Islamic Private Equity: a funding solution for Shariah-compliant companies

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Despite the impressive growth of Islamic banking and finance, with 17 percent CAGR between 2009 and 2013 (Ernst and Young), many early stage companies and small to medium-sized enterprises (SMEs) in the Muslim world struggle to source Shariah-compliant bank financing. As many young, growing companies in the Islamic Economy seek to realize their next phase of growth, Islamic private equity represents a potentially lucrative source of financing for young ambitious companies, providing capital and a wealth of experience.

WHEN IS PRIVATE EQUITY APPROPRIATE?

Bank funding and IPOs are not viable sources of capital for young, growing companies. Banks often impose onerous collateral requirements for young companies, and equity investment routes such as initial public offerings (IPOs) are unavailable to companies at their early stage of corporate growth.

Private equity is an important financing option for young and growing companies that seek to access both capital and expertise. According to Bain’s 2014 Private Equity report, $252 billion was invested globally by Private Equity firms in 2014, of which $5 billion was invested in companies with revenues less than $100 million.

GLOBAL AGGREGATE VALUE OF PRIVATE EQUITY INVESTMENTS LESS THAN $100 mln, 2013-14 (USD BILLIONS)

Source: Bain and Company Global Private Equity report, 2015

There are several benefits for SMES in receiving private equity investment. As Chatti & Yousfi (Islamic Private Equity, 2011) point out, for young and growing companies, three main benefits that PE investments offer are:

1. An active partnership with the entrepreneur: PE funds are active investors and professional managers, in contrast with passive financiers. They very often have substantial and relevant business experience, in contrast with that of the entrepreneur.
2. A sustainable partnership with the contractor: The involvement of an investor, alongside the entrepreneur, creates a real dynamic for the company which will benefit from financial resources, complementary skills and some modern and effective modes of management and governance.
3. Financial support: For each stage of a business’s lifecycle, PE investors provide specific services and skills to enable the firm to move to the second stage (for example, from the starting stage to the development stage).
4. However, be prepared for scrutiny, prior to investment and on an ongoing basis.  Before investing, private equity firms will undergo a rigorous review of the business and financials via a due diligence process and will often seek a seat on the board, as well as ongoing transparency with company accounts.
5. Furthermore, many conventional firms are typically not Shariah-compliant. It is common practice for private equity firms to invest in non-Shariah-compliant industries (such as gambling and alcohol), and to use both a combination of debt and equity to acquire companies, all of which can conflict with the values of an Islamic Economy company.

HOW IS ISLAMIC PE DIFFERENT FROM CONVENTIONAL PE?

 There are several similarities in the objectives of conventional and Islamic private equity. According to Sheikh Taqi Usmani, a leading Islamic finance scholar, an Islamic Private Equity (IPE) fund has three main features:

1.   It pools investors such as business families, corporations and institutions, as is done with conventional PE funds.
2.  It seeks to diversify investors’ portfolios and achieve high returns by raising capital for target companies, as with conventional PE funds.
3. However, it must invest in companies that are Shariah-compliant to make a halal profit (in contrast with conventional funds, which invest across all industries, subject to their own specifications).
4. Furthermore, key differences occur in the investment and screening processes for target companies that seek funding. In addition to the standard due diligence process that conventional PE firms will undertake, there are additional qualitative and quantitative screens that apply to potential targets.

Qualitative screening means that target companies seeking Shariah-compliant private equity must not fall short of Islamic law’s core stipulations. Some of these are highlighted below:

Quantitative screening: Be sure to meet the screening criteria to successfully secure IPE funding. In addition to passing the hurdle for financial performance, there are additional financial criteria that companies must meet to secure Shariah-compliant funding (Chatti & Yousfi, Islamic Private Equity (2011).

1.    Interest-bearing debt: must not exceed 33 percent of total assets

2.    Interest-bearing securities and cash must not exceed 33 percent of total assets

3.    Accounts receivable: must not exceed 33 percent of total assets

4.    Non-permissible (haram) income: should be no more than 5 percent of total net income, according to most Shariah supervisory boards

ISLAMIC PE FUNDS: SOME KEY PLAYERS

Islamic Private Equity is still in its infancy. In a recent report of Islamic Private Equity published in 2013, it was indicated that $41 billion was raised in new Islamic Private Equity funds globally.

For early stage firms and SMEs that have decided to source private equity funds, it is important to have a sense of who to approach, as well as how to approach them successfully.

Some notable examples of MENA-based funds that are involved in Islamic PE transactions and/or provide Islamic PE financing include, but are not limited to: Abraaj Capital, Amwal, Citadel Capital, Fajr Capital, Global Investment House, Gulf Capital, Injazat Capital, Investcorp, and Sana Capital.

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