“Risk Capital”: Islamic Private Equity in a Globalized World, Part 2
Yesterday we published the first part of this post introducing the world of Islamic private equity. Today, Mujir and Shahzad explain the potential of this stream of finance for private equity and entrepreneurship in Canada.
Culture of Entrepreneurship
While private equity success stories like Google and The Body Shop surround us in everyday life, there is no hiding the “catch” for investors: private equity investment can be a risky exercise. In a world where debt-based investment is well-entrenched (the bond market in Canada is astronomically larger than its equity counterpart), raising equity financing can be daunting, particularly at earlier stages of the business cycle. On the other hand, obtaining significant amounts of debt financing typically requires assets for collateral, which can be a tough ask of many growing businesses.
In this way, a financial system driven by lending can dissuade entrepreneurship, and this is one of the primary reasons that Islamic finance so strongly encourages equity over debt investment: it promotes a greater distribution of risk and, as a result, entrepreneurship.
Prohibition of Interest
It is difficult to understand any aspect of Islamic finance, including private equity, without first contextualizing its oft-stated prohibition against interest. In a nutshell, the Shari'a prohibits any exchange of usurious commodities (typically fungible goods like gold and money of the same currency) at other than par.
Thus, to use an overly simplistic scenario, a lender exchanging $10 dollars today for $15 dollars (for example, next week) is not allowed. However, other modes of financing such as the sale of an asset on a deferred-payment basis (i.e. a credit sale) or even a lease, which has an interest-based benchmark, are commonplace. The key is that the lending occurs in connection with the transaction of an asset.
Most markedly, a system based on Islamic financial principles would have a very different concept of financial institutions and no equivalent of a bank as we know it – a deposit-taking institution offering capital certainty while reinvesting borrowed funds. The idea is to force a more constant flow of capital and, most importantly, encourage the taking and sharing of risk.
Rise of Modern Islamic Private Equity
Perhaps ironically however, it is risk management that has sparked the recent growth of Islamic private equity funds throughout the world. Following the "Arab Spring", high-net worth individuals in the Middle East & North Africa (MENA) have started to discreetly seek external opportunities, and this has been the major focus of Islamic funds launched in the region. With greater global diversification, MENA investors are starting to grow more comfortable investing outside the region – to the direct benefit of the global marketplace.
One such beneficiary is likely to be Canada. Since the MENA region is not known for an abundance of universities, opportunities in post-secondary education can be scarce. As a result, many of the region's young have recently come to Canada for educational purposes, thereby creating greater awareness of Canada in their home countries among their wealthy senior family members. This—coupled with continued weakness in the Eurozone, stubbornly tepid U.S. growth and the resulting perception of Canada as something of a "safe-haven"—positions Canada well for increased MENA-sourced investment.
For now, the popular form of investment is private equity and venture capital financing which, to be clear, operate within the same universe as their conventional counterparts but have more selective screening.
Qualitative and Quantitative Screening
Islamic private equity fund managers begin their Shari'a due diligence on the qualitative side by looking at the industry of a potential target, namely to see whether its business operations are Shari'a-compliant. This rules out the “usual suspects”: purveyors of alcohol, pork, pornography, weapons and interest. If a company passes this initial step, fund managers (with the counsel of their Shari’a advisors) will need to determine if the company has any long-term debt, ancillary income from non-compliant sources (such as alcohol revenues in an airline) in excess of 5% of revenue, or large accounts receivable.
While devout investors may prefer zero long-term debt, many Islamic institutions have begun using exceptions ordinarily available to public equities – most notably the allowance of up to a 33% debt-to-equity ratio – to private companies (typically retail operations with heavy cash-flows).
The third step of the test is whether income is "cleansed." At this stage, if there is any income from a non Shari'a-compliant source, it must be purged from all distributions. Hence, if 4% of a hotel's revenue were from alcohol sales, then this amount would have to be removed from any profit distribution and remitted to charity. However, it is worth noting that this cleansing requirement does not apply to capital gains, as the percentage of the accretion attributable to non-compliant sources cannot be calculated.
Another issue for Shari’a-sensitive investors is share structure. In particular, preferred shares, warrants, options and convertible securities (which include convertible preferred stock, convertible zero-coupon debt and convertible bonds) can be problematic from a Shari'a standpoint if they offload risk from one class of equity holders to another. Hence, any class of shares that is given preference on dissolution or even offered a guaranteed return-of-capital (for example, prior to any profit distribution to other equity holders) can be problematic and may have to be redeemed or bought out prior to investment.
That being said, the industry is not without creative solutions. For example, counsel have redrafted preferred stock rights to give preference on merger and change-of-control events as opposed to during dissolution or distress.
Given that Shari'a-sensitive investors are largely confined (at least, in theory) to riskier equity-based investment and that Canada is well-positioned to see greater capital in-flows from MENA, the Canadian private-equity market might be in for a significant boost in the coming years. In particular, this could be the adrenaline injection that the Canadian venture capital scene has long been seeking. To that end, it is worth noting the recently-announced partnership between MaRS and the United Arab Emirates, which merely reflects a trend that has apparently already begun.
Note: This post was co-authored by Mujir Muneeruddin and Shahzad Siddiqui.
Shahzad is the Managing Partner of Abrahams LLP, a law firm focused on entrepreneurs. He is a graduate of the University of Toronto and Osgoode Hall Law School and recently completed a Master’s in Islamic finance at the University of Pennsylvania Law School. He is the author of Shari’a-Compliant Private Equity: a Primer for the Executive.