For the uninitiated, the prospect of establishing a Shariah compliant fund in an offshore jurisdiction such as the Cayman Islands may seem daunting. So how are such ‘offshore funds’ structured to be Shariah compliant and what are the challenges facing Islamic asset managers when seeking to establish an offshore fund? How viable are Islamic funds established in offshore jurisdictions such as the Cayman Islands and what can we say about their prospects?
One of the key decisions to be taken at an early stage will be whether to establish the fund vehicle as a company or a limited partnership (in the author’s experience, it would be very unusual for an Islamic offshore fund to be structured as a unit trust). Often the decision will be based on nothing more scientific than the experience of the manager and the target investors. Clearly non-Shariah structuring issues will play a role. For example, whether the investors are to make a capital commitment to be drawn down over time (such as in a private equity fund), whether a single subscription will be made (such as in a closed-ended fund) or how the manager is to receive its performance fee (or ‘carry’ in the context of a limited partnership).
In addition to the flexibility generally afforded by a limited partnership, a limited partnership lends itself neatly to the requirements of Shariah. The exempted limited partnership structure consists of a general partner and several limited partners (or investors). Like a company, exempted limited partnerships bestow the benefit of limited liability upon investors. The general partner (usually a special purpose company incorporated in the jurisdiction of the partnership’s domicile) remains liable for the partnership’s debts and liabilities. Unlike a company, the exempted limited partnership structure comes close to resembling true Murabahah. The contributions of limited partners returned over time approximate the hire-purchase type arrangements made in a spirit of partnership, as in classic Murabahah arrangements. This makes the structure popular for those seeking to set up their funds as a long-term relationship.
Challenges
Historically the Islamic funds industry has been focused almost exclusively on closed-ended private equity funds. While these structures are still prevalent, Islamic investors are looking for a more diversified portfolio and Islamic asset managers are looking for ways to distinguish themselves with innovative fund products. As a result, Shariah compliant funds have been diversifying both in the sectors in which they invest and in the domiciles which managers choose for funds. Funds are being established focused on areas as diverse as logistics warehouses, healthcare and education-related assets in Saudi Arabia and the Gulf-Arab region. Significantly, a number of fund managers in the MENA region are looking to set up open-ended funds (giving investors the ability to redeem at their own option). Open-ended funds mean less of a long-term commitment, with investors exercising greater control over their money once a commitment has been made.
The ability to redeem arguably puts open-ended funds in conflict with Shariah principles: putting money in and ‘betting’ on a fund’s success can be seen as haram. Many Shariah scholars now reject this view so long as investors themselves do not invest in Shariah compliant funds with a view to quick exits. (The fund manager can also address this concern by setting minimum periods, or ‘lock-up’, for which investors must keep investments in the relevant fund prior to redemption.) Greater challenges arise at the level of the fund’s operations. Shariah compliant open-ended funds face significant issues in terms of liquidity and the way they invest.
Unlike closed-ended limited partnerships, open-ended funds do not have a guaranteed corpus of money which investors have committed to keep in the fund until it is liquidated. Redemptions may mean that a fund’s assets under management are insufficient to make lucrative investments.
Conventional hedge funds typically deal with this by taking out bridge financing or long-term loans. Interest payments or receipts by a Shariah compliant open-ended fund conflict with Islamic prohibitions on usury or payment of interest. Shariah compliant borrowing – by way of Murabahah or Ijarah structures – can address this, but clearly thought needs to be given by the manager, at the outset, as to how this borrowing is structured and secured.
More problematic still is the notion of short-selling assets, given its clear parallels with gambling. This seems to be the greatest impediment to a true Shariah compliant hedge fund. To the extent that they are open-ended, Shariah compliant funds seem set to stay ‘long only’.
One of the issues faced most often when structuring offshore Islamic Funds, particularly in the Middle East, is regulatory hurdles. Managers looking to set up funds not domiciled in the country where investments take place should always seek local advice. Only certain funds can be marketed in some jurisdictions, rules as to disclosure in marketing communications are not uniform across the Middle East and the rules are changing, as evidenced by draft regulations issued by the Emirates Securities and Commodities Authority (ESCA) in relation to Investment Funds and Fund Management in the UAE.
These issues are not insurmountable, but do require fund managers to seek sound advice in the jurisdictions where they wish to obtain and spend money. As an offshore lawyer, the author finds himself stressing the need for good onshore advice.
Viability
Once a fund has been established in an offshore jurisdiction, managers and investors can take comfort in the fact that should things go wrong, there will be transparency in how matters will be resolved.
One of the most appealing aspects of forming funds in offshore jurisdictions such as the Cayman Islands is the common law framework. Courts in offshore jurisdictions have traditionally been robust, creditor-friendly and enforced contractual terms on their face. In many parts of the world this has meant that fund managers with offshore funds can enforce default provisions in limited partnership agreements or subscription agreements, when investors fail to pay, with comparative ease.
In terms of continuing requirements, in the Cayman Islands, for example, there is no restriction on the investment objectives, rates of return or other commercial matters (such as the appointment of local custodians or managers) relating to an Islamic fund. There is no requirement that a Cayman Islands’ fund should have any local directors or officers; the advisors, administrators, promoters or the investors themselves may provide these. Nor is there any requirement for local service providers, for example, administrators or custodians; except that for funds regulated under the Mutual Funds Law, there is now a requirement for their audited accounts to be signed off by a local firm of auditors. The lack of burdensome ongoing requirements is one of the appeals in domiciling a fund offshore and should add to the viability of even the smallest fund.
Prospects
Whilst predicting the returns to be made by Islamic offshore funds is not within the author’s expertise, consideration can be given to the prospects of the jurisdictions in which the offshore funds themselves are domiciled.
A number of recent publications focus on the possibility of Luxembourg and Ireland becoming established jurisdictions for Shariah compliant Undertakings for Collective Investment in Transferable Securities (UCITS). Both countries have flexible regulatory frameworks for investment funds.
The Dubai Financial Services Authority’s adherence to the Standards of the Accounting and Auditing Organization for Islamic Finance Institutions raises the prospect of a regulator which has Shariah standards engrained in its regulatory framework, although the establishment of collective investment schemes in the Dubai International Financial Center does not yet seem to have much traction.
However, as Cayman Islands, British Virgin Islands and Irish investment funds lawyers in Dubai, we note that most investment funds in the MENA region remain domiciled in the Cayman Islands. A majority of Shariah compliant funds are set up as closed-ended exempted limited partnerships in the Cayman Islands and the confidence in the offshore jurisdictions as a whole is such that most Islamic investment funds seem certain to continue to be set up offshore.
Philip Ireland is a partner at Maples and Calder based in Dubai. He can be reached at
[email protected]
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