Sharia-compliant funds are one way to get a foot in the door in the Mena region, say Neil Miller, David Baylis and Judy Kawaf

The economies in the Middle East and North Africa (Mena) region are booming, with a gross domestic product (GDP) growth rate averaging at 6.1 per cent in the past three years, as compared with the global growth rate of 3.5 per cent.

The high growth rate has been fuelled primarily by an increase in crude oil prices. The resulting liquidity in the Mena region, estimated by KPMG to be in excess of $2.3tr (£1.17tr), has driven the demand for private equity funds. According to the Gulf Venture Capital Association’s (GVCA) 2006 annual report, $18bn (£9.14bn) has been raised since 1997 for investments in closed funds, 55 per cent of which was raised in 2006.

For the most part these funds have had a general focus on buyouts. However, an increasing number are now becoming sector specific, targeting areas such as infrastructure, energy, real estate, telecoms and technology. In addition, private equity firms in the Mena region, in recognition of the liquidity, are creating sharia-compliant funds.

Sharia compliance
Sharia-compliant funds are similar in structure to conventional funds in that they are usually established as limited partnerships, with a general partner/fund manager and investment adviser appointed to manage and advise the fund. An additional feature of sharia funds, however, is the requirement to appoint a sharia board. The Accounting and Auditing Organisation of Islamic Financial Institutions (AAOIFI), an autonomous not-for-profit institution, has stated that a sharia board must consist of at least three sharia scholars. The sharia board provides guidance to the fund on matters of sharia law, and in particular whether a proposed investment is sharia-compliant and therefore can or cannot be made by the fund.

The sharia board should be consulted when the fund is being established and also in relation to making and divesting investments. The board should be appointed early in the process of structuring the fund, as one of its functions is to review material contracts and to approve the fund’s structure.

A sharia-compliant fund may not invest in businesses that, among other things:
•manufacture, sell or offer alcohol or pork;
•invest in, or are, gambling establishments;
•provide interest-based financial services;
•invest in, or are, nightclubs, or are involved in pornography or adult-orientated material.

In addition to the restrictions on the type of businesses into which sharia-compliant funds may invest, there are several other criteria that apply to a sharia-compliant fund. These relate to the target business and concern the percentage of outstanding debt and the percentage of cash and receivables it has. In addition, a sharia-compliant fund may not invest in conventional derivatives, futures or options (although it is worth noting that developments are taking place to design hedging arrangements and certain types of option-like products that are capable of operating within approved sharia-compliant criteria). Income generated by a sharia-compliant fund must also be ‘purified’. As it is likely that some of the income generated by the underlying companies in which a sharia-compliant fund invests will include some form of interest (a prohibited form of income under Islamic law) it is necessary to ‘purify’ that income, as it has been termed. This process requires either:#that the ‘tainted’ income be deducted prior to distribution of dividends; or#that investors be informed of the amount that should be deducted from their dividends to achieve a sharia-compliant return.

Clearly, the second option is more appealing from a commercial perspective in that it correctly states the total income generated by the fund and more accurately reflects the gross returns of the fund. The sharia board’s input is again required in determining the types of income that need to be purified. The amounts purified should, under Islamic principles, be donated to charity.

Funds’ attractiveness
The approach taken by sharia-compliant funds is consistent with Islamic teachings on risk-taking, which provide that investors in a fund share in profits and losses equally unless the losses are suffered as a result of mismanagement of the fund or the negligence of the general partner/fund manager. Also, consistent with Islamic principles, investors in a sharia-compliant fund may never be guaranteed a profit or a return on their investment.

By making funds sharia-compliant, private equity firms make funds a more attractive option for Muslim investors, not only in the Mena region, but worldwide.

According to the GVCA’s annual report, “historically, private equity players in the region tended to restrict their activity to collecting funds for investment in pre-identified opportunities. More recently, they are collecting funds prior to seeking opportunities to invest in funds in ventures both in the Mena region and worldwide”. With investment funds seeking to raise and invest more in the Mena region, it is likely that an increasing number of funds established will be sharia-compliant. These funds may be established in the Mena region or other tax-efficient jurisdictions, such as the Cayman Islands and the Channel Islands.

Governments in the Mena region have facilitated both the entry of foreign-based funds into the region and the establishment of local funds. The activities of such funds are regulated by the relevant regulatory authorities. The Central Banks of Bahrain (CBB)(formerly known as the Bahrain Monetary Agency) in Bahrain and the more recently established Dubai International Financial Centre (DIFC) in Dubai undertake this activity on a regular basis. Both entities allow 100 per cent foreign ownership of companies and the international standards applied by the CBB and the DIFC appear to have captured the confidence of investors.

The key drivers affecting private equity include favorable macroeconomic conditions, a stable regulatory structure and the availability of capital. In the Mena region these drivers are illustrated by a high GDP growth rate, increased liquidity and the creation of regulatory establishments. The private equity market in the Mena region is expected to experience further growth as the region continues to prosper. Accordingly, this will almost certainly lead to an increasing demand for sharia-compliant funds.

Neil Miller is global head of Islamic finance and David Baylis is head of international private equity at Norton Rose. They were assisted with this article by associate Judy Kawaf