American Islamic Private Equity Transactions: Successes, Challenges and Opportunities
Umar F Moghul, Murtha Cullina
Although the bulk of activity and growth in Islamic finance lies in the Muslim world, the US remains an important market for many Islamic investors because of its depth and diversity. Many foreign-based institutions that have long invested in the US continue to do so, and many new, significant entries have been made over the last few years. As Islamic finance has grown both quantitatively and qualitatively worldwide, so have the number and sophistication of its participants. And, as the American Muslim population has grown, so have the number of consumers and market-makers within it who are slowly, but surely, addressing their own demands for a variety of financial products. Interestingly, “foreign” and “American” Islamic finance are coming together in the form of early-stage venture and private equity capital transactions to develop Shariah-compliant assets in the US that can in turn be sold to Islamic investors. This article briefly explores a recently closed transaction involving an Islamic investment bank investing in a US consumer goods business in what might be termed a growth equity investment.
Because of the congruence between equity investments and Islamic financial principles generally, Islamic financial institutions are not normally faced with significant structuring difficulties when acquiring equity in a lawful enterprise. However, because this investment was proposed as an acquisition of a minority interest in the company, it raised a number of challenging business and legal issues.
Perhaps the most compelling aspect of this investment was the willingness of a US company to operate itself according to Islamic guidelines, even though the Islamic bank was to own only a minority share. In order to successfully close this transaction, the Islamic investment bank and its counsel patiently undertook a lengthy, informational dialogue with the company (and a host of other American institutions). This dialogue was a process, not a single occurrence, and evidence of a long-term commitment not only to the company and the US market, but to Islamic finance generally. The innovation that took place over several months in this private equity transaction succeeded in implementing some of Islam’s legal and financial principles that had perhaps not been previously implemented, or at least not implemented in such an effective manner. This is a strong testament to the Islamic bank and the respect it gained through the relationship it forged with the company.
Under Islamic principles that require entitlement to profit to be coupled with an entrepreneurial risk borne by the capital provider, liquidation preference provisions, among others, are prohibited. Scholars have interpreted this principle to mean that “losses” must be shared on a pro-rata basis, but have differed as to whether this must be so with “profits.” Thus, most Islamic private equity transactions in the US have simply done away with this concept, and in so doing, we have learned that some conventional investors may actually prefer the absence of such preference because they believe it results in greater equality among shareholders and incentivises parties who might otherwise be positioned more adversely.
In making a growth equity investment, an investor’s principal concern is a significant ability to participate in the target company’s growth. Relying on the flexibility of Islamic law’s profit-sharing rules, legal counsel to the Islamic bank, addressing this goal, articulated a method matching only those certain aspects of liquidation preference not prohibited by Islamic law. Transaction documentation was drafted so as to eliminate previously existing equity classes. This was perhaps the most innovative feature of this deal: the structuring and documentation of a tiered waterfall schedule designed to replicate the permissible features of liquidation preference rights such that, upon certain events, such as a merger or sale of the company, distributions of the net proceeds from such events are shared by both the existing shareholders and the Islamic investor to a greater extent than they could have, had only “plain vanilla” common stock been issued. Of course, “losses” were properly shared on a pro-rata basis with the company’s existing shareholders. Predictably, the company’s various existing shareholders welcomed these provisions.
These same Islamic tenets also impact how redemptions and dividends are calculated. The mandatory redemption often insisted upon by private equity investors at a price articulated as a multiple of their investment amount is problematic. Keeping to Islamic principles, the investor in this deal articulated these items in a manner reflective of the market value and performance of the company. Again, these provisions were welcomed by the company.
As is well known, Islamic principles also impact how businesses finance (and operate) themselves. So long as the Islamic investor held equity in the company, any future financial transactions undertaken by the target had to be compliant with Islamic law. Not only did this mean that interest-bearing borrowings would be prohibited, but also that future issuances of conventional preferred stock in the company would be prohibited as well. Contractual restrictions were put in place controlling the company’s ability to borrow conventionally and issue equity with Islamically unlawful features. As can be expected, company management was principally concerned with its consequent inability to access the conventional debt market going forward and its estimation that future conventional equity investments were made less likely in light of the Shariah-related restrictions. Both the company and the Islamic bank, as well as their respective legal counsel, explored various options to address these concerns. Ultimately, the company’s concerns were alleviated by an increased investment and an agreement regarding the possibility of additional funding by the Islamic bank in the future.
It is hoped that the success and opportunity demonstrated by this transaction will pave the way for increased Islamic private equity transactions in the US and will generate discussion and dialogue as to how Islamic finance may be furthered.
Umar F Moghul is a senior associate in the Islamic Banking Finance Group of the law firm Murtha Cullina. This article was first published in Islamic Finance news (Volume 4, Issue 13). Portions of it have been previously published elsewhere.