the carried interest or performance fee is viewed as a Mudarabah agreement (a silent partnership where certain parties (the Rab Al Maal) provide capital and the other party (the Mudarib) manages and deploys that capital toward an agreed investment policy or within investment guidelines and provides expertise in return for a share of the profit). Payment of the carry or performance is, as is usual in the conventional fund sector, dependent upon the investors first achieving a certain rate or return and/or on the returns exceeding a high water mark.

While the basic documentation for a Shariah compliant fund is similar to that of a conventional fund – ie analogous to a limited partnership agreement – certain terms, such as the equalization mechanism for investors admitted after the first closing and the charging of default or penalty interest on amounts due from limited partners which is not contributed (ie using a typical commitment model), must be adjusted in the context of Shariah.

As a result of their unique operating and investment restrictions, fund managers often set up the Shariah compliant fund as a parallel fund which invests proportionately in portfolio investments on substantially the same terms and at the same time as a separate conventional fund. While the parallel fund will have the same fund manager and investment focus as the conventional fund, such a structure allows the fund manager to provide a Shariah compliant investment vehicle to investors without restricting the operations of the conventional fund and burdening its investors with any additional costs.

Shariah supervisory board
A Shariah compliant fund must appoint a Shariah supervisory board that reviews proposed investments and issues opinions (Fatwa) as to their compliance or otherwise with Shariah. Most private equity funds from the Middle East simply engage an already existing Shariah board (typically the Shariah supervisory board of the fund’s sponsor or anchor investor). Alternatively, a fund may hire a Shariah consultant or establish its own Shariah supervisory board comprised of various Islamic scholars. There are also certain service providers with their own Shariah boards which may be engaged on a contractual basis to advise a fund.

The Shariah consultant or supervisory board is required to review and approve the private placement memorandum or other offering documentation and all other fund documents. 

The Shariah consultant or supervisory board routinely audits the fund’s activities and produces an annual report regarding ongoing Shariah compliance. Such a review may involve, among other things, visiting portfolio companies and the examination of documentation pertaining to investments. Details of investments proposed by a fund manager involving structures or securities not previously approved by a Shariah consultant or supervisory board are usually presented to the consultant or board for review and approval prior to investment.

Permissible investment areas
In order to qualify as Shariah compliant, a fund’s investment policy must contain restrictions that prohibit investment in industries or asset classes considered to be forbidden or Haram. These restrictions thus prohibit investment in companies active in the following industries and activities:

(a)    conventional financial services (including conventional banks and insurance companies)
(b)    tobacco
(c)    gambling
(d)    alcohol or pork products
(e)    certain entertainment, such as pornography (but often including cinemas, music and publications)
(f)    weapons or military equipment, and
(g)    any other immoral or unethical activities identified by the Shariah consultant or supervisory board.

The application of these investment restrictions is subject to differing interpretations. For instance, some Shariah scholars argue that an investment by a fund in a hotel or restaurant that serves alcohol and/or pork is prohibited, whereas other scholars argue that if the alcohol sales are less than a certain percentage of the total revenue of the hotel or restaurant, the investment by the fund may still qualify as Shariah compliant. Alternatively, funds or other investments are often structured so that any revenues from any activities considered to be Haram are segregated and not distributed to the Shariah compliant investors – they are typically donated to a charity – or that such revenues are applied or reinvested in permissible activities or assets, so that any further ensuing revenues are ‘purified’.

While a Shariah compliant fund may engage in leverage through the use of Islamic financing instruments (such as Murabahah), it may not obtain or provide conventional loans or otherwise invest in conventional interest-bearing instruments, including convertible debt securities. Cash held by a fund may only be invested in Shariah compliant, short-term investment products, such as Islamic money market instruments (eg Sukuk). 

Similarly, a Shariah compliant fund is subject to restrictions on the amount of conventional leverage permitted at the portfolio company level. This often takes the form of financial parameters in relation to the debt-to-equity ratios and interest income of its investments. The generally accepted standard is that the ratio of total conventional debt to total assets should be less than 33%. Additionally, the ratio of interest income (plus income from any incidental Haram or unidentifiable activity) to total revenue typically must be less than 5%. The ratio of liquid assets (cash plus accounts receivable) to total assets should be less than 45%. Finally, any conventional debt of a portfolio company must be restructured in a Shariah compliant manner generally within three years after acquisition.

Conclusion
As we can see, therefore, the inherent nature of a fund as a partnership between providers of capital and one or more expert and experienced managers of that capital and the requirement that all such parties should bear the risk and enjoy the rewards of their investment on an even or proportionate footing fits very comfortably into the ethos of Islamic finance.

The creation of screening services and widely accepted and trusted Islamic indices by a number of market participants – perhaps most notably Dow Jones – has further facilitated and hastened the growth of this exciting market. 

Notwithstanding the continuing era of low interest rates and inflation, signs of tightening liquidity in the traditional debt markets would suggest that further opportunities will open up for the well-advised and fleet-footed equity investor, including those requiring Shariah compliance. 

Neale A Downes is a partner at Watson Farley & Williams. He can be contacted at ndownes@wfw.com.

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