The previous report on the Halal sector largely focused on the opportunity that the sector represents for investors and Islamic finance financial institutions. Specifically, the report highlighted the three drivers of demographics, consumption patterns, and fragmentation, all of which converge to make the Halal sector very attractive for investors and financial institutions. This month, KAVILASH CHAWLA focuses on fleshing out the key challenge posed by informational inefficiency in bridging the gap between Islamic finance and the Halal sector.
A central tenet of the Efficient Markets Hypothesis (EMH) is that informational efficiency provided by free markets enables financial capital to be allocated to investment opportunities at the optimal risk-adjusted rate. Several financial events that the global economy has experienced since the 1990s suggest that a belief in the informational efficiency of contemporary financial markets is severely misplaced.
In even the most developed and seemingly transparent financial markets, as insider training cases and concerns over the control of information by major financial institutions have borne out, informational asymmetries and inefficiencies still exist. In turn, these informational asymmetries and inefficiencies exact a very steep price on both the financial markets and the broader economy, as manifest in mispriced assets, asset bubbles and burst cycles, and a less than robust economic growth rate.
According to the EMH, the key vehicle through which informational efficiency is delivered is a robust and vibrant marketplace. The marketplace not only provides but effectively distributes critical data and information that then enables marketplace actors to make optimal choices, thereby enabling peak performance across the system. In returning to information flows in the Halal sector, the Halal marketplace is ineffective in both providing and distributing information to market participants, resulting in an information flow asymmetries and inefficiencies across the entire sector. The informational inefficiency of the Halal marketplace is driven by three key characteristics of the Halal sector at large:
Dominance by small to medium size enterprises;
Prominence of highly localized marketplaces; and
Prominence of highly disconnected marketplaces.
The fragmented nature of the Halal sector as characterized above has created a Halal marketplace where broad, global flows of information are structurally impossible. For capital providers, the informational asymmetries in the Halal industry make financial intermediation in the marketplace riskier and potentially more expensive by distorting two critical elements in the capital allocation process: 1) financial valuation and 2) due diligence.
Despite what many bankers believe, valuation is more of an art than a science, with the real-world value of any financial model largely resting on the underlying assumptions that drive the model. To sanity check the assumptions that underpin any specific valuation model, financial analysts tend to use both a discounted cash flow (DCF) model and a comparable methodology. This allows analysts to check their individual/institutional views and assumptions against those of the broader market. Ideally, both models yield the same value for any given asset/set of assets.
When we look at a DCF-driven valuation, the information asymmetries in the Halal sector pose a challenge to building a realistic financial model that accurately captures the market, which can lead to mispriced assets and overpaying for Halal assets. This is complicated by the dearth of publically listed Halal companies which can serve as suitable comparisons for a comps analysis and sanity check against the broader market. The net effect is that ill-experienced investors over pay for assets as they are unable to access adequate information to accurately price and value Halal opportunities.
Conducting due diligence prior to any capital investment can be a relatively smooth and streamlined process. In addition to the standard due diligence required for any transaction, transactions in the Halal space also require a Halal due diligence wherein every input and all the manufacturing processes involved are certified to be Halal. While similar to a Shariah screen in concept, Halal due diligence is anything but a simple screen in practice. In part, this is due to the complex nature of any manufactured good, whereby the Halal integrity of multiple inputs from multiple sources in a global supply chain must be verified.
The difficulty in executing a Halal due diligence is also complicated by the highly decentralized nature of the Halal certification process. Globally, there are over 100 Halal certification bodies, each with their own set of Halal standards and each with their own set of processes to certify a product or process as Halal. Navigating the complex and decentralized terrain of Halal certification can be a costly and unwieldy process, and can add significant time, cost, and risk to any transaction.
The challenges posed by information flow inefficiencies in the Halal marketplace can make transactions in the sector riskier and potentially more expensive. Like every other emerging market, however, the Halal sector represents an opportunity that can generate premium returns for capital providers, provided they can access and leverage the limited and disparate information in the Halal marketplace.
Disclaimer: Any views and/or opinions expressed in the report are those of the individual author.
Kavilash Chawla is the chief operating officer at Azka Capital. He can be contacted at