Structuring Shariah Compliant Venture Capital/Private Equity Fund

Introduction

A Shariah-compliant Private Equity (“PE”) / Venture Capital (“VC”) fund is no less significant than its conventional counterpart. From the investment point of view, both conventional and Shariah-compliant funds apply the risk-sharing investment concept, as opposed to the risk transfer concept.

From the legal point of view, the regulatory framework does not differentiate between a conventional and Shariah-compliant PE and VC. Thus, it enables both conventional and Shariah-compliant funds to coexist.

Development of Shariah-Compliant Private Equity and Venture Capital in Malaysia

Shariah-compliant PE and VC funds have gained its popularity in the Middle East and North Africa (MENA) region, the Gulf Cooperation Council (GCC) region and also in South East Asia countries.

In Malaysia, the development of Shariah-compliant VC was initiated by the recommendation of Bank Negara Malaysia under the Financial Sector Stability Master Plan 2001-2010.

Following this, the first Shariah compliant VC, Musharakah Venture Tech and Musharakah Venture Management were established by Malaysian Venture Capital Management on 17 July 2008. The fund size was RM35 million and was established based on the concept of Musharakah.

On 9 March 2015, the Securities Commission Malaysia (“SC”) issued the Guidelines on the Registration of Venture Capital and Private Equity Corporations and Management Corporations (“Guidelines”), which superseded the Guidelines and Best Practices on Islamic Venture Capital which was previously issued in May 2008. The purpose of the Guidelines is to streamline the regulation of conventional and Shariah-compliant PE and VC corporations.

For recent developments, in 2015, RHB Islamic Bank Berhad signed a collaboration agreement with Malaysian Technology Development Corporation to act as the custodian for the RM150 million funds entrusted by the Malaysian government.

Later in the same year, a Japanese investment company jointly established an Islamic PE fund with Permodalan Nasional Berhad and Japanese regional banks.

At present, there is a significant number of PE and VC funds available in the market including CIMB Private Equity and Venture Capital, KFH-Private Equity, Navis Capital and others.

The Guidelines

The Guidelines regulate both conventional and Shariah-compliant PE and VC corporations. All PE and VC corporations are required to be registered with the SC and to satisfy the criteria set out in the Guidelines.

A corporation who wishes to undertake Islamic PE or VC activities must appoint a Shariah Advisor and ensure that the activities comply with the Shariah requirements.

If a Shariah-compliant PE or VC corporation undertakes investment in securities, it must ensure that the activities are Shariah-compliant.

In determining the Shariah-compliant status, the Shariah Advisor may employ the Shariah screening methodology of the Shariah Advisory Council of the SC (“SAC”) or any other appropriate methodology.

If a Shariah-compliant PE or VC corporation invests in listed securities on Bursa Malaysia Securities Berhad, it must only invest in the securities classified as Shariah-compliant based on the List of Shariah-compliant Securities by the SAC.

Nonetheless, any investment decision, either local or abroad, must be endorsed by the Shariah Advisor to ensure its compliance with the general Shariah principles, standards or resolutions issued by the SAC or other recognized Shariah authority.

Common Structures for Shariah-Compliant Private Equity and Venture Capital Funds

The structures which are commonly used in PE and VC funds are Musharakah, Mudharabah and Wakalah.

Musharakah

Musharakah is a common structure used in a Shariah-compliant PE/VC fund. Musharakah refers to a partnership between two parties or more to finance a business venture whereby all parties to the Musharakah contribute the capital.

The capital contribution can either be in the form of cash or in kind. If the venture is profitable, the profit will be distributed based on a pre-agreed ratio. However, in the event of a loss, the loss will be shared on the basis of capital contribution. A simplified Musharakah structure is stipulated in Figure 1.

Mudharabah

Mudharabah is another common structure used in a Shariah-compliant PE/VC fund. It is a contract made between two parties in order to finance a business venture.

The parties are a Rabb al-Mal, an investor who provides the capital and a Mudharib, an entrepreneur who manages the project/business. This is akin to a conventional PE/VC fund in the sense that there is a relationship between the investor and the manager. If the venture is profitable, the profit will be distributed according to the pre-agreed ratio. If there is a business loss, it should be borne solely by the investor, only to the extent of his capital contribution.

The significant element of a Mudharabah structure is that the manager cannot be put in a position at risk to bear losses unless proven negligent, fraud or misconduct on its part. A simplified Mudharabah structure is stipulated in Figure 2.

Wakalah

Wakalah is the most popular structure used in a Shariah-compliant PE / VC fund in recent years.

Wakalah refers to a contract whereby a party (principal) authorises another party or parties (agent) to act on his behalf, based on the agreed terms and conditions for a fee consideration (Wakalah Bil Ujrah) or without any consideration (Wakalah Bi la Ujrah).

The Wakalah contract confers power and rights to the agent to act. A simplified Wakalah structure is stipulated in Figure 3.

Combined Structure: Coexistence Between Shariah-compliant and Conventional PE and VC Funds

As stated earlier, it is possible for conventional and Shariah-compliant PE / VC funds to coexist. In this respect, the combined structure of conventional and Shariah-compliant PE / VC funds will be adopted. Conventional investors commit funds into a conventional SPV and Shariah-compliant investors commit funds into a Shariah-compliant SPV respectively.

Both SPVs will ultimately invest in the PE / VC fund. In order to ensure full compliance with the Shariah principles, the Shariah-compliant investors should form the majority shareholders.

However, if the Shariah-compliant investors only form a minority, then they should ensure the enforceability of a strong shareholders’ agreement that guarantees Shariah compliance at all times. Nonetheless, in any event, at the level below the SPV (i.e. fund company and investee companies), sufficient reporting system should be in place for the Shariah Advisor to ascertain that the investment strategy meets the Shariah standards in particular the utilization of the funds is for Shariah compliant purposes. An example of a combined structure is stipulated in Figure 4.

Parties involved in a Shariah-compliant PE and VC Funds

In a typical Shariah-compliant PE /VC fund, a Shariah Advisor must be appointed to ensure the fund’s compliance with the Shariah principles. Every investment decision of the fund’s portfolio needs to be endorsed by the Shariah Advisor.

Apart from Shariah Advisor, lawyers are responsible in preparing all the agreements for the fund and also ensuring that the structure of the fund is in compliance with the regulatory framework, which will then be endorsed by the Shariah Advisor. Additionally, a PE / VC fund, whether conventional or Shariah-compliant may be required to appoint an auditor and also a tax advisor.

Conclusion

The Shariah-compliant PE and VC industry has developed significantly and became an alternative fund raising option for companies’ capital requirements.

One of the factors that contribute to develop this industry is the increasing awareness of its significance for economic growth and diversification. This industry has a lot of potential evidenced by growing demands for Shariah-compliant PE and VC.

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References

• Darawati Hussain, ‘The Roles & Responsibilities of Managing Islamic Private Equity Fund”, paper presented at Islamic Venture Capital & Private Equity Conference, Kuala Lumpur (2018).
• Said Adekunle Mikail, Dr. Mahamad Arifin and Prof Dr. Rusni Hassan, “The Evolution of Islamic Venture Capital in Malaysia: An Expository Study” (LexisNexis, Issue 3 of 2013).
• Financial Sector Stability Masterplan 2001-2010, Bank Negara Malaysia.
• Guidelines on the Registration Venture Capital and Private Equity Corporations and Management Corporations, SC-GL/3-2015.
• “Islamic Finance: An Ideal Model for Private Equity and Venture Capital” by Malaysia International Islamic Finance Centre (2015).
• Zaid Hamzah, “Islamic Private Equity & Venture Capital: Principles and Practice” (IBFIM, 2011).

Written by:

Ahmad Syahir Yahya (Partner) syahir@azmilaw.com

Rohaisha Jamil (general@azmilaw.com)