Islamic banks need to commit more venture capital

DUBAI — Access to venture capital is recognised as important for new business startups and rapid business expansion. Consequently, it is well appreciated that the economic development prospects for communities and states are linked to the availability of venture capital for local entrepreneurs and businesses.



By Nathif J. Adam

Published: Tue 2 Aug 2005, 10:37 AM

Last updated: Thu 2 Apr 2015, 4:11 PM

In Islamic finance, no topic has received more attention in all contemporary literature than the subject of profit and loss sharing (PLS) contracts. This was quite expected because of the importance of these contracts in business and joint venture finance. There is apparent consensus among Muslim Sharia jurists and scholars that the two major modes of PLS financing i.e. Musharakai and Mudarabaii represent the most desirable ways of financing investment and business because of their ability to tie reward-sharing to risk-sharing between the two transacting parties.

The two contracts together form the Islamic substitutes to conventional methodologies for venture capital and private equity financing. Yet unfortunately, most Islamic banks have never made them popular forms of finance. Probably much less than 10% of the funds of most Islamic banks have been committed to these modes of finance while many of the banks may in fact have never practiced them.

Various reasons are advanced for this unfortunate state including the following:

1. Secretiveness and lack of adequate transparency on the part of the managing partners with regard to the performance of the projects.

2. The high cost of following up and monitoring of projects.

3. Unfair treatment in taxation in some countries. While profit made from such contracts is taxed, interest on the other hand is treated as a cost item and is not taxed. Such discrimination can prove negative and can limit the growth of PLS contracts.

While the above reasons may be justified to an extent, but a close consideration of the circumstances involved would reveal deliberate avoidance of these modes by the banks on the back of complacency by offering relatively less riskier modes of finance such as Murabaha and Ijara which offer predetermined rates of return. It is, however, notable that venture capital forms a big part of the businesses of most conventional banks and the successful implementation of Musharaka and Mudaraba activities by the Islamic banks should not have required anything more than the prudence and due diligence needed to be undertaken by a conventional venture capitalist on a business being acquired or a new business venture being financed. This, therefore, brings to question as to whether the Islamic banks are devoid of undertaking the necessary credit checks and viability studies on Musharaka and Mudaraba proposals to warrant the virtual avoidance of these modes of finance.

It is also commonly argued by some that venture capital in the conventional world is the domain of specialised institutions. However, given that most of these institutions are owned by banks it is ironical that Islamic banks could not form similar specialised institutions to undertake venture capital on the basis of Musharaka and Mudaraba.

A PARADOX

In the advanced economies, the venture capital industry has fostered the addition of many new enterprises to the economy. It is in fact noteworthy that venture capital is friendlier with the younger generations who tend to be more involved in entrepreneurial activity in every country. According to a recent report by the Global Entrepreneurship Monitor "the younger generation typically spur new business". In particular, the Venture capital system has played a leading role in the industrial development of the United States. VC allows US entrepreneurs to build a firm without having to borrow and pay high interest charges before they generate revenues. It is a process of co-operation between entrepreneurs and venture capitalists with risk sharing an essential element - entrepreneurs provide the bright ideas and hard work while Venture Capitalists furnish the money. If the business succeeds both benefit and if it fails, the entrepreneur is not obliged to repay the investment - indeed the essence and spirit of Islamic Finance.

Thus, although the united states is yet to accommodate Islamic finance in a big way, but in spirit and in real terms, its financing institutions offer more "Musharaka type investments" than that provided by all the Islamic banks combined. In the USA for instance, about 3000 venture capital deals were executed in 2004 increasing the outstanding dollar investments in this sector to about $21 BN. These amounts helped finance the development and growth of thousands of new start-ups in health care, information technology, manufacturing and other promising industries. By contrast, Islamic banking institutions invest less than $1 Billion a year on Musharaka and Mudaraba.

It is unfortunate that the opportunities of venture capital are missed out in the Muslim world where the industry, even in conventional terms, is not yet a developed phenomenon. Meanwhile, the PLS modes of finance which could represent the new blood needed to inject life into this sector has also not been given its right positioning by the Islamic finance industry. Hence, it is indeed a paradox that venture finance, which is highly advocated for by the principles of Islamic finance, is hardly practiced by the Industry.

There is no denial to the fact that Islamic finance has emerged as a formidable force and one of the fastest growing areas of international finance; however, the industry shall remain short of providing comprehensive value propositions on a global basis without developing properly the conventional equivalents to venture capital and private equity.

VIABLE MODES

For record, there aren't any reasons to suggest the slightest that PLS modes are inherently inefficient. To the contrary, these contracts are highly practical and successful. The practicality of these modes is not one that is taken for granted due to ideological reasoning or belief but empirical evidence is plenty from contemporary Islamic finance confirming the viability of these modes of finance.

These contracts offer ideal risk financing alternatives for all types of businesses - both new and continuing. A particularly important aspect of these mode of financing is in mitigating inflation risk especially in many of the Muslim and third world countries where inflation is high, unpredictable and undocumented. Successful transactions tend to adjust automatically for inflation as the money recovered by each partner will be based on a proportion of the profits actually earned and not fixed in monetary terms.

On the risk side, the methodology and spirit of these modes of financing is such that their successful implementation does not require anything more than a genuine business-based relationship between the banks and their clients. Positive results can be expected by a bank from a transaction where it is based on an accurate appraisal of the entrepreneur and the proposal itself in addition to a regular monitoring of the venture to forestall problems. A bank may not be successful in all transactions; but if the risks are correctly analyzed and mitigated, then losses in certain ventures should be made good by the share of profits to be generated from other successful enterprises.

i Musharaka: A form of equity participation between two or more partners, usually for a limited period of time and with a specific purpose. Profits or losses are shared according to each partners' contribution to the investment

ii Mudaraba: An agreement between two parties on specific business ventures whereby one provides finance while the other provides entrepreneurship and management. Profits generated (if any) are shared according to a pre-determined ratio while monetary losses (if any) are born by the financier alone.

This article has been written for the Business Times by Nathif J. Adam, Head of Investments and International Banking, Sharjah Islamic Bank.


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