Friday Letter: Shariah vision

At a time when much of the essence of private equity is subject to intense scrutiny by many outside the industry, it is notable that a different version of the asset class is taking shape which takes its definition from compliance with Islamic teaching.  

In fact, a number of financial markets are now delivering products that are compliant with Shariah law. Middle Eastern investors, flush with oil revenues, are the primary driver of a phenomenon that is turning this formerly very niche part of the global capital market into an industry of scale. Estimates vary, but according to the Financial Services Authority in London, as much as $500 billion of capital is already being invested through Shariah-compliant structures, i.e. instruments that accord with the rules and principles codified in the Koran. And it is estimated that upward of $3 trillion of capital is presently available for investment by Muslim investors.

In terms of total global capital flows, $500 billion may not be a huge amount, but few financial professionals have failed to notice that Islamic finance has been growing exponentially, and is widely expected to go on growing at a significant rate.

The trend is having an impact on several asset classes. Both issuers and investors for example have been learning about the defining characteristics of sukuks. Under the Koran, interest (or riba) earned on money is forbidden, whilst other types of financial return are allowed. The key principle behind the Sukuk is that the holder has an undivided ownership interest in a particular asset and is therefore entitled to the return generated by that asset. Rating agency Standard & Poor’s predicts that sukuk issuance will increase from $70bn in 2007 to over $100bn by 2010.

The notion of Shariah-compliant hedge funds has also attracted attention, even though with less than $1 billion currently under management according to research from Ernst & Young, this is an area where Islamic finance still has a long way to go. Nevertheless, hedge fund experts predict significant expansion in the coming years, especially if certain structural obstacles can be overcome. And a number of managers are already developing appropriate fund vehicles for what they see as a compelling source of capital.

In the private equity world, Shariah is fast growing its profile. In Europe, one of the most eye-catching events thus far came in March, when Ford agreed to sell its iconic sports car maker Aston Martin to a syndicate involving Middle Eastern investors. WestLB, the German bank, arranged a £225 million Shariah-compliant debt facility to finance the deal. 

And there are other ways in which Islamic finance is making inroads into private equity. Middle Eastern principal investors such as Arcapita in Bahrain and Abraaj Capital in Dubai are using Shariah-compliant investment funds to acquire assets. Earlier this week, we reported the launch of the first-ever Shariah-compliant mezzanine fund, a $150 million vehicle managed by CORECAP, an alternative investment group based in Qatar.

And in a period when mainstream private equity firms are experimenting with new ways of raising capital – just think Blackstone, China and $3 billion – it seems just a question of time before Shariah-compliant side funds co-investing alongside traditional limited partnerships will become a much more common feature of the market. A partner at a leading European LBO house told PEO: “We haven’t looked at such a structure yet, leverage being the obvious issue. But the market has grown significantly over the last few years and this is now something we would possibly consider.” It’s early doors in other words, but private equity dealmakers and fundraising strategists alike are clearly mulling their options.

In the meantime, Islamic finance is spreading its wings and expanding geographically as well. London in particular has emerged as an important hub for the industry, which lends credence to those who predict that Shariah-compliant finance will continue to gain influence – in financial markets generally, and alternative assets in particular. With that in mind, we at PEI are hosting the first ever conference dedicated to Islamic alternative assets. Run in partnership with the Dubai International Financial Centre and CIMB Group and taking place on 25 & 26 June in London, the event provides a unique opportunity for all those involved in alternative assets to meet and learn more about this dynamic and, we think, increasingly important part of the alternative asset industry.

If you’d like to join us on what looks set to be a stimulating couple of days, visit www.peimedia.com/if07. Anyone serious about engaging with this innovative area of their industry (whether you are planning to raise a fund or not) should be there.