Private equity, as the name suggests, has always been conducted behind closed doors. Shahzad Siddiqui brings this sector to the surface with his comprehensive insight.
“Load the ship and set out.
No one knows for certain
Whether the vessel will sink
Or reach the harbor.
Just don’t be one of those merchants
Who won’t risk the ocean!
This is much more important
Than losing or making money.
This is your connection to God.”
Jalaludin Rumi, ‘Work in the Invisible’, One-Handed Basket Weaving: Poems on the Theme of Work
In the 1480s, Christopher Columbus made a pitch to Queen Isabel of Castile. In return for funding his voyages to seek the spices of Asia, he offered her the bulk of his profits. The Queen balked at the offer but, in order to prevent Columbus from taking his business elsewhere, gave him an annual allowance and directed the towns in her realm to provide Columbus with food and lodging at no cost. After several years of indecision, the Queen made a deal with Columbus on the following terms: he would get 5% of the profits, 10% of the gold, all his expenses paid and the title of ‘Admiral of the Ocean Sea’.
Lawyers documented the deal for both sides and, for his part, Columbus retained specialist Moriscos (Moors who pretended to be Christian so that their lives would be spared and who specialized in the partnership contracts of the time). On his return from the New World, the Queen reneged on the deal and Columbus commenced a lawsuit against her. He died while the litigation was ongoing. One of his last wishes was that his casket be suspended above the ground so that his body would not suffer the ignominy of being buried in the soil of Queen Isabel’s Spain.
Private equity has subsequently financed everything from maritime trade in ancient Italy to the digital revolution in Silicon Valley. Islam was there at the start of the private equity story. Meccan Arab traders were pioneers of private capital profit-and-loss sharing and the Prophet Muhammad became its greatest exemplar. The Prophet’s companions, most notably Abdur-Rahman ibn Awf, were heavily involved in the funding of trade caravans and became the equivalent of today’s billionaires. Since then, Muslims have continued to take leading roles in profit-and-loss sharing and Islamic finance firms are starting to take Islamic private equity principles onto a global scale.
Direct investments, funds and funds-of-funds
Private equity success stories surround us in daily life: from
Google to the The Body Shop, private equity has contributed to the conveniences of modern life. However, as indicated by the little-known background to Christopher Columbus, private equity has also been behind some of the greatest ventures in human history and, indeed, some of the Islamic finance companies profiled in these pages.
However, recent research on private equity, most notably by Dr Tom Weidig and Yves Mathonet, has shown that direct private equity investments have a 30% chance of loss. Investments into diversified private equity funds are relatively safer and sanctioned by tradition in the Islamic world, as Vogel and Hayes point out in their primer on Islamic finance, ‘Islamic Finance: Religion, Risk and Return’: “Classical law permits a
mudarib to choose not to perform the work himself but to invest the partnership capital with other mudaribs.”
Funds-of-funds tend to be the safest method of private equity investing; with research showing Gaussian distributions with no ‘fat tails’ (think those nice bell curves from high-school mathematics). While there is a dearth of Islamic funds-of-funds due to the relatively recent re-emergence of Islamic finance, there is a growing cornucopia of Islamic private equity funds operating both publicly and privately.
Following the spring revolution in the Arab world, high net worth individuals started discreetly seeking private equity opportunities outside the MENA region, which has historically been the major focus of Islamic funds launched in the region.
With greater global diversification, Middle Eastern investors are starting to take greater risks, outside of their comfort zone, with indirect benefits to both the Muslim and non-Muslim world.
Simply put, Islamic private equity or venture capital funds are very similar to their conventional counterparts, with the exception of some strict qualitative and quantitative screening. Both conventional and Islamic funds engage in profit-and-loss sharing and follow the GP/LP structure with the Islamic private equity firm acting as the
mudarib general partner and limited partners acting as rabb-ul-maal.
Islamic funds have attracted both Islamic and conventional investors under double-tranche or stand-alone structures. Under a
Musharakah structure, the Islamic private equity fund would co-invest on its own account and the other partners would take an active management role in fund management.
By doing so, however, the other partners would lose their limited liability status. This is, perhaps, why in the modern context most Islamic private equity funds are set up under a
Mudarabah structure in line with ancient practices and conventional norms.
Furthermore, under
Mudarabah, while the profit share of the rabb ul-maal is negotiable, their liability is limited to the amount of capital invested. If there are debts and losses beyond the amount invested (arising out of litigation or unpaid taxes, for example), then the
mudarib will have to bear those.
Qualitative and quantitative screening
When it comes to screening, there are marked differences between Islamic and conventional private equity. On the qualitative side, Islamic GPs often begin their due diligence by looking at the overall business of a potential portfolio company. They will screen out the ‘usual suspects’: purveyors of alcohol, pork, pornography, weapons and interest. If a company passes industry screening, Islamic GPs and the
Shariah advisors will drill down and determine if the company has any long-term debt, income from impure sources (such as alcohol revenues in an airline) or large accounts receivable.
Short-term debt is defined as any financial liability that is due in the current fiscal year. Long-term debt is, therefore, any liability that is carried on the books for over a year and usually includes financing leases and bank loans. Some Islamic institutions will apply public equity thresholds to private equity, including the now well-known 33% debt-to-equity ratio.
More devout investors may prefer zero long-term debt, especially when investing in private companies that are not carrying public company burdens. While rare, these companies generally include retail operations with heavy cash flows (such as dollar store chains or ethnic supermarkets).
Shariah-sensitive investors will also want to examine the share structure of potential investee corporations, especially with regard to preferred stock, warrants, options and convertible securities (which include convertible preferred stock, convertible zero-coupon debt and convertible bonds). Any stock other than simple common with voting rights may have to be redeemed or bought out prior to an investment by the Islamic private equity firm. Advisors in Islamic private deals have become creative with respect to firms that wish to have some preference rights.
Since the
Shariah issue is having liquidation preference, counsels have redrafted preferred stock rights to have preference on merger and change-of-control rather than dissolution or insolvency. Furthermore, Vogel and Hayes have suggested the use of convertible capital leases, whereby investors offer a business a full-payout lease for equipment they need with an option for the investors to convert the remaining rent obligations into common shares at certain milestones in the life of the lease. While complex, the convertible capital lease may be a way to ‘Islamicize’ much-needed convertible debt financing.
Ongoing due diligence
The main hurdle to the full development of the Islamic private equity sector may be information asymmetry and moral hazard between the investors and investee companies. Interest-based banks who demand fixed income and collateral security will often not face the same issues. Researchers have proposed the following solutions, among others, to the issue of moral hazard:
Social suasion: This could be accomplished by better business bureaux or lists that are shared between Islamic banks and private equity firms. Interestingly, research has found that it is the infrequent release of business ratings that improves levels of contract compliance and reduces moral hazard.
Random audit: Random audits of accounting records may reduce moral hazard, but may also lead to an inverse result, namely, the more random the audits the greater atmosphere of distrust generated between the parties.
Aligning incentives: Instead of random audits, it could be better to reduce unobservable cash flows (by ensuring payments to the business are made by cheque and debit card) and manage operating costs (to reduce incentives to maximise perks from the business).
Private investigation: In the Islamic context, this may be problematic as sura Hujurat of the Holy
Quran says: “Do not spy or backbite each other.”
Close supervision: Close and regular supervision of a portfolio company may be preferable to random audit and private investigation. This can be accomplished by active direction of management or a permanent seat on the board.
Collateral: In addition, or in the alternative, private equity firms could combine random auditing with taking collateral from the assets of the portfolio company. Collateral could be on or offshore and could even include cash in a reserve account, to be released upon exit from the company and final accounting.
Co-investment and staged financing: Private equity firms could also syndicate and stagger their investments into portfolio companies. This increases the number of ‘eyes and ears’ around the business and may reduce transaction costs for all parties. As many have noted, moral hazard becomes irrelevant if parties abide by Islamic business ethics: fair dealing, honesty and good faith. This is perhaps why the Prophet stated: “The honest businessman will stand with the prophets, the truthful and the martyrs on the Day of Judgment.”.
Shahzad Siddiqui is a Canadian lawyer and is the author of ‘Shari’a-Compliant Private Equity: a Primer for the Executive’. He can be reached at
[email protected].