In United States, Private Equity outperformed the US stock market over both the short and long term. Discuss ways in which Islamic Private Equity can be structured and challenges it faces in the global market
- Why Private Equity
Ernst & Young says private equity firms are exceptional executors of business growth, with more than 60% of their businesses exceeding their initial targets. The 100 largest private equity deals surveyed across western Europe in 2005 increased business value by 26% a year, compared with the average 12% achieved by listed companies. Management is more aligned with its private equity partners, sharing any upside or downside. Private equity groups apply more efficient capitalization structures, using an appropriate mix of debt and equity. This study found the appreciation did not come from cost cutting or financial engineering. In 85% of the investments, the value creation came from new strategies to drive growth, refocusing investment, making acquisitions and making a few key changes happen fast. Private Equity delivers better products, generates sustainable employment and ultimately results in companies that generate higher profits.
According to a recent study undertaken by the European Commission, the private equity industry can make an important contribution to the re-generation of an economy by nurturing new enterprises and re-energizing existing companies. Furthermore, private equity can lay the seeds for sustained growth and job creation and assists in the drive to be increasingly globally competitive. Private equity financing also improves management and corporate governance in companies by setting a level of discipline.
Graph 1shows sources of TSR (Total Shareholder Return) of one large private equity firm.
Source: Boston Consulting Group
The graph below shows the comparison of Private Equity Growth indicators within the economy and the stock market
Source: McKinsey and Co.
Table 1below shows how Blackstone Private Equity Group made a Turnaround at “Celanese Company”, one of the world’s leading chemical companies in just three years of time, between 2003 when Blackstone bought the company and 2006 when Blackstone re-listed it on the German stock exchange.
Table 1: Celanese Performance between 2003 and 2006
Item (USD m)
Revenue Growth Rate
R & D Expenditure
Expenditure on Plant and Equipment
Productivity Per Employee
Why is there growth in this industry?
Professionals enjoy approximately 20% carry (25% – 30% in the best venture funds) – flock to this industry and provide product to investors
Regional Macro Trends
Economic dis-equilibriums, corporate restructuring, and acceptability of selling assets, rapid technological change, and available financing – all provide private equity opportunities
Investors have an abundance of equity capital – the rise in public markets has ironically provided more capital for private equity (percentage allocation might stay same – but base is larger)
Returns are consistently better than other investment opportunities. With public returns expected to go down in the coming years, private equity is even more attractive
- Islamic Private Equity Outgrowing Conventional Private Equity
Islamic finance has witnessed tremendous growth over the past years, both in terms of the growth of the entire industry and in terms of the development of new and more sophisticated products that meet the increasing yet unmatched demand for structured products and comply with the principles of Shariah law. The global Islamic finance industry is valued today at approximately US$800 billion. Furthermore, there are a number of additional factors such as growth in the Muslim population (estimated to grow by over 20% within the next 8-10 years, to reach 1.6 billion, which represents 21% of the global population, against 19% as of today), an enormous increase in the wealth of this population (the wealth of high net worth individuals in the Middle East is estimated to grow at 8% per annum, to reach US$1.8 trillion by 2010), as well as a sharp rise in interest by international (non-Muslim) investors, governments, financial institutions and capital markets to enter the Islamic finance and investment space. This is documented by the value of Sukuk to be issued over the next three years, which is estimated to be worth US$30 billion, with global issuance totaling US$100 billion by 2010.
Islamic private equity focuses on acquiring majority stakes in privately-held Shariah-compliant companies. By doing so it enables investors to maintain control and ensure the company’s adherence to Shariah principles. Islamic private equity provides investors with an ethical investment product offering high performance, portfolio diversification, superior risk-adjusted returns and diverse investment opportunities. Private equity and Islamic investment share a lot of common principles: both of them are based on investment in the real economy, and on the principle of sharing risks and rewards through partnership. Private equity takes a long-term view on investments and aligns the interests of stakeholders, which are also among the key principles of Islamic investment.
At first sight Islamic private equity appears to be restrictive in comparison to conventional private equity, In fact, on the investment side, there are indeed some limitations in terms of industries (for example alcohol, tobacco and leisure-related activities are prohibited industries), as well as certain financial parameters such as the use of debt instruments and investing in companies with high leverage. However, such obstacles can in most cases be overcome by innovative structuring, for example through repaying a portfolio company’s conventional debt and refinancing it through Shariah-compliant structures such as Murabahah agreements, amongst other solutions.
Since Islamic investment adheres to high ethical standards, it has been attracting a growing number of non-Muslim investors, in addition to the 1.3 billion Muslims worldwide, thereby targeting a substantially larger investor base than conventional private equity. Recent research has found that a considerable number of private equity and venture capital funds have passed Shariah compliance tests, with only minor adjustments made to the investment policies of these funds.
Nevertheless, regional private equity in general and Islamic private equity in particular are still in their very early stages. Today, players in the industry face a lack of information and academic research, as available market data is often incomplete and inconsistent. Additionally, there is only a limited number of professionals who are well-trained in the principles of Shariah law and their application, especially when it comes to the development of new products and structures.
What is needed to accelerate the Islamic finance and the Islamic private equity industry’s development in particular is skilled and educated human capital, as well as a higher level of standardisation across countries, disciplines and products of the entire Islamic finance space. Critical success factors on the micro level include product development expertise, client relationship management and competitiveness, both in terms of quality and pricing, among others. In this context, innovation is the key, as it enables individual players and the industry as a whole to draw the link between conventional and Islamic financial products by structuring the former in adherence to Shariah principles.
Islamic private equity promises to be one of the fastest-growing areas both within the private equity and the Islamic finance space over the coming years. To date, there are only a few Islamic private equity funds in the market. However, the popularity of these funds is growing tremendously; over the last year alone, Islamic private equity funds announced exceeded US$4 billion, demonstrating a strong and yet unmet investor demand. Considering the growth in assets of global and GCC Islamic banks and financial institutions, it is estimated that the Islamic private equity industry in the region will be worth US$41 billion by 2011.
2.1.Private equity – modern day musharakah
Islamic finance has been widely acclaimed as the fastest growing sector within the financial arena. Much of this development has occurred within the debt and related capital markets sectors – sukuk, commodity murabaha, and so on. In the mainstream financial world, a parallel area which has also witnessed incredible growth levels in recent years is the private equity (PE) sector. Now accounting for nearly a quarter of the UK workforce, the meteoric rise of the PE players has not gone unnoticed. Omar Shaikh of Ernst & Young’s Private Equity Transaction Advisory Services practice, explores some of the interesting parallels between these two previously obscure, but now high profile, mainstream alternative financial products.
2.2.The importance of equity-based solutions to the Islamic finance industry
While growing rapidly, the Islamic finance industry today faces a number of challenges. This is unsurprising, perhaps, given its age. Academics and industry practitioners alike have identified a number of issues, ranging from an absence of secondary markets, a lack of consistency and uniformity of standards within Shari’ah compliance to the shortage of qualified professionals with an adequate understanding of both the Islamic and the conventional sides of the equation.
A key challenge, increasingly cited, is the perception of Islamic financial products as being overly engineered and mimicking conventional products. Previously unaccepted products, such as derivatives and hedge funds are coming to the fore. In addition, the extensive use of tawaruq and other structuring methods to create cash loans is raising the question as to the authenticity and direction of the industry. Many analysts are referring to the phenomenon of ‘Shari’ah arbitrage’, class-ing Islamic products as another series of structured products, which create ‘wrappers’ to overcome restrictions.Indeed, grass root opinion in the UK struggles to deal with the benchmarking of Islamic home financing against LIBOR.
The argument that Islamic home financing charges a ‘profit or rent rate’ not an interest rate begins to lose credibility when users realise that the ‘profit or rent rate’ is benchmarked against interest rates.
A number of industry practitioners, such as Iqbal Khan (founder and ex-CEO of HSBC Amanah), believe that a change in mindset is called for, by which Islamic products would become ‘Shari’ah-based’ as opposed to ‘Shari’ah-compliant’. Similarly, Tariq Sheikh (founder of RHT Partners) comments that ‘in essence Islamic finance is an equity-based, not debt-based system, and we need to develop Islamic products which are more in line with the “spirit” of the law, as much as they currently are with the letter of the law.’
A banking system based on faith and credibility (and more importantly the perception of it as being so based) is critical to the sustainability and differentiation of the Islamic finance industry.
2.3.Private equity – the elusive musharakah solution?
As in certain forms of the conventional private equity market, the concept of risk/profit and loss sharing is an important fundamental principle of Islamic finance – the principle of musharakah. The Arabic term musharakah is not actually found in classical Islamic texts on fiqh (jurisprudence) and was coined later within texts relating to Islamic financing modes. Fiqh texts refer to the concept of ‘shirkah’ which is translated as meaning ‘sharing’ and is sub-divided into two categories: shirkatulmilk (the joint ownership of a particular property by two or more people); and shirkatulaqd (joint commercial enterprise).
Whilst the principles of Shari’ah require that loss must be shared in proportion to the capital invested, whereas profit share can be set at agreed levels, in general the Islamic model for business financing encourages profit and loss sharing through equitable financial and contractual arrangements. On the face of it, the private equity model seems to provide a natural musharakah-based solution with a proven track record of success within the conventional system.
Demystifying private equity
The term ‘private equity’ represents a diverse set of investors who typically take a majority equity stake in a private limited company.
In Europe, the term ‘private equity’ is synonymous with ‘venture capital’ and is used to cover funding at all stages of a business life cycle. In the United States, ‘venture capital’ refers specifically to investments in early stage and expanding companies, whilst ‘private equity’ relates to involvement in more mature businesses – through management buy-outs and buy-ins, for example.
PE firms are typically structured as partnerships with two key components: the General Partnership (GP), that is, the management team responsible for making the investment decisions; and the Limited Partnership (LP), the providers of the capital. The LP commits funding and allows the GP to draw down as required for investments that meet an agreed profile. A hurdle rate is typically set by the LP to represent a minimum investment return target for the GP. Returns in excess of this are split with the GP on a pre-determined rate (often referred to as ‘carry’).
An alternative asset class
Traditionally, PE sits within the broader financial investment spectrum as an alternative investment class, as represented in the table below. This table has been adapted from a special paper on ‘Why and how to invest in private equity’, published by the European Private Equity and Venture Capital Association (EVCA).
The deal process
Private equity provides medium- to long-term finance (usually three to seven years), in return for an equity stake in potentially high-growth, unquoted companies. In the course of the holding period, the focus of the PE firm is to improve the profitability of the company, hence increasing the value upon exit. A study on PE exits in 2005, conducted by Ernst & Young’s commercial advisory team, analysed the key techniques used by PE firms to increase value and measured the impact of these on the internal rate of return (IRR). Results showed that the top three interventions by an active PE firm leading to value creation lay in:
- Restructuring part or all of the business
- Changing the CEO and/or the CFO
- Effecting cost improvements
2.4.Industry challenges facing PE
Recent market sentiment, coupled with the inherent risks of unprecedented levels of gearing in an environment characterised by creeping interest rates, has produced significant public concern around the tactics of the PE firms. Old baggage and negative connotations associated with the leveraged buy-out (LBO) firms of the past, appear to be resurfacing, with strap lines such as ‘PE – locust or lifeline?’ being used by the business press.
The market impact, control and tax mitigation techniques used by PE firms are currently the subject of considerable regulatory and government scrutiny in the UK. This is placing more pressure on PE firms to increase their level and transparency of reporting, and is also prompting changes in tax laws to capture a greater share of the bonus payouts earned by the GPs’ ‘carry element’ upon exits. Perhaps one of the biggest challenges facing PE firms is that they have fallen victim to their own success, to the extent that there are a number of new players in the PE arena – hedge funds, for example. This has culminated in an environment where too much capital is chasing too few quality deals.
2.5.The Middle East private equity experience
Since Islamic finance is more mature within the Gulf region, it is interesting to see how the PE industry has developed there and to review current developments in that region.
The ‘sell down’ model
The PE structure described in an earlier section is in common use in the United States and Europe. Some Middle East-based funds, however, use a ‘sell down’ model. Here, the LP is represented by a consortium, typically of tiered high net worth individuals. The GP will identify the target, undertake the due diligence, agree principle terms with the investor group and then make the acquisition. Normally, the GP will mark up the price before selling down the stake to the various investors, as per the pre-agreed terms.
The petrodollar influence
The current increase in the petrodollar has made the Middle East region flush with liquidity and has resulted in an enormous amount of infrastructure investment and corporate acquisition activity, both regional and overseas. Examples of this activity are: Travelodge and the Doncasters Group, both acquired by Middle East investor, Dubai International Capital (DIC); and the recent acquisition of Aston Martin by Investment Dar, the Kuwait-based Islamic PE firm.
Analysts have estimated that the region currently has approximately $1.5 trillion of excess liquidity. Part of this cash has been directed towards Shari’ah-compliant investments resulting in sukuk issues being commonly oversubscribed and Islamic banks being highly capitalised.
A report by the Gulf Venture Capital Association (GVCA) indicated that $7.1 billion had been raised in PE funds in 2006, up from $4.3 billion in 2005. Total PE fund sizes have reached $14 billion, which is a significant increase over the $78 million experienced in 2001. Early indications show that this growth rate is continuing with funds over $9 billion having already been raised in the first half of 2007.
Increase in overseas interest
The Middle East is seeing increased interest from overseas players attracted by the impressive growth rates in the region. In the past year alone, a number of multi-national banks have opened offices in the Gulf and analysts at HSBC estimate that nearly one third of global project finance spend is currently going into Middle East projects. The Carlyle Group has also opened offices in Dubai from which it intends to increase its participation in regional PE deals.
The likes of conventional PE, addressed with Islamic tenets firmly in place, should result in the best of both practices. The opportunity to innovate, as opposed to imitate, has never been more timely…
The Survey of Limited Partner Interest in Emerging Markets Private Equity, conducted by the Emerging Markets Private Equity Association (EMPEA) in April 2006 found that, of the 300 LPs contacted, 65 per cent of respondents expected to increase their commitments to the emerging markets within the next five years. Portfolio diversification was cited as a key reason.
Shari’ah-Compliant private equity
A study carried out by CORECAP showed that Islamic PE promised to be one of the fastest growing areas within the PE and Islamic finance spaces. Fund-raising activity has increased with over $4 billion of Islamic funds announced in 2006. The Middle East region is seeing a number of new Shari’ah-compliant boutique firms springing up: Venture Capital Bank, which launched a $100 million real estate fund; and RHT Partners, which was involved in the AED750 million Dubai Madaares education deal. Abraaj, an established regional player, also raised a $2 billion Shari’ah-compliant fund towards the end of 2006.
In an environment of rising interest rates and pent-up demand in the Shari’ah space, the possibility of using Shari’ah-compliant financing as ‘tranches’ within conventional PE transactions presents an interesting opportunity. Many Middle East investors are attracted to the idea of partnering with the likes of Blackstone, KKR, Apax and Permira and, as with sukuk financing, if the price and structure is right, Islamic finance could provide a useful source of diversified funding for conventional PE firms.
- Islamic Private Equity – Criteria for Investment
The demand for Shari’ah compliant investments and financing sources as a whole grows ever more important and may well be on its way to becoming mainstream. As part of this development, Shari’ah compliant private equity funds are increasingly coming to the attention of private equity fund managers, keen to tap a market of investors not only from the booming Gulf States, but from over a billion Muslims worldwide. Those investors who prefer investing in a Shari’ah compliant fashion, also seek an asset class that represents socially responsible investments and view fund investments much like conventional investors. Although the first Islamic equity fund was established as far back as 1986, it is only fairly recently that the sector has started to expand rapidly, with more than 150 such funds currently available on the market.
Legal Structures and Documentation
The lack of standard legal documentation in the Islamic finance space is a major concern for the sector. It gives rise to duplication of processes and inevitably to increased transaction costs.
Bankers rue the fact that there are no standardized legal documentation or templates for internationally-accepted Islamic instruments such as Murabaha, Ijarah and Istisna.
Legal documentation also encompasses other issues in the Islamic finance transaction process. These include the relationship with the Shariah governance process, especially the compiling of the document to reflect the Shariah provisions; the Shariah review of the documentation; the time taken for this review; the quality of this review; the potential areas of conflict and disagreement and how these could be reconciled to satisfy both the law of the land and Islamic financial principles; and issues relating to the etiquette of conducting this legal documentation review process.
The sharing of profit and loss in business is another facet of that same mirror and one which the foundations of the Islamic economy and finance is built upon.
Venture Capital can briefly be described as capital that is made available for newly established to middle sized businesses that have a significant growth potential. Sometimes it is also accompanied by the contribution of additional human resources and networking aid made availabe by the investors (or their management team).
Mostly, the investment is designed to exit once the growth targets have been reached. The investors aim to generate a return, typically through an IPO or merger of the company. It is a full risk project where profit and loss is shared by both parties concerned during the growth phase and intended capital gains are reaped at the exit thereof. Both mudaraba and musharaka principles can be fully applied so there is therefore no better compliant way of investment possible.
Any portfolio manager will confirm that it is advisable to spread the risk of failure of a Target Company over several investors and over a larger portfolio of investments.
It also makes sense to pool the investors in larger investment structures. The benefit thereof is that more money is available which in turn enables increased stakes in different Target Companies to be acquired (further spreading the risk). The pooling also allows special fund managers to be hired to manage the business professionally.
Investing money on the public stock exchange has its advantages. The concerned companies usually have had a reasonable life span, sufficient publicly available information, controlled governance, supervision by Capital Markets Board or Stock Exchange Regulators, financial track records and dividend policy.
Companies that are in their early or mid stages or even in their start up stage for that matter, lack all that and by consequence pose more risks to the investor. On the other hand, they also offer more growth prospects and profit returns.
As far as the Target Companies are concerned, Shari’ah imposes some restrictions to the ethical selection criteria to make sure that the investments stay halal (lawfull). In general activities are considered to be haram (unlawfull) when::
A number of “rules of thumb” have been developed and are largely accepted in order to help discern which investment targets are acceptable and those which should be avoided. We give here an example of the FTSE Shari’ah Global Equity Index Series guidelines which can be roughly be summarized as follows :
Excludes investments when total debt on total assets exceeds (or is equal to) 33%.
Total interest bearing securities and cash
Excludes investments when total cash and interest bearing securities on total assets exceeds (or is equal to) 33%.
Excludes investments in Target Companies if account receivables on total assets are greater than (or equal to) 50 %.
Threshold haram income
Any haram income of a non-compliant Target Company that does not exceed 5 % of overall gross income is considered marginal or accidental. The Target Company will still be acceptable, provided that sufficient cleansing is made according to the guidelines set forth by the Shari’ah Adviser (isolated and given to charity ).
Of course, the nominative contracts such as the mudaraba and musharaka partnerships can be used to structure such consortia of investors.
But more contemporary limited partnerships, trusts, funds or corporate structures also have been accepted to be compliant. South East Asian scholars in general tend to be more lenient in this respect than some of their Gulf based counterparts.
3.2.Shari’ah Adviser and legal assistance
The use of experienced legal council on both Shari’ah and conventional consulting of course is beyond question. It facilitates the communication between the Shari’ah Adviser, the Investors, the Management Team and the Target Company and its initial shareholders.
In order to assure full compliance to the Shari’ah, it is compulsory to involve a Shari’ah Adviser. Since that adviser cannot be available all the time, he/she should be assisted on a daily basis by the function of the Shari’ah Compliance Officer whenever possible.
The Shari’ah Adviser will:
- check that all aspects of the business are in accordance with the Shari’ah (including portfolio management, trading practices, operational matters, administrative matters, etc.).
- provide Shari’ah expertise on documentation, structuring, investment instruments and ensure compliance with the general Shari’ah principles and the standards, regulations and resolutions of the regulator.
- scrutinize any compliance report or any investment transaction report prepared by the Shari’ah Compliance Officer.
- provide written opinions of compliance from time to time or when needed and at least annually to the Board of Directors of the private equity fund.
Besides tax implications in jurisdictions that are not apposite to receiving Islamic structuring, focus is streamed into aligning contracts, partnership structures and conventional regulations with the Islamic principles.
Moreover, in most cases, the expectations of lawyers and consultants involved – and possibly the other conventional investors or even the Target Company – do not fit the Shari’ah framework. The conventional mindset indeed is directed to minimizing risk (and sometimes even excluding) and optimizing profit on interest based basis.
Just to give a brief of a few topics:
- Preferential and not fully subordinated shares/debt for instance is commonly used in conventional structuring. This would entail that some shareholders bear less risk or at least the risk of loss is not equally distributed between the shareholders. In this sense, preferred stock – giving the holder the right of pay out of investment before the common stock – is prohibited.
- Guaranteed liquidation pricing (in a way excluding the risk of sharing a loss) is also contrary to Shari’ah.
- Guaranteed return on investment (say dividend of x % per annum) is also unlawful for the same reasons.
- On the other hand, preference to profits might be construed within limits when attached to common stock. Also, convertible and exchangeable structures have been approved.
- Vesting techniques can be used. This means that some stock only accrues for the entrepreneur (or key employees) after agreed periods have elapsed or benchmarks have been reached.
- Lock-in agreements also have been approved.
- It also is adviseable to draft good covenants and where possible insert Shari’ah protection clauses in articles of association and so forth.