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Islamic private equity: Misunderstood?
Three key misconceptions continued in 2012 to mar the Islamic finance
industry’s grasp of private equity and venture capital (PE/VC). Islamic
finance actors must come to realize that real estate and private equity
constitute separate asset classes. Arshad A Ahmed shares his thoughts.
That they may share a common organizational device — for
example they both may be partnerships — does not eclipse
the obvious difference between real estate assets and PE/VC
assets. PE/VC funds invest in the equity (and, on occasion,
debt capital) of operating businesses.
To the extent a PE/VC portfolio enterprise happens to own or
lease real property, it is incidental, and certainly not central,
to the business proposition. Where real property motivates a
transaction to happen, it is an indication that the transaction
should be treated and categorized for investment management
purposes as a real estate asset and not as a PE/VC asset.
Though leveraged buyouts (LBOs) are the most glamorous of
PE/VC transactions, they are far from being the most common
(or profitable) type of PE/VC transaction. In my own PE/VC
career spanning nearly 15 years, my most lucrative PE/VC deals
relied on no leverage at all. They were 100% equity investments
that generated over ten-times returns in just a few years. Growth
equity, venture capital, and ordinary buyouts do not rely on debt,
and they generally prefer investing in businesses that are debtfree.
In addition, they are the most common varieties of PE/VC deals
in emerging markets. Yet, venture capital and growth equity
investing continue to be glaringly absent from the Islamic world,
even though VC alone is responsible for over a trillion dollars of
new value creation added to the American economy in the past
decade — all from equity.
In developed markets, banks and other debt financing sources
have practically no meaningful role in venture capital, growth
equity, and ordinary buyout activities. In the PE subcategory of
LBOs (arguably the most caustic method of PE investing), banks
show up to provide the debt financing such as the leverage.
No discussion of Islamic finance’s key misunderstandings of PE/
VC would be complete without emphasizing the bright line dividing
PE/VC from public equities. Enough space is not available to
spell out all of the differences, but the key principle here is that
PE/VC tends to operate in the private sector, outside the limelight
of public disclosure requirements. Due to this limitation, PE/VC
tends to be limited to the most sophisticated investors.
However, the opposite is the case for businesses making their
initial public offering of equities. With broader public disclosure
comes a business’ right to sell their equity securities openly to
public investors. Because the same kind of demand for public
disclosure applies to debt and fixed income securities such as
bonds, it is hardly conceivable for PE/VC to be found participating
in Islamic finance’s rapidly expanding Sukuk markets.
LBOs (where the leverage comes from Islamic debt financing).
As was noted in early 2013 by Alberto Brugnoni, chairman of
Italy’s Associazione per lo sviluppo di Strumenti Alternativi e di
Innovazione Finanziaria, Islamic products have done little more
than mimic their conventional counterparts by adopting the same
debt-driven base. Extending this modus operandi to Islamic
LBOs does nothing to benefit Islamic PE.
Several PE firms based in the Gulf have been operating this
way for years, with no meaningful benefit to anyone other than
their attorneys who continue to be enriched by billing hours on
contriving legal structures resembling Murabahah that obfuscate
not only each transaction’s over-exposure to leverage but, more
insidiously, their risk concentration and relative lack of profit
sharing.
PE/VC is celebrated in Silicon Valley largely due to the asset
class’ attitudes on profit- and risk-sharing. It is a very different
attitude than one encounters among commercial bankers.
When it comes to banks and fixed income, it is a sine qua non
that borrowers must repay their debts regardless of how their
businesses do.
PE/VC firms are profitable when their portfolio businesses do
well, and PE/VC lose their investments when those businesses
go bankrupt. In the PE/VC mindset, risk is mitigated at the macrolevel
(by spreading risk among many investments) and at the
micro-level (by grooming each company) — this is far from the
way banks (Islamic or not) seek to handle risk of loss.
2013 also needs to be a time when deliberated legal reforms take
place in Islamic countries with regard to property rights, corporate
governance, and bankruptcy. So far we have seen severe lack
of certainty in these areas, all of which are critical to fostering
PE/VC investing. Instead of mimicking Western rulemaking in
these areas of the law, Islamic countries may choose this year
to develop policies thoughtfully and consensually in a manner
bespeaking Islam’s legal and intellectual heritage.
If Islamic finance now faces a dearth of qualified talent, this
problem is magnified to the extreme in Islamic PE/VC. Recently
the Malaysian sovereign, Malaysia Venture Capital Management,
elected to make 2013 the year in which they enhance their
Islamic PE/VC capabilities by partnering with Silicon Valleybased
experts in both PE/VC and Islamic finance.
At Silicon Valley lies the heart and soul of PE/VC. The Malaysians
realized that a banking mentality hinders PE/VC, and enduring
success in PE/VC investing will come by linking with high caliber
talent steeped in the intricacies and global best practices of
consulting www.IslamicFinanceConsulting.com
www.IslamicFinanceEvents.com
equity investing rather than debt financing.
www.IslamicFinanceNews.com
www.IslamicFinanceTraining.com
As we look ahead, we disagree strongly with recent sentiments
that Islamic PE’s expansion ought to be led by an increase in
www.MIFforum.com
www.MIFmonthly.com
Arshad Ahmed is managing partner www.MIFtraining.com of Elixir Capital. He can be
www.REDmoneyBooks.com
contacted at arshad.ahmed@elixircap.com.
12 February 2013