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Friday, 7 August 2009

Islamic private equity: An untapped opportunity

As the economies of the oil producing countries of the Middle East and North Africa (Mena) region have boomed over recent years most areas of finance have witnessed spectacular growth rates. Islamic private equity, however, has not been a particularly large beneficiary of this growth. The reasons for this are hard to fathom.

There is a close relationship between Islamic tenets of investing and private equity.

By its nature private equity is participatory and inevitably it must lead to the sharing of both risks and rewards.

As long as the company seeking the private equity infusion is not operating in a haram area of business such as pornography or liquor, or is not heavily indebted, then few forms of co-investing could be more pure from a Shariah compliance perspective.

The reality of the matter is that there is a close relationship between Islamic private equity and conventional private equity and therefore as private equity has grown in size across the globe then we might have expected its Islamic counterpart to have done the same.

Immediately prior to the financial crisis, conventional private equity had become the whipping boy of the financial world and there was much talk of the need for increased legislation and greater transparency in the industry. Too many people were making enormous amounts of money out of private equity transactions that were, in essence, being fuelled by excessive cheap debt.

Islamic private equity never fell into quite the same trap, largely because of the prohibitions inherent in the Islamic financial system against too much debt.

The Shariah requirement that transactions have a productive activity underpinning them, and that financial flows and assets remain correlated, meant that debt simply never had the chance to balloon out of control in the Islamic sphere to the same extent that it did in the conventional market.

Size of the market
Industry estimates suggest that the global private equity market is worth around $2,200bn at present although the volume of transactions completed in the first quarter of 2009 is miniscule. According to Greenpark Capital, a specialist secondary investor in private equity, deals closed in the first quarter of 2009 amounted only to $2bn. A market with too many sellers and too few buyers inevitably means depressed asset prices.

Figures for the Islamic private equity industry are much harder to come by, but estimates from Yasaar Media research suggest that the industry is approaching $3bn in funds raised and deals done, much of it in the Mena region. This is a far cry from the $40bn that pundits suggested was the kind of level that the industry would reach by 2011. For an overall Islamic finance industry, whose size is estimated at around $800bn, it is not hard to see that private equity does not play a very significant part yet.

Before the credit crisis some observers had postulated that there were not enough potential Shariah compliant target portfolio companies around to be able to soak up the Islamic private equity funds available. Remember that at this time there seemed to be money for even the most speculative of investments, redolent of the boom where there was too much money chasing too few opportunities.

The picture that has emerged since the collapse of Lehman Brothers is still far from clear but there is now much less of a mismatch between the financial heft of investors and potential Shariah compliant private equity targets and the undeniable conclusion is that the Islamic private equity sector is particularly well placed for expansion at present.

Long-term view
The Islamic private equity model is very similar to the classic Mudarabah model with the alliance of general partner and limited partner being a straightforward example of what a Mudarabah is supposed to be. Equally importantly, the long time frame involved in most private equity transactions is complementary to the overall tenets of Shariah investing.

In its most basic form, Shariah finance is about participatory investing for the long term health of both parties in the transaction as well as to the overall Islamic financing system.

The reality, however, is that that the Islamic private equity industry is still in its infancy both in terms of overall size and the number of players in the market. One of the core developments that will be needed for the mature development of the industry is for more and better qualified human capital: More people with a higher level of training. This is a requirement that afflicts much of the Islamic finance industry and the same dilemma applies here: Does the private equity firm employ private equity experts and teach them Shariah? Or does it employ people who understand Shariah and then teach them the art of private equity?

In order to address this issue fully, however, there needs to be a greater level of standardisation across countries to ensure common levels of compliance. In this way the Gulf-based Islamic private equity practitioner can engage staff from Islamic markets in Asia and vice versa without the usual culture shock that so badly affects Islamic retail banks trying to ferry staff in from overseas to meet demand.

As the financial sector leaves the realm of excessive cheap debt and enters a world where any form of financing is much harder to come across, then Islamic private equity becomes a much more attractive beast when compared to its conventional cousin. Expensive debt is burdensome and paying down debt has been a real focus for most finance houses of late. The beauty of Islamic private equity is that it has no tolerance for high levels of debt and in practice if a private equity fund takes a stake in a portfolio company whose debt level is too high then the first priority has been to refinance conventional debt through Shariah compliant instruments.

Dependence on Shariah advice
Indeed this kind of refinancing manoeuvre illustrates the 'intrusive' influence of Islamic financing principles in a private equity transaction. The Shariah involvement in an investment does not end when the documents are signed and money exchanged but rather it carries on for the length of the portfolio investment. If a company has been taken over as part of an Islamic private equity portfolio then it must remain Shariah compliant in all significant respects throughout the duration of the investment.

The Shariah advisers on the transaction will have an ongoing duty to ensure that the tenets of Shariah are not strayed from: The portfolio company will not incur excessive debt or begin trading in haram areas of business.

While this need for an extra level of oversight might be interpreted as an extra level of cost, it is absolutely essential in maintaining the integrity of the Islamic private equity system as well as the credibility of all those involved in the transaction.


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