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July 03, 2009

Shariah Compliance for PE Funds

Here is a note on the above topic prepared by our knowledge partners



There has been a growing demand from investors domiciled in the Gulf Co-operative Council region for investment portfolios to include Shariah compliant instruments. With growing credit crunch, LP defaults in other jurisdictions and other factors that have emerged from the global financial turmoil, the fund managers are evaluating options to tap investors in Gulf, which amongst other things require the fund to comply with the tenets of Islamic laws. This note briefly identifies some basic considerations whilst establishing a Shariah compliant fund.

Introduction
Many Muslim investors conduct their commercial activities in accordance with an Islamic body of law called Shariah. Shariah, or literally “the way”, is based on the Quran (the religious text in Islam), Hadith (the sayings and actions of Prophet Mohammed), Isma (the consensus of Shariah scholars), Qiyas (reasoning by anology) and centuries of interpretation and precedents. Shariah law does not have uniform set of standards and interpretations. While some institutions, such as the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institution, work to unify the various interpretations and opinions of scholars, but they are only recommendatory in nature. Whether an investor views a particular private equity fund and its investments as “Shariah-compliant” will depend upon the review and approval by a Shariah consultant or supervisory board engaged by the fund manager and/or the investors' own consultant or supervisory board.

Investment Restrictions
In order to qualify as Shariah-compliant fund, a fund’s investment policy must contain restrictions that prohibit investment in industries considered haraam.

These restrictions usually prohibit investments in companies involved in the following industries and activities:

• Conventional financial services (including conventional banks and insurance companies);

• Gambling and casinos;

• Alcohol and pork products;

• Certain entertainment, such as gossip columns or pornography (but often including cinemas, music and publications);

• Weapons or military equipments; and

• Any other immoral or unethical activities identified by Shariah consultant or supervisory board.

What are considerations for fund managers?

An investment fund may be structured based on the Mudaraba contract under which an investor provides capital to another person/body (a fund manager), who uses their expertise to devise a suitable investment strategy. Any profits generated by the joint enterprise are divided between the manager and the investor in accordance with a predetermined formula. The financial losses are borne by the investor to a maximum of his capital investment. As indicated above, although there are several restrictions on investments that could be made by the fund, over a period of time there have been certain favorable interpretations by Shariah scholars which permit structuring of the investments and be within the four corners of the permitted activities. Some of the possible avenues include:

• Shariah prohibits usury, which may be defined as exploitation by the owner of a product which another requires. The payment of receipt of interest is usury and therefore investment in entities involved in lending (or borrowing) are prohibited. This restricts ability for most companies to have interest-based debt finance and invest surplus cash in interest bearing bank accounts and other investments. However, some Islamic jurisprudence accepts a debt to equity ratio of 1:3.

• Similarly, there is a school of thought that investors are not partners in a fund but are merely investors. Since no one investor has the power to veto, it would be wrong to ascribe responsibility to an individual for a particular transaction. This may allow some headroom to invest in entities which have merely incidental non-halal features, since investors will not be deemed under Shariah to have authorized the investment. In some instances any company engaged predominantly in halal business, but earns interest on account, an equivalent portion of any dividend paid to a Shariah compliant fund must be given to charity, be it at the fund or the investor level.

• An Ijara fund is usually established for the purpose of purchasing assets (property, machinery, etc) and then leasing those assets to third parties in return for rental income. This may be relevant for real estate funds. Legal ownership of assets remains with the fund as does responsibilities for the management of such asset. A management fee will normally be paid to the manager. It is important that the assets that are leased out must be used in a halal manner and the leasing arrangement is compliant of Shariah.

It is evident from above that there are number of interpretations whilst ensuring whether a particular activity or investment by the fund would be Shariah compliant. Therefore, funds appoint a Shariah consultant or supervisory board that reviews proposed investments and operations and issues opinions as to their compliance with Shariah. There are also certain service providers with their own Shariah boards, which may be engaged on a contractual basis to advice a fund.

Some investors may insist on establishment of Shariah Committee in relation to the fund, which would consist of Islamic scholars and which would advice the General Partners in relation to Shariah compliance. Compliance will be an ongoing obligation and the Shariah committee will be responsible for conducting annual audits to ensure that the fund and portfolio companies continue to operate in accordance with Shariah. One other option that is looked at is that a Shariah compliant parallel vehicle could be established with the main fund.

It is important whilst structuring the fund and preparing investments strategies, private placement memorandum and other fund documents that above restrictions are appropriately addressed for the fund to be able to attract investors for a Shariah compliant fund. With demand for providing opportunities to Gulf investors, the Shariah-compliant funds are growing in numbers and present opportunities to General Partners to tap wider investor base.

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Please Note: This note is only informative and is prepared based on our past experience and publicly available information. The contents of this document are intended for informational purposes only and are not in the nature of a legal opinion or advice. They may not encompass all possible regulations and circumstances applicable to the subject matter and readers are encouraged to seek legal counsel prior to acting upon any of the information provided herein. This note is the exclusive copyright of ARA LAW, Advocates & Solicitors and should not be circulated, reproduced or otherwise used by the intended recipient without the prior permission of ARA LAW.