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Private Equity Modern-Day Musharakah?

Omar Shaikh, Ernst & Young

March 2008
 

Islamic finance has been widely acclaimed as the fastest-growing sector within the financial arena. Industry reports indicate the size of global Islamic assets to be over US$500 billion, with growth rates of 15% to 20%. Much of this growth and development has been within the debt and related capital markets sectors such as sukuk and commodity murabahah.

In recent years, a parallel trend in the mainstream financial world has been the magnanimous growth of the private equity (PE) sector. Now accounting for nearly a quarter of the UK workforce, the meteoric rise of PE players has not gone unnoticed. Interesting parallels have developed between these two previously obscure, but now high-profile, mainstream alternative financial products and this is of interest to all parties.

Importance of Equity-based Solutions

Although growing rapidly, the Islamic finance industry as we know it today – perhaps unsurprisingly because of its age – faces a number of challenges. Academics and industry practitioners alike point to issues ranging from a lack of secondary markets, consistency and uniformity of standards within Shariah compliance to a shortage of qualified professionals such as lawyers, bankers and scholars who adequately understand both the Islamic and conventional sides of the equation.

One of the most prominent challenges relates to the perception of Islamic financial products being overly engineered to mimic conventional products. But Islamic finance appears to be entering a new era where previously unaccepted areas are now coming to the fore. Sectors such as derivatives, hedge funds, the extensive use of tawarruq and other structuring methods to create a cash loan are raising many questions on the authenticity and direction of the industry. Many analysts commonly refer to the phenomena of “Shariah arbitrage” and classify Islamic products as another structured product creating wrappers to overcome restrictions.

To date, grass roots opinion in the UK struggles to deal with the benchmarking of Islamic home financing against the London interbank offered rate. The argument that Islamic home-financing charges a “profit rate”, and not an interest rate, begins to lose credibility when users realise that the “profit rate” is benchmarked against interest rates.

A number of industry practitioners, including Iqbal Khan, founder and ex-CEO of HSBC Amanah, have identified this challenge as requiring a change in mindset, ie that Islamic products be “Shariah-based’ as opposed to “Shariah compliant”.

Tariq Sheikh, founder of PE house RHT Partners, comments that “in essence, Islamic finance is an equity-, not debt-based, system and we need to develop Islamic products that are more in line with the ‘spirit’ of the law, as much as they currently are with the letter of the law”.

A banking system based on faith and credibility and, more importantly, the perception of it as being so are critical to the sustainability and differentiation of the Islamic finance industry.

PE – Elusive Musharakah Solution?

Like certain forms of the conventional PE market, an important fundamental principle of Islamic finance is that of risk/profit and loss sharing – a principle of musharakah. The Arabic term “musharakah” is not actually found in the classic Islamic texts on fiqh (jurisprudence) but was coined later within texts relating to Islamic financing modes.

Fiqh texts refer to the concept of shirkah, which means “sharing”, and is sub-divided into two categories: shirkat ul mulk – joint ownership by two or more people of a particular property; and shirkat ul aqd – joint commercial enterprise.

While the principles of Shariah require that loss be shared in proportion to capital invested, whereas profit share can be set at agreed levels, in general the Islamic model for business financing encourages profit and loss sharing through equitable financial and contractual arrangements.

The PE model, on the face of it, seems to provide a natural musharakah-based solution with a proven track record of success in the conventional system.

Demystifying PE

The term “private equity” represents a diverse set of investors who typically take a majority equity stake in a private limited company. But there are subtle differences in meaning across the western world.

In Europe, PE is synonymous with venture capital and is used to cover funding at all stages of a businesses life cycle. In the US, venture capital refers only to investments in early stage and expanding companies while PE covers more mature businesses; ie management buyouts and buy-ins.

PE firms are typically structured as partnerships with two key components: the general partnership (GP) – the management team responsible for making the investment decisions; and the limited partnership (LP), providers of the capital.

The LP will commit the funding allowing the GP to drawdown as required for investments that meet the agreed profile. There is typically a hurdle rate set by the LP which represents a minimum investment return target for the GP. Returns in excess of this are split with the GP on a pre-determined rate (often referred to as “carry”).

Alternative Asset Class
Traditionally, PE sits within the broader financial investment spectrum as an alternative investment class as represented in the accompanying table.

Deal Process

PE is medium- to long-term finance (usually three to seven years), provided in return for an equity stake in potentially high-growth unquoted companies. During the holding period, the focus of the PE firm is to improve the profitability of the company with a view to increase value upon exit.

A recent Ernst & Young study (“How Do Private Equity Investors Create Value?”) into the business performance and strategies of PE firms in the largest deals of 2006 showed four key drivers for PE:
  • Careful and selected buying;
  • Driving delivery of the business plan;
  • Management and incentives; and
  • Selling well.

Industry Challenges Facing PE

Recent sentiments in the market, coupled with the inherent risks associated with unprecedented levels of gearing in an environment of creeping interest rates, have resulted in a significant public debate around the tactics of the PE firms. The tactics of PE firms are being challenged, as are their returns by adjusting for leveraged amounts. Old baggage and negative connotations associated with the leveraged buyout (LBO) firms of the past appear to be resurfacing.

One of the biggest challenges facing PE firms is the result of its success, which has meant that there are a number of new players in the space, particularly around hedge funds. Now there is too much capital chasing too few deals.

The market impact, control and tax mitigation techniques used by PE firms are currently under great regulatory and government scrutiny in the UK, and have been addressed in its recent pre-budget report.

Middle East Experience

Islamic finance is more mature in the Gulf region. But how has the PE industry developed there, and what are the current developments?

Sell-down Model

Some Middle East (ME)-based funds use a sell-down model where the LP is represented by a consortium of typically tiered high net worth individuals. The GP will identify the target, undertake the due diligence, agree principal terms with the investor group and then make the acquisition. Normally, the GP will mark up the price before selling down the stake to the various investors on the pre-agreed terms.

Petrodollar Influence

The current increase in the petrodollar has made the ME region flush with liquidity and has resulted in an enormous amount of infrastructure investment and corporate acquisition activity, both regional and overseas. For instance, P&O was acquired by Dubai Ports World for US$6.9 billion in March. It was partly funded by a US$3 billion sukuk (Islamic bond) issuance.

The Aston Martin deal in the ME is an example of a PE-style acquisition of European assets that was fully funded by Shariah financing.

Analysts have estimated that the region currently has approximately US$1.5 trillion excess liquidity. A portion of these revenues has been dedicated to Shariah-compliant investments, and as a result of the limited universe of such assets, many of the sukuk issues have been oversubscribed and Islamic banks continue to see excess liquidity.

The Gulf Venture Capital Association recently reported that US$7.1 billion was raised in PE funds last year in the Gulf alone, up from US$4.3 billion in 2005. Total PE fund sizes have reached US$14 billion, which is a significant increase from the US$78 million in 2001. Early indications show this growth rate is continuing, with over US$9 billion having already been raised in the first half of 2007.

Overseas Interest

The ME is seeing increased interest from overseas players, attracted by the impressive growth rates in the region. Over the past year, several multinational banks have set up offices in the Gulf. Analysts at HSBC have estimated that nearly one-third of global project finance spend is currently going into ME projects. The Carlyle Group has also opened its offices in Dubai, from which it intends to increase its participation in regional PE deals.

The Emerging Markets Private Equity Association found that of 300 LPs contacted, 65% of respondents to its survey on limited partner interest in emerging markets PE expect to increase their commitments to the emerging markets over the next five years. Portfolio diversification was cited as a key reason for this.

Shariah-compliant PE

Put simply and very broadly, Shariah-compliant PE is carrying out the usual PE activities in a Shariah-compliant manner. This means: (i) acquisition target industry is ethically screened; (ii) debt to equity and income ratios are within the specified Shariah boundaries; and (iii) Shariah-compliant financing is used for the acquisition and funding.

Islamic PE promises to be one of the fastest-growing areas in the PE and Islamic finance space, according to a CORECAP study. Over US$4 billion of Islamic funds were announced last year.

New Shariah-compliant boutique firms are springing up and raising considerable amounts of cash: Venture Capital Bank launched a US$100 million real estate fund; RHT Partners was involved in the AED750 million (US$204.23 million) Dubai Madaares education deal; and established regional player Abraaj raised a US$2 billion Shariah compliant-fund last year.

Rising interest rates and pent-up demand in the Shariah space raise questions on the possibility of using Shariah-compliant financing as tranches within conventional PE transactions. Partnering with established European and US PE houses presents an attractive proposition for many ME investors. And as with sukuk financing, if the price and structure are right, it could provide a useful source of diversified funding for conventional PE firms.

Conclusion

Islamic finance, like PE, continues to enjoy strong growth. PE provides an attractive outlet for musharakah-based investments in institutional Islamic funds, culminating in an increasing trend of Islamic banks getting involved in PE deals by setting up their own PE funds or deploying a sell-down model.

Islamic banks should be wary that the PE model requires a broader mindset beyond financial engineering to include operation improvements as this is a key area for driving value. In order to effectively engage in PE deals, Islamic banks need to ensure they have the right resources, use experienced individuals with proven track records or consider partnering with existing boutiques or deploy a fund-of-funds approach.

In the UK, the crossover into the retail as well as small- and medium-sized enterprises market remains a key challenge. Perhaps this is a segment that Islamic finance can pioneer by adapting early-stage PE techniques to the owner-managed small business (sub-£1 million – US$2.08 – million value level) market. This is where the needs of the majority of the UK business community grassroots lie.

The Islamic finance industry and its practitioners could successfully pioneer a form of financing similar to conventional PE, but addressed with Islamic tenets firmly in place, to result in the best of both practices. The opportunity to innovate as opposed to imitate has never been more prime, as the sector is embryonic and has not yet fixed its structures. To create a new identity rooted in strong financial success and to change the current paradigm will go a long way in differentiating Islamic finance and adding credibility to the industry.

This is what the PE asset class has managed to do in the conventional sphere, and as such, the Islamic finance industry at large can take great hope and inspiration in the knowledge that similar equity-based success is achievable in its own market.

 

 

Omar Shaikh is a manager in Ernst & Young’s Islamic finance and private equity practices based in London.

This article first appeared in Islamic Finance news (Volume 4, Issue 45).

 

 

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