Islamic private equity: Has it come of age?

The private equity (PE) industry has experienced some extraordinary periods in recent years, fuelled by resilient fundraising and growing economic activity.

Momentum created in the year 2021, in the wake of the Covid-19 pandemic, cascaded into the first half of 2022.

It was a purple patch for the Islamic economy space as well. Investments across halal food, halal cosmetics, travel, pharmaceuticals, media and recreation, modest fashion and Islamic finance, totaled $25.7 billion in 2020/21, up from $11.8 billion recorded in 2019/20, the State of the Global Islamic Economy Report 2022 (SGIE), published by  DinarStandard, revealed.

Of the 210 deals recorded during 2020/21, 114 were venture capital (VC) transactions.

Amid growing awareness and a rise in the adoption of Shariah-compliant financial instruments, the Islamic PE space has gained considerable momentum.

“Private equity and venture capital (VC) will continue to be vital engines to boost the growth of the Islamic economy. Availability of PE and VC funding and expertise has helped innovative startups to get off the ground and scale, creating a vibrant and diverse economic landscape,” notes Adela Mues, partner, Global Corporate Group at Reed Smith.

“The infusion of Islamic finance principles in the PE and VC space has contributed to the popularity of private funding structures in Islamic economies. One successful example is the rise of Shariah-compliant funds, which provide an ethical investment approach, and resonate with a wide range of investors.”

Key alignments

Private equity, via its various strategies such as venture capital, growth equity and leveraged buyouts (LBOs), has been a significant mode of investment, fuelling innovation, growth, and impact.

However, realigning it to Shariah values warranted structural modifications, which included strong oversight on permissible sectors and lines of business of the target company as well as acceptable Islamic instrument structures.

The most typical form of Islamic private equity and venture capital investment structure includes contracts such as Mudarabah – a contract between an investor (rab-al-maal) providing capital and an entrepreneur (mudarib) running the venture; and Musharakah – a partnership in which all parties fund the business and share profits and losses.

A lesser deliberated and often overlooked fact, however, is that the conventional private equity and venture capital structure essentially mirrors a Mudarabah contract. Investors are, in essence, limited partners (LPs), while the general partner (GP) is the PE firm itself.

“The GP/LP structure is the most vivid example of a Mudarabah structure in modern finance. The simple dynamics of a GP/LP structure is very much in the spirit of Islamic finance because it includes the 'mudarib', better known as the general partner, who invests capital on behalf of the investors and has a share in profits,” Dr. Aamir A. Rehman, chair, Innate Capital Partners tells Salaam Gateway. 

The ‘leverage’ conundrum

As is largely perceived, Shariah law is not categorically opposed to debt. Rather, Islamic finance helps create sustainable levels of debt, pursued through a Shariah-compliant route. This has paved the way for leveraged buyouts to enter the fray, in which a company looks to acquire another business largely on borrowed money (leverage). 

Shariah debt financing instruments such as Murabahah (cost-plus-financing facility) are lending themselves to this cause.

The key difference, however, lies in the way leverage is created in a Shariah-compliant buyout deal. “In an Islamic LBO transaction, the leverage that's put on the target company must directly finance specific assets that the company will use. Debt, is thus limited, to the value of assets being financed. A conventional LBO, by contrast, is more like a general-purpose debt facility. A free cash flow analysis of the target company is conducted. Based on that, banks agree to a level of debt, which is typically expressed as a multiple of earnings and can be used for any purpose,” adds Dr. Rehman.

Companies under non-Muslim ownership leaning towards Shariah-compliant PE offerings has added to their visibility and growth – 40% of the notable Aston Martin deal was financed through a Murabahah instrument, arranged by German lender WestLB AG, back in 2007.

A decade later, Shariah-compliant refinancing of an office accommodation owned by Youngberry Properties in Scotland, was furnished. The funding was achieved via a commodity Murabahah facility, with properties let out to Petrofac and NHS Scotland.

Essential support

To propel the Islamic private equity and venture capital space, several Muslim-majority countries have chipped in, via initiatives and incentives.

In 2008, Malaysia's Securities Commission introduced new guidelines and best practices to develop the Islamic venture capital industry. The country also offers a five-year tax exemption on registered VC companies.

In the UAE, Dubai Silicon Oasis, a government-owned free zone, supports 'Islamic digital' and 'Arabic content' initiatives, pursuant to which, the freezone’s regulatory body offers venture capital funding and other incentives to startups operating in these domains.

“Policy makers and public sector leaders should recognise the role private equity and venture capital play in the business ecosystem and encourage more players. This includes both allocating funds for PE investment and raising awareness of its benefits within the broader business community. Aligning PE with the values of stakeholders – including both investors and business owners – is an important part of enhancing its relevance. In that context, Islamic PE firms have a lot to offer,” explains Dr. Rehman. 

Sector focus

From a sector perspective, the Islamic finance space has proven to be a sweet spot for PE/VC investment. Of the 346 Islamic finance professionals quizzed by IslamicMarkets.com in August 2022, 41% predicted a dramatic growth in PE and VC investments in the sector over the next five years.

According to the SGIE report, Islamic finance and halal food comprised 66.4% and 15.5% of the total 2020/2021 investment deal value, respectively.

“The global Islamic finance industry continues its growth path. We expect around 10% growth across the industry in 2023-2024 after expanding by a similar number in 2022. However, we note that the Gulf Cooperation Council (GCC) countries - notably Saudi Arabia and Kuwait - largely fuelled this performance,” says Dr. Mohamed Damak, senior director and head of Islamic finance at S&P Global Ratings.

Reed Smith’s Mues adds that startups creating digital platforms for Shariah-compliant banking, lending, and investing services, have witnessed particular interest, mainly due to the level of demand within a large, underserved Muslim population across the globe, and the general shift towards digitisation in the financial sector. 

“While other industries, such as the halal food industry and Islamic tourism have also seen PE involvement and investor interest, the potential for scalability and high returns in Islamic fintech is making this sector particularly attractive for private capital investment.” 

What's in store? 

Muslims are a formidable consumer force, with a strong imprint on the world’s business ecosystem. To cater to this burgeoning segment, new halal values-based players will seek to enter the market, in tandem with existing ones looking to expand their offerings.

In essence, both are expected to seek suitable financing options, industry expertise and added strategic value. This signals immense growth potential for the Islamic PE space.   

“I look forward to seeing a thriving ecosystem of Islamic private equity, where we have a diverse range of managers, pursuing different strategies and mandates. Private equity is, by definition and legacy, a specialised business. We should expect to see an array of PE managers focusing on different strategies (growth equity, buyouts, etc.), as well as specializing in various sectors and regions. There is immense need – and thus opportunity – for asset managers in the real economy with specialized expertise,” explains Dr. Rehman.