Islamic Finance: A new form Private Equity?
By GITTEL AYUK Esq.
Islamic Finance (IsF), though new, is fast gaining credence in the global financial market. Standing on five principles, IsF is most renowned for its no-interest principle. Apart from the no-interest motive, another key principle is that of shared profits-and-losses, which is the focus of this article. This principle presupposes participatory banking. That is to say, the Islamic financing institution (IFI) does not just lend money to or finances the activities of the requesting company, but it participates fully in the business activities of the requesting Company, in order to share in the risk taking and subsequently share in the profit of the venture. When broken down, the participatory model of business fits into the framework of private equity. Just like IsF, PE is not out for interest but profits. The PE firms don’t lend out money in return for an interest but they invest money into a business venture in return for a share of the profit, which is the key element in Islamic Finance. Also, private equity institutions as they are well known, do not only put their money and wait for returns, but they participate largely in the management of the business which is in tandem with the mutual participation which anchors IsF.
Private Equity in Brief
Private equity is the direct opposite of public equity. The basic meaning of equity is ownership. Public equity or buying shares in companies listed in the stock exchange market is the most conventional way for investors to get equity in a business. But with private equity, investors become investors in companies which have not been traded in the stock exchange market by financing their business and participating in the management where necessary. The ultimate end of every private equity firm is to see the business grow in such a way that it can be traded publicly.
Islamic Private equity (IPE)
According to Clifford Chance, Islamic Finance has 8 vehicles, which are; Murabaha (cost-plus financing), Tawarruq / Commodity Murabaha (murabaha financing), Ijara (leasing), Istisna’a (construction financing), Wakala (agency), Sukuk (Islamic bond), Musharaka (equity financing) and Mudaraba (participation financing). Among these 8 vehicles, three, that is; Mudaraba (participation financing), Musharaka (equity financing) and Wakala (agency) combine to make up what has been commonly referred to as the IPE.
Mudarabah (profit-sharing)
According to the Institute of Islamic Banking and Insurance, Mudarabah is a business agreement between a financier (rab al maal) and an expert (mudarib) whereby the financier contributes his/her finances for a business venture while the expert brings in his/her expertise as his/her own contribution. At the end, both parties share the profit according to percentages initially agreed by them. If any losses accrue from the business, it is borne entirely by the financier meanwhile the expert remains unpaid for his/her labour. The business venture of the expert can be of any type, howbeit that it must be sharia-compliant. That is to say, it must not be within any of the activities considered as haram by the sharia.
Musharakah
In simple terms, Musharakah is participatory financing. According to the Centre for Islamic Finance, it is a business engagement between partners whereby they pool finances together for a business venture, agreeing to share in the profits and losses in proportions of their investments. In more practical terms, it is not any random pool of investors with a profit-&-loss sharing motive. In most cases, theIslamic bank or Islamic financial institutions are a main stakeholder, who makes contributes to already existing funds for a business venture.This makes the financing institution a partaker in the equity of the venture as it becomes part of the owners of the business
Wakalah
According to Financial Islam, Wakalah is an agreement for agency. Under this kind of venture, a principal gives express instructions to an agent to perform a specific business transaction on his behalf. In practical terms, a financer mostly, a financial institution, “agrees to put up capital for a specified period which the agent (entity requiring financing) invests on the investor’s behalf in Sharia’a compliant investments”
Key Principles of IPE: Sharia’a Compliance
The principles of IPE are the same with those of IsF. They are both built on the principle of utmost Sharia’a compliance.
- No Interest Policy (riba): IsF forbids the making of interest through lending. It holds that value should not be given to money just because its money. Money should serve only as a tool for exchange[1]
- Anti-speculations (maisir): forbids speculation or Uncertainty in financial transactions like selling something that one does not own.
- No unlawful use (haram): IsF forbids money to be invested in things which the Sharia considers bad, prohibited, harmful or dangerous.
[1] Bank of England, Op. Cit.
Partnership – Shared gains and profits: when people partner together, they should be able to share both their gains and their losses
Securitization: Loans must be backed by a tangible asset
Points of divergence
IsF and PE have many similarities but to claim Islamic Finance and Private equity are synonymous will be an attempt to mislead people. First things first, Islamic Finance is built entirely on the Sharia’a principles which prohibits certain kinds of activities. What a PE firm may see as a profitable venture may be seen as a prohibited activity by IFI. An IFI for example would not invest into businesses whose activities are inline with speculation, uncertainty and interest. So meanwhile IsF is restrictive, PE is open to any kind of business permitted under the law.
Another distinguishing factor is that PE firms could be classified as Profit-profit entities while IFI are profit-&-loss entities. At the back of a PE investor’s mind, the business has to grow to an extent where they can have a safe exit plan, which is by listing the Company in the stock exchange market. IsF on the other hand is out to grow and sell the business as a way of exit. Their aim is to manage the business and make as much profit from the business, or share in losses when they accrue.
Conclusion
IsF is a new, but yet thriving business. It presents itself as a new version of PE but still remains distinct from the traditional PE by its Sharia’a compliance principle. Also key, is the fact that IPE isn’t out for interest but for participation in the profits and losses of the business. Be it Sharia’a compliant or not, IsF and PE are all interested in becoming owners of private businesses by making investments and getting returns to same.