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Tuesday, 15 February 2011

Islamic private equity on the rise, hurdles remain

Demand for Islamic private equity in Gulf Arab states is on the rise among investors who value its more prudent debt approach and its flexibility in structuring deals, even though the sector faces hurdles in the form of a shortage of qualified professionals and restrictions in its investments options. 

The global Islamic finance industry-widely valued at $1tn-is booming and whetting the appetite of many financial institutions in the Gulf region, which want to tap new revenue streams against a backdrop of slower growth and subdued lending.
As private equity activity is picking up again after it came to a virtual standstill during the financial crisis, Shariah-compliant private equity in particular is emerging as a popular investment tool among regional investors. 
“This is in part because of the natural fit between providing risk capital to enterprises and Shariah law’s profit and risk sharing principles, which makes private equity an asset class well suited to Islamic investors,” said Yahya Jalil, head of private equity at Abu Dhabi-based The National Investor, or TNI. 
“Business owners also feel Shariah structures are more company friendly, as Shariah private equity investors are less likely to over leverage the company, and/or use excessive leverage to pay themselves special dividends, which is a significant aspect of certain types of traditional private equity,” he said. 
The global financial crisis highlighted the risk of over-leveraging deals and complex investment structures. Islamic private equity funds, however, have to follow certain criteria, including a maximum debt-to-equity ratio of a target company being around the one-third mark. 
“These criteria have insulated Islamic private equity funds from some of the more highly leveraged and therefore riskier investments,” said Muneer Khan, who is head of Islamic finance at law firm Simmons & Simmons. 
Another significant benefit of Shariah private equity is “the flexibility and variety of structuring alternatives that address a wide range of investment situations,” TNI’s Jalil said. 
The four principal forms of structuring within Islamic finance-mudarabah, musharakah, murabahah and ijarah-provide plenty of flexibility to structure private equity deals, he said. market data show that the share of Shariah-compliant private equity funds as a percentage of total new private equity funds raised has spiked from 5% in 2005 to 50% in 2008. 
The non-government private equity industry in the Gulf region is worth about $20bn, while the Islamic private equity share probably represents about $4bn of available capital in these markets, according to industry estimates. 
GCC firms like The National Investor, Arcapita, Rasmala, Eastgate Capital, Global Investment House and Kuwait Asset Management Co, or Kamco, are some of the regional players that are active in Islamic private equity. Bahrain’ Arcapita in 2009 sold US-based restaurant operator Church’s Chicken to private equity firm Friedman Fleischer & Lowe in a deal valued at more than $300mn. 
As Islamic private equity gains traction, however, there remain a number of obstacles that the sector has to overcome to reach its full potential. 
“The Islamic private equity sector is facing the same challenges as the conventional product providers, namely lack of clear investment strategy, transparent and diligent processes, professional management and investor communication, and a clear exit strategy,” said Markus Massi, partner and managing director at Boston Consulting Group Middle East. 
In addition, the range of businesses Islamic private equity players are able to invest in is more limited. 
“The potential investment opportunities for an Islamic private equity fund are therefore more restricted and some have argued that it makes them more risky due to less diversification,” Khan said. 
Perhaps the biggest challenge is to find sufficient experienced professionals to execute Shariah-compliant deals, he said. 
“One of the biggest obstacles for the industry is a lack of suitably qualified and experienced professionals who can advise on the establishment and successful operation of such funds,” Khan said. 
The Islamic private equity industry in the Gulf region remains largely a play of domestic specialised financial houses, offering conventional and Islamic commercial banks a window of opportunity to tap this fast-growing segment. 
“Shariah-compliant private equity products are an integral part of the product offering of Islamic institutions. However, conventional and Islamic commercial banks have, so far, not capitalised on this development,” said Boston Consulting Group’s Massi. 
“Rather, Shariah-compliant funds are so far offered by specialised, mostly regional, Islamic private equity houses or Islamic investment banks,” he added.
There are currently about 300 Islamic financial institutions operating across 70 countries, and all of them are looking to actively expand their portfolio of Islamic Offerings, said TNI’s Jalil. 
“A relatively small number of specialist players in this space have shown that it is possible to make profitable Shariah-compliant private equity investments. There is no reason why others cannot follow suit if they can assemble the right team to do so,” Khan said. 
Experts expect deal activity to focus on sectors likely to boom in the region because of growing populations, such as oil and gas, food and beverages, healthcare, utilities, education and manufacturing. 
The majority of investors would buy regional Shariah-compliant private equity products from regional Islamic private equity companies as they believe that regional companies can better evaluate regional market opportunities, Boston Consulting Group research shows. For international markets they prefer international product providers. 
That could suggest that the market for Islamic private equity outside the Gulf may develop even faster. 
“The latter (Gulf countries) are still regarded by most asset managers as frontier markets. Countries with significant domestic markets such as Malaysia, United Kingdom etc. and which have well developed markets and product portfolio can offer a wider and broader range of Islamic private equity products sooner than their GCC counterparts,” Jalil said. 
“That said, one would expect that the GCC market will be a strong growth engine for the Islamic private equity market,” Massi said.

(Zawya Dow Jones/Dubai)

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