Shariah-compliant private equity funds are governed by the laws and principles of Islam. The amount of capital managed by these funds continues to increase, partly due to the build-up of savings from successive oil and gas booms in the Middle East, the heartland of the Islamic world. Many investors would like to put their money to work in a manner consistent with their religious beliefs.
Perhaps the most distinctive characteristic of Islamic finance is the prohibition of interest (Riba). Islamic law conceives of money as a medium of exchange and store of value, but not a tradeable commodity. Accordingly, earning money from money is unlawful (Haaram). Instead, the money should be invested in projects and commerce, with the profits so generated providing the returns to participants.
Due to the prohibition on interest, the payment of preferred return cannot be fixed in an Islamic fund. For the same reason, investors admitted at later closings would not owe equalisation interest to the fund’s existing investors, although it is possible to structure equalisation premia such that new investors are admitted on the basis of current NAV. If an investor defaults on a capital call, no interest accrues on the overdue amount. Instead, the defaulter may be subject to late payment fees, which are then donated to charity.
Under Shariah, owning equity in a company is tantamount to owning the company’s business and assets directly. It follows that any activity or trade that is forbidden in Islamic law (e.g., gambling) is forbidden to the portfolio companies of a Shariah-compliant fund, and thus to the fund itself. The fund’s activities must not involve an unacceptably high degree of risk (Gharrar). Contracts involving financial speculation (Maisir) are considered unlawful. As a result, a Shariah-compliant fund cannot trade in options or other derivatives used to hedge against possible outcomes. In addition, leverage at the portfolio company level is normally capped, often by reference to some financial ratio, e.g., indebtedness to be less than 33% of total assets.
Sharia supervisory board
The manager will need to empanel a board of Islamic legal scholars to advise on, monitor and certify the fund’s ongoing compliance with Shariah law, including whenever it selects targets and allocates and distributes investment proceeds. Determinations of compliance are generally issued as formal written declarations (Fatwa). The Shariah board also audits Islamic compliance in the annual accounts of the fund and, sometimes, its subsidiaries. Consequently, a great deal rests on having a well-resourced Shariah board, staffed with highly-regarded scholars who can issue Fatwas.
Islamic investment funds may be structured as:
- Mudaraba: a form of joint venture, in which investors (Rab-ul-Mal) pool capital for investment purposes under the control of an entrepreneur (Mudarib). Both sides share in the profits and losses. The investors are not involved in day-to-day management.
- Musharaka: a form of partnership, in which all of the partners are involved in the running of the business and share in profits and losses according to a pre-agreed ratio.
- Wakala: an agency contract, in which the investors engage a fund manager to act as their agent (Wakil). The Wakil exercises its powers only in compliance with investors’ instructions. The Wakil charges a fee for its services, which may be a fixed sum or a percentage of profits. It is not liable for losses, except where these arise from its own negligence or breach of terms.
Most Shariah-compliant private equity funds are structured as limited partnerships, combining a Mudaraba arrangement (covering the carried interest element of GP compensation) with a Wakala (for the GP’s management fees).
Most managers prefer to maximise their availability to investors by combining a Shariah-compliant fund with a conventional fund. This is permissible, so long as the two categories of investor are kept apart. Secular investors would be admitted to the main fund vehicle (Main Fund), while religious investors are directed into a Shariah-compliant parallel fund or side pocket (Shariah Fund). The two funds appoint different subsidiaries of the fund manager to act as their respective general partners.
It is also essential for non-Shariah-compliant profits to be ringfenced. One way to achieve this is to have each fund invest in the portfolio indirectly through a fund-owned holding vehicle. Leverage in deals is deposited at the holding vehicle level. The two holding vehicles then pool their cash in an aggregator limited partnership, which is administered by its own GP, also an affiliate of the manager.
The aggregator makes the portfolio investments. The aggregator’s middle position, between the two funds above it and the assets below, enables it to shield that the Shariah Fund from non-Shariah-compliant proceeds emerging from the portfolio. The aggregator does this by identifying and allocating specific items of income and gain received from portfolio investments to the Shariah or Main Funds, according to whether the item is adjudged Shariah-compliant or not – a thoroughgoing process known as “purification”, on which the Shariah board would be expected to advise.
The Shariah Fund is accorded priority over profits screened as Shariah-compliant, while the Main Fund has priority over non-compliant profits. If the Shariah Fund’s pro rata share of overall profits can be met out of Shariah-compliant items, the balance is subsequently available for distribution to the Main Fund if the latter needs a top-up to achieve its pro rata share. If Shariah-compliant profits are insufficient to fulfil the Shariah Fund’s pro rata share, they may be topped up from non-compliant profits, but these would usually have to be purified by donation to approved charities.