Islamic Private Equity - Ernst & Young - Luxembourg

Islamic Private Equity

By Olivier Jordant and Farabi Zakaria
Corporate Intl
August-September 2009  

There is a close relationship between Islamic tenets of investments and Private Equity (‘PE’). Both are participatory in nature, lead to the sharing of risks and rewards, invest in the real economy taking a long term view on investments with an exit plan in mind aligning the interest of the stakeholders. Islamic PE focuses on acquiring majority stakes in privately held Shari’a-compliant companies to ensure control and compliance with Shari’a principles.

Islamic PE may appear to be restrictive when compared to conventional PE. Indeed, there are limitations on investments such as alcohols, gambling, leisure related activities, and to some extent investment in companies highly financed through debt. However, investment restriction into highly leveraged companies can be overcome through innovative structure, by repaying a conventional loan and refinancing it by Shari’a-compliant instruments through Mudharabah agreements.

The Shari’a Principles for Islamic Private Equity
Shari’a principles are derived from a number of sources; the Quran, the Sunnah or Hadiths (examples and sayings of the Prophet Muhammad), qiyas (analytical comparisons), ijtehad (reasoning and logic applied by Islamic Scholars) and ijmaa (consensus on issues requiring ijtehad). Two of the main Shari’a principles governing Islamic PE are the ‘Mudarabah’ and the ‘Musyarakah’.

Mudarabah means the surrender of capital by an investor to a ‘mudarib’, an entrepreneur, for investment in a commercial enterprise. Widely agreed conditions applied to a mudarabah contract are:

• The investor is an investor on a non executive basis.
• Profit sharing between the mudarib and investor is agreed at the outset. ! Ownership of the invested assets remains with the investors at all times.
• Losses should be shared according to the financing share of each investor. The investor’s maximum loss is limited to his share of the financing and the mudarib must not bear any loss.

When compared to conventional business, a mudarabah contract is similar to the relationship between a General Partner and Limited Partners. In this context, the mudarib can be understood as the General Partner and the investors as the Limited Partners. Musyarakah is a type of ‘Shirkat-ul-Anwal’, which means sharing. It refers to a joint enterprise in which partners (or parties) share the profit and loss. Musyarakah is extremely important in this context as it provides an excellent alternative to the traditional interest-based economy. In a musyarakah contract, the party investing the capital equally shares the profit and the loss, which is different from the interest-based economy where the upside is limited while the downside is almost non-existent.

Widely agreed conditions applied to a musyarakah contract are:

• Distribution of profit

Profit to be distributed among the partners must be determined and agreed to at the time the parties enter into the contract.

• Share of losses

Share of losses must be equal to the ratio of each initial investment.

• Management

Typically, each partner takes part in the management of the partnership, with each partner acting as an agent of the partnership. However, alternative arrangements for the management of the partnership could be arranged based on the  onsensus of each partner.

Luxembourg, a potential hub for Islamic Private Equity
Luxembourg’s role as the major European center for the PE was first established in the late 1980s with the introduction of the financial participation companies, or Soparfis.
The Soparfis offer PE firms suitable intermediary vehicles for cross border acquisition. Funds based in the UK or in the US, use the Soparfi as SPV for tax optimization due to the double tax treaties concluded by Luxembourg. As of May 2009, Luxembourg had 53 double tax treaties.
The establishment of the risk capital investment company (the ‘SICAR’) in 2004, as a lightly regulated vehicle designed specifically to attract PE buyout and venture capital business, has given a major boost to the Luxembourg PE industry. A SICAR is subject to the normal Corporate Income Tax Rate of 29.63%. However, income generated from investment is exempt from tax.
In February 2007, the Specialised Investment Funds (the ‘SIF’) vehicle was introduced to further attract investment to Luxembourg. The SIF is aimed at alternative investment products with a light regulatory regime, exercised, like for the SICAR by the Financial Sector Supervisory Authority (CSSF) of Luxembourg.
219 SICARs and 858 SIFs are currently registered with the CSSF demonstrating the success of these vehicles which have been chosen by many of the top PE houses, as well by other smaller PE players.
Islamic PE can be set up using any of the above mentioned vehicles. However, to ensure compliance with Islamic Finance, leading practices will need to be implemented when structuring the fund.
One example is the role of the Shari’a Advisory Committee for the fund. This committee, composed of independent Shari’a scholars, reports annually to the shareholders. The description in the fund’s prospectus of its functions is key to ensure the compliance of the operations of the fund with Shari’a principles.
Another example refers to reporting for Islamic PE implying number of specificities that needs to be addressed, notably because certain Shari’a compliant transactions are not similar to conventional business. The Accounting and Auditing Organization for Islamic Institutions (“AAOIFI”) is responsible for developing accounting, auditing, governance and ethical standards for Islamic finance. The AAOIFI standards are a useful reference in determining the accounting framework for Islamic products that do not have a clear parallel under IFRS or Luxembourg GAAP. It may therefore be useful for the SIF or the SICAR to design a Charter of Accounts compliant with AAOIFI standards.
PE and Islamic finance are therefore far from being incompatible. The world of the Islamic finance professionals and top asset managers already found it attractive to rely on Luxembourg as an ‘on shore’ international financial center coupled with welldefined legislation and tax regime, professional expertise and multi-lingual staff. It is estimated that there are currently 10 Shari’a-compliant funds listed on the Luxembourg Stock Exchange, as well as approximately 12 billion of bonds listed by Gulf countries issuers; among them, 16 are ‘Sukuks’ (Islamic bonds) for a total volume of approximately 5.2 billion euros.
We believe that Luxembourg’s unique PE expertise and ability to adapt are key success factors to enable it to participate to the development of Islamic PE.

*Olivier Jordant is Partner Private Equity at Ernst & Young, Luxembourg
*Farabi Zakaria is Senior Manager Private Equity atErnst & Young, Luxembourg

Posted on 8 September 2009