Venture capital opportunities diversify risk profiles through Islamic finance

April 2015 | SPOTLIGHT | PRIVATE EQUITY & VENTURE CAPITAL

Financier Worldwide Magazine

There has been a steady increase over the last few years in the prevalence of new start-ups and entrepreneurs originating from the Middle East region, including from the United Arab Emirates (UAE). In light of its continuing growth and development, the UAE has been subject to increased attention from investment arms of conventional and Islamic banks and investment vehicles. Investors are looking for ways to diversify their risk profiles with alternative sources of financing, and Islamic finance structures are becoming a popular choice to facilitate the same. Whilst many Islamic financing structures are available to structure such investments, the two most suitable instruments in venture capital opportunities are Mudaraba and Wakala.

This article provides an outline of commonly used Islamic structures and discusses the current market opportunities, and how the larger business community can assist to promulgate the efforts of such new ventures.

What are the opportunities?

Whilst much has been achieved in the UAE over the last few years to endorse business innovation through various projects and initiatives such as the Entrepreneurs Development Program (Tejar Dubai) and the Mohammed bin Rashid Establishment for Young Business Leaders (Dubai government), in addition to established institutions such as the Emirates Foundation which promotes the welfare of youth across the UAE, much more can be accomplished. In addition, a number of start-ups have grown organically or relocated to the UAE, from other markets in the Middle East. Nonetheless, further significant strides can only be made if a concerted effort is made by the venture capitalists and other establishments in the region including, but not limited to, legal firms and service providers.

Islamic instruments

Two main forms of investment are available to individuals and businesses in the venture capital field; by way of active investment or passive investment. Active investment involves the parties sharing, usually in varying degrees, decision-making powers and profits in the given venture whereas passive investment relates to a venture where the investor receives the profits of its investment but otherwise has minimal involvement in the management or decision-making of the venture. Passive investment is more commonplace with new start-ups that essentially only need assistance with financing their ideas but are largely capable of implementing them alone.

A form of partnership – Mudaraba

Mudaraba is a structure which has seen a significant diminution in its use over the years, yet was once seen as the purest form of Islamic finance, being based on the principles of profit and loss sharing (PLS), one of the original fundamental principles of Islamic finance.

In a Mudaraba transaction and subject to adhering to pre-agreed policies and procedures, the Mudarib (or entrepreneur) is typically permitted to run the enterprise as they deem appropriate and the role of the Rab Al Mal (or investor) is limited to funding the same (although they may provide input on certain strategic decisions). The Mudarib and Rab Al Mal commonly share any profits the venture makes in a predetermined ratio and any losses sustained are borne solely by the Rab Al Mal. However, the Mudarib will have to bear any losses incurred if they are a result of its direct negligence, i.e., where the Mudarib has not exerted the degree of care expected of them in managing the venture. For the Rab Al Mal, a Mudaraba structure is, therefore, based more on the premise of profit-sharing-and-loss-bearing and less on PLS.

In practical terms, the Mudaraba financing structure can be utilised in venture capital opportunities in one of two ways: through a fund which acts as the Rab Al Mal in place of the ultimate investors, in which case the fund has all legal rights in the venture; or directly between the investors and the entrepreneur. Using a venture capital fund as an intermediary often has its benefits – it gives both the investors and entrepreneur a more streamlined process to identify the most appropriate counterparty that can work alongside the other on any given venture.

Furthermore, the Mudaraba structure does not typically require the Mudarib to provide further security to the Rab Al Mal following its investment as the Rab Al Mal has a direct equity interest in the venture already. Additionally, any recourse for the Rab Al Mal is dependent on whether the Mudarib complies with the investment policies and guidelines pre-agreed with the Rab Al Mal. These can be seen as quite attractive aspects of using Mudaraba structures for asset poor entrepreneurs in the UAE who are trying to materialise their business ideas and only require funding to do so.

An agency arrangement – Wakala

The concept of agency or Wakala involves an agent (the Wakeel) acting for and on behalf of a third party (the Muwakkil) for a pre-agreed fee pursuant to a Wakala agreement. In the context of venture capital investments, the investor can either invest its monies directly with the entrepreneur who has the business idea for the venture, or invest via a venture capital fund which will manage and on-invest the investors’ funds in such ventures which conform with the parameters that have previously been agreed between the parties – the fund can then utilise the Wakala structure to further invest the funds with the ultimate entrepreneurs.

Mudaraba or Wakala?

The downside to using a Wakala structure over a Mudaraba structure for an entrepreneur is that the former does not give the entrepreneur an equity interest in the venture but rather a management or performance fee, or possibly a share in the revenues. In fact, structurally and contractually, the Wakeel is an agent not a shareholder unless given the option by the investors to convert its management or performance fees, or share of the revenue, into equity in the venture. As in a Mudaraba structure, investors do not have recourse against the Wakeel, save where it materially breaches its obligations under the Wakala agreement (particularly as they relate to complying with the investment policies and guidelines), as well as fraud and wilful misconduct, but not if the venture fails to return the projected profits.

Thus, Mudaraba financing structures may be seen as a more attractive option to both investors, who get an equitable stake in the underlying venture, and entrepreneurs, who will not have to provide separate collateral over any of its assets yet still retain an ownership interest. This could, if structured correctly and if appropriate in the given nuances of the deal, see the use of the seldom used financing technique of Mudaraba increase for new start-ups in the UAE.

What can we do?

Ultimately, the prevalence of investment opportunities and young entrepreneurs in itself will not assist the organic growth of the UAE economy. Often, new entrepreneurs require support and assistance beyond the provision of funds including, but not limited to, being educated and guided in respect of their rights, both legal and commercial, in the complex and often unclear business markets in the UAE.

The obligation to train and cultivate the upcoming generations in the UAE must fall to the businesses that are currently prospering in the region and those that are well placed to provide truly hands-on advice. Some firms are already trying to lead such initiatives through pro bono activities. However, such initiatives need to be undertaken on a wider scale in order for there to be a true impact in the market and to truly elevate the UAE to the global financial hub that has been targeted in recent years.

Amanjit K. Fagura is an associate at Morgan Lewis. She can be contacted on +971 4 312 1860 or by email: afagura@morganlewis.com.

Amanjit K. Fagura

Morgan Lewis