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The Role of Venture Capital Model in an Islamic Economic System
Kashif Nisar
July 2010
 

Since their inception, Islamic banks have been criticised for not using participatory (profit and loss sharing) modes of financing such as musharakah and mudharabah. Generally, scholars argue that participatory financing is the key to achieve the main goal of equitable distribution of wealth in society. There has been little progress in this area and Islamic banks still heavily rely on less risky financing modes such as murabahah and Ijarah. Hence, there is a need to revisit the whole process to find out whether the criticism of Islamic banks is justified and whether the current commercial Islamic banking model can alone achieve an equitable distribution of wealth.

Any person would feel reluctant before handing over his life savings and expensive belongings to another individual for safekeeping. The reason for such reluctance is the 'trust' factor as it is possible that the person responsible for safekeeping may not return the belongings back to the actual owner. But when we talk about the commercial banking model, the same owner would readily deposit his funds and keep his belongings in lockers with a bank and would feel very secure after doing so. The commercial banking model exists on the basis of 'trust'. A depositor may have opened an account to avail certain banking services or to earn periodical profit on his funds. But in either case, he trusts the bank to prudently manage his funds and ensure that his principal funds remain intact. Imagine a depositor entering in an Islamic bank branch to withdraw part of his funds. He is, however, informed at the cash counter that out of the total PKR500,000 (US$6,000) deposited by him, only PKR300,000 (US$3,512) were available in the account due to the default of a corporate client, with whom the Islamic bank had entered into a musharakah transaction.

In spite of signing the mudharabah contract at the time of account opening and knowing about the possibility of loss in mudharabah, it is much likely that the depositor may not accept such loss. He may question the prudence and risk management exercised by the Islamic bank while investing his funds. He may even doubt the integrity of that Islamic bank and feel that the bank is deceiving him. Once the trust
level is shaken, the existence of that Islamic bank may be in jeopardy as other depositors may also approach the bank for withdrawal of their funds.

Similarly, the shareholders would generally expect the bank to perform better or at least at par with other competitor banks. They would have a certain expected return in mind as they have invested large amounts of funds and may also look towards alternative investment opportunities in case the Islamic banks fail to provide the desired return. So there is a dilemma for the Islamic banks. The fund providers (depositors and equity holders) are generally risk averse, whereas other stakeholders expect Islamic banks to deploy funds in participatory modes of finance which are riskier in nature.

Therefore, the criticism that Islamic banks are not investing the majority of their funds in participatory modes seems unfair. But, as is always the case, any extreme position taken is wrong. On one hand, it is unrealistic to expect an Islamic bank to base the majority of its asset portfolio on participatory modes. On the other hand, it is disappointing to see that, apart from a few players, there have been no visible efforts to utilise these modes even in a gradual manner. Major responsibility falls on the shoulders of leading Islamic banks to take the lead and promote participatory financing modes wherever possible.

Overall, the combination of the 'trust' factor of depositors, 'return' expectation from shareholders and strict regulatory control make it difficult for the management of an Islamic commercial bank to have a large portfolio based on participatory modes. This is exactly where the venture capital model scores.

Venture capital is a type of private equity capital mainly provided for early-stage, high-potential growth companies in the interest of generating a return through an eventual realisation event such as buyout or initial public offering. In such a model, there is an inherent risk of losing one's entire investment in a start-up company. In other words, the investor in venture capital may accept failure of six out of seven transactions. But the depositors and shareholders of an Islamic bank have a limited risk appetite.

Venture capital can be used as a tool for economic development in developing regions. It contributes to the economy as follows:

  • Venture capital is most attractive for new companies with limited operating history that are too small to raise capital in the public markets and have not reached the point where they are able to avail financing from banks;
  • Technology advancement;
  • Increase in job creation and innovation in an economy. We have examples of highly successful companies originated by venture capitalists such as Google, Amazon, Apple Computer, Intel, FedEx and Microsoft.

It was initially in the US that venture capital originated as an industry. Accordingly, the US venture capital companies have been the major participants in venture investments. Venture capital investments later increased in other regions such as Europe, Canada, China, Malaysia, India, Thailand and such.

The venture capital model works in a region when there are some initial success stories. For example, in the case of China, the venture capital industry started in the 1980s. Initial efforts failed due to lack of experience in this area. However, due to continuous support from the Chinese government as well as from the private sector, the industry took off from 1999 onwards.

As with China, the venture capital industry in Pakistan has witnessed sluggish development. One of the venture capitals, Pakistan Venture Capital, had to shift from the venture capital model due to portfolio issues and problems created by the local loan recovery procedures. In 2000, the government launched a US$50 million venture capital fund for technology development in Pakistan, but no notable progress was achieved and the initiative soon fizzled out. Steady support from the government and private sector is required to make the venture capital model a success since many high-potential projects in different sectors such as energy, agricultural and health remain untapped due to lack of funding. The government needs to facilitate the venture capital industry through different measures to ensure its success. The critical issues include development of an adequate legal framework, an easy entry and exit mechanism, necessary relaxations in the regulatory framework and promoting innovative ideas and potential entrepreneurs. The government can also play a major role by creating its own venture capital fund.

Venture capital is a mode of investing that seems ideal for Islamic finance through the application of participatory financing modes, with the mudharabah concept being the most common. In the Islamic venture capital model, mudharabah financing will involve a partnership contract under which the investor (or Rab-ul-maal) will provide financing, whereas the manager/entrepreneur will propose a business venture and will be responsible for the management and work. As per the mudharabah principles, the parties will have to agree in the contract on the proportion of the actual profit arising from the business venture. Loss in the venture will have to be borne by the investors unless the loss is due to the negligence or violation of the contract terms by the entrepreneur. In the Islamic venture capital company, a Shariah advisor should be appointed who will provide guidance on conformance to the Shariah principles in all matters and will ensure that the proposed investment contract and instrument structures are Shariah-compliant.

The Malaysian government is playing a major role in this area and is encouraging Islamic venture capital firms to establish bases in the country. In this regard, the Securities Commission of Malaysia has already introduced a set of guidelines and best practices to promote the adoption of appropriate standards for the development of the Islamic venture capital industry. It is expected that other regions, specifically where Islamic banking is growing rapidly, will follow suit and promote the Islamic venture capital industry. The Islamic venture capital model can provide ideal support to Islamic banks in achieving the vision of equitable distribution of wealth in the economy.

 

 

 

This article first appeared in Islamic Finance News (Pg 12, Vol 7, Issue 23, 9 June 2010. For more details, please visit www.IslamicFinanceNews.com

 

If you have any comments about or contributions to make to this newsletter, please email advisor@eurekahedge.com

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