“Risk Capital”: Islamic Private Equity in a Globalized World, Part 1
Note: This post was written by Shahzad Siddiqui and Mujir Muneeruddin
“Load the ship and set out.
No one knows for certain
Whether the vessel will sink
Or reach the harbour.
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.”
Jalaluddin Rumi, “Work in the Invisible,” One-Handed Basket Weaving: Poems on the Theme of Work, trans. Coleman Barks, p. 38.
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 initially balked at the offer but – in order to prevent Columbus from taking his business elsewhere – gave him an annual allowance while directing that all subject towns provide him with free food and board. After several years of indecision, the Queen finally agreed to the following terms: Columbus 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 pretending to be Christian so that their lives would be spared) who specialized in Islamic commercial law – the structure of choice for most partnership contracts of the time. However, on his return from the New World the Queen reneged on the deal, causing Columbus to commence a lawsuit against her, only to die mid-litigation.
Private equity – here defined as profit-and-loss financing by wealthy, sophisticated or professional (and often large institutional) "private" investors – has financed everything from maritime trade in ancient Italy to the digital revolution in Silicon Valley. Yet unknown to many today, Islam (as suggested by Columbus' choice of both legal counsel and structure) was there at the start of the private equity story.
Private Equity in Islamic Finance
Early Arab traders were pioneers of flowing private capital into profit-and-loss sharing ventures, with the Prophet Muhammad (570-632 AD) himself becoming a great exemplar. The Prophet’s companions, most notably Abdur-Rahman ibn 'Awf (580-652 AD), were heavily involved in the equity financing of trade caravans and became the equivalent of today’s private equity tycoons. Since then, Muslims have continued to take leading roles in profit-and-loss sharing while Islamic finance firms have begun taking Islamic private equity principles to a global scale. Recently, such firms have financed everything from Shari'a-compliant hotels (eg., Shuaa Capital in Saudi Arabia), self-storage units and industrial plazas (Conundrum Capital in Canada), to fried chicken and coffee franchises (Arcapita in USA), to biotech and pharma start-ups (VenturEast in India) and capital-intensive financial services (Fajr Capital) and infrastructure projects (Islamic Development Bank).
Fundamentally, Islamic private equity is based on broader Islamic commercial principles requiring that transactions be based upon, and stay true to, certain legally-recognized instruments and structures. In the private-equity context, the two major instruments are mudaraba (limited partnership) and musharaka (general partnership). Importantly, Islamic private equity or venture capital funds are very similar to their conventional counterparts, with the exception of some strict qualitative and quantitative screening. Islamic funds engage in profit-and-loss sharing and follow the familiar General Partner/Limited Partner (GP/LP) structure, with the Islamic private equity firm acting as the general partner (mudarib) and investors (arbab-ul-maal, literally "lords of capital") acting as limited partners with no role in management. As a result, many Islamic funds have successfully attracted both Shari'a-sensitive and conventional investors.
Under a musharaka structure, the Islamic private equity fund would invest along with other capital contributing partners, who would have the right to actively participate in the fund's management. However, in so doing, such partners would lose their limited liability status, which is typically why most Islamic private equity funds today are set up under the former mudaraba structure (in line with both ancient practices and contemporary norms). Furthermore, under mudaraba, while the profit share of the arbab-ul-maal is negotiable, their liability is limited to the amount of capital invested. Any debts and losses in excess of this amount invested (for example, arising out of litigation or unpaid taxes) would have to be borne by the mudarib.
End of Part 1 of 2
Mujir Muneeruddin is a partner practising Corporate & Securities Law at Abrahams LLP, a law firm focused on entrepreneurs. He is a graduate of Queen's University Faculty of Law, holding both a professional law degree (J.D.) and a masters of law (LL.M.) specializing in Securities Law. He also holds a diploma in Islamic Finance.