Still in the Closet

Private equity – be it Islamic or otherwise – is not dissimilar to the perfect marriage. Both parties enter into an agreement for better or for worse and stick through it. More popularly known as venture capital in the western world, private equity is slated to be the new frontier for Islamic finance.

Ironic, because it is essentially the most fundamental form of partnership in the universe of Shariah financing. Should this sector kick off, it will further boost the real economy by promoting profit and loss sharing partnerships and asset-based trade finance contracts spanning murabahah, Ijarah and salam.

However, despite this, there is still a little exposure to the sector, with data showing that there are currently only an estimated 608 Islamic funds globally and across all asset classes, with equity exposure taking up a big chunk at 52%, while private equity and real estate make up a mere 18%, followed by money market, balanced and fixed income funds at 13%, 8% and 6%, respectively. In terms of value, it is estimated that the global Islamic private equity market is currently worth US$2.2 billion, a far cry from the US$40 billion anticipated by 2011.

Private Equity? What’s That?

Essentially, there are three major types of private equity investments – one involves investment in organic growth, another is to increase the value of a core business and the third is buying and building.

According to Paul Wouters of Bener Law, private equity investments are generally linked to the shares of non-listed companies; meaning young companies in the startup or early phases. As they do not have a proven performance record and usually also lack sufficient assets, these companies have difficulty in getting access to public investments or even to much desired bank loans. Most of the time, additional injection of capital is the only option available.

Another issue with this type of companies is that their shares are generally not easily transferable due to legal barriers, such as laws, articles of association or private shareholder agreements. Therefore, without an exchange listing, their shares are not available for easy trading, making it difficult to attract investors. In a nutshell, private equity is marked by a higher risk profile and a longer time span of illiquidity. Hence, the more conservative scholars are usually hesitant to condone the quick-fire buying and selling of equity on stock markets as, to them, it resembles gambling. This has also created bumps in the road for the mobilisation of regulations on Islamic private equity businesses in most jurisdictions.

Ayman Khaleq, partner at law firm Vinson & Elkins (VE Law), feels that private equity and venture capital are very Islamic because of their risk-sharing nature. “You take a risk and you are contributing value to a business, trying to improve it; you may make money or lose money. But the problem now is that banks are looking for ways to make money, so are they actually willing to invest in something that’s new like Islamic private equity?”

A majority of the investors in the Middle East, he added, prefer to invest in Islamic funds. Most of his clients from the US and Europe who have gone to the Middle East to raise funds have quickly realised the potential in creating Shariah-compliant funds to expand their net to attract both conventional and Islamic investors. “Fundraising is a very important aspect of it all, and once you have the money, you can come up with user-friendly structures that are still Shariah-compliant.”

Leaving it to the Big Boys

Despite the slow pick-up of Islamic private equity instruments and investments, Khaleq remains optimistic, “For the first time, we are seeing more international private equity venture capital firms and companies which have commenced projects involving private equity funds or private equity investments structures and acquisitions. That has led me to believe that innovation within this industry will be led by international players.”

Why international players? “They see the value in this form of investments. There are basically two types of value now – one is the ability to raise funds from Islamic investors and the second is more attractive valuations in terms of the targets that they are investing in. And frankly, the big boys are the ones who have the patience and resources to invest in structures that work.”

That is why, Khaleq says, international players such as ABN Amro and Deutsche Bank are fast becoming purveyors of the space, coming in to take a look at the investment options and figuring out the best and quickest possible way to structure their fundraising and investments Islamically. “Apart from people like Arcapita, I really feel that the innovation in terms of developing structures that work and are competitive outside the Islamic world – and can grow and compete for an asset in any jurisdiction, be it the US, Europe or Southeast Asia – will come from the bigger players,” he added.

According to him, the middle market is the place to start because investors are looking for straightforward solutions. “Middle market companies in Germany, for instance, want to be comfortable doing murabahah or some different type of structure or buy assets and basically, there are certain areas where it is hard to structure these assets. If this industry is to work, it would have to start with the middle market and unless we are able to come up with straightforward transactions, we have an issue.”

Post-crisis Trauma?

Although there is no official data as yet, it is estimated that US$500 million worth of Islamic private equity investments from the Middle East are expected to come into Asia this year, with strong interest in sectors such as healthcare, education, real estate and manufacturing. A banker in the Middle East says, “The current crisis provides a rare opportunity for the private equity funds to invest in Asia. On average, we see companies facing devaluation of around 60%. This is indeed the best time to acquire.”

It was also reported that the private equity sector is expected to profit from the current dumping of assets by distressed sellers, with most Islamic private equity deals focused on the Middle East and North Africa, especially the Gulf. According to Issam Al Tawari, managing director of Kuwait-based Rasameel, “The upside potential will be huge, especially in emerging markets, because the markets have been so oversold and prices have been so depressed.”

Khaleq, however, is more politically correct in addressing the issue. “I wouldn’t call them distressed assets, rather that the valuations now are more sensible. In the past, you wouldn’t find a big private equity firm paying attention to smaller investment categories but they are now. Most of the Islamic private equity work currently involves western fund managers – whether European or American. They are the ones who are really being robust and creative about both capital raising functions and investor functions.”

Most jurisdictions currently do not have specific guidelines for setting up and managing Islamic venture capital activities, same for Malaysia which issued its Guidelines and Best Practices on Islamic Venture Capital in May 2008. The Accounting and Auditing Organization for Islamic Financial Institutions in Bahrain and the UAE-based Dubai Financial Services Authority have also issued similar guidelines on private equity.

However, many still believe that proper regulations are needed to mobilise the sector, as countries such as Indonesia are suffering from the under-achiever syndrome of having so much investor potential but not enough clarity for investors to do business.

According to Hanim Hamzah, Islamic finance partner at Jakarta law firm Roosdiono & Partners, regulations are essential to fuel the growth of Islamic instruments, especially secondary market products. “Private equity is definitely a growing market, although Islamic private equity instruments are still very rare. There is, however, a huge untapped market here because there are many rich Muslims and a growing middle-class population looking to invest in halal products.

“What we are actually seeing in Indonesia are other advisors coming in from Malaysia and the Middle East, trying to produce and promote private equity products, but again, it is hard to push forward because there are no regulations in place for such instruments.”

Ayman Khaleq of VE Law was candid, pointing out that the Islamic private equity space suffers from a dearth of expertise and insufficient track record. “We cannot fool ourselves. The number of banks and firms doing private equity deals is still very small. The Arcapitas, Unicorns and Gulf Finance Houses are prominent but in small numbers. Even most of those tend to do deals within the Middle East because they are easier to structure.”

“The real success will come when Islamic banks are able to compete with the conventional private equity industry in non-Islamic jurisdictions. We are not there yet, and the industry is not yet ready to spend time and resources to do so because most of them are smaller banks that have spent the last year trying to figure out how the credit crunch would have impacted them,” Khaleq concluded.

This article first appeared in Islamic Finance Asia (Pg 34, October/November 2009 issue). For more information, please visit