Islamic venture capital: Increasing relevance in promoting entrepreneurship and Islamic finance

This article was originally published in Islamic Finance News Volume:10 Issue:13 dated 26/06/2013

“Despite its origins in the Islamic concept of Mudarabah, Islamic venture capital has yet to take off as a meaningful

sector. Yet it can play a vital role in connecting and developing global markets and encouraging economic growth.

MOHAMMAD ASIF discusses whether the Islamic venture capital might fi nally be ready for lift -off .”

Some of the most infl uential companies in the world today include Google, Yahoo, eBay and Microsoft . A common feature of these companies is that they have been backed by venture capital (VC) firms.

VC is commonly invested in the early or start-up stage of the lifecycle of a company, and is sustained through the company’s growth until a determined exit; mostly in special situations in which there is opportunity for explosive growth. While a fund structure diversifi es risk, these funds are inherently risky.

Historically, VC started from the Islamic concept of Mudarabah, a form of partnership used even before Islam by Arab traders. In the 10th century, the concept of Mudarabah was taken up by the Italians and spread through Europe. About three decades ago, a kind of quantum leap happened and the concept of the modern Islamic bank (Mudarabah in the form of the bank managing the funds from the depositors) emerged.

VC is a risk sharing scheme between investors who provide capital and the entrepreneurs who bring about innovation and undertake activities in the real economy. These two concepts (risk sharing and favoring activities in the real economy) are distinctive features of Islamic finance. Despite this convergence, Islamic finance has yet to fully adopt the VC industry as one of its integral segments.

VC constitutes an important intermediary in the financial system as it provides fi nancing and advisory services to companies that might otherwise encounter diffi culty in attracting capital, as they are typically high risk, young and do not possess sufficient assets

that would be eligible as collateral. The nature of VC as an investment asset class is unique as it has an option-like character in that it has limited downside (the investor cannot lose more than the amount invested) and substantial upside gains. There is always a disconnect between risk and reward for investors. Although the VC industry is flourishing, the failure rate is also high, nearly half of

the companies have negative return. The risks are in the form of:

• Liquidity risk, which is a consequence of the lower liquidity of VC investing;

• Information asymmetry risk, which stems from the fact that VC firms are not subject to the same disclosure requirements as compared to public stocks; and

• Uncertainties surrounding the profitability of the venture capital backed companies.

Despite the failure of the VC industry to neatly outperform publicly traded equities, investments in the former do offer some risk and return features unavailable in the latt er. This implies that VC provides the investors with an avenue for portfolio diversify cation. Within the VC industry and over time, the return is not homogeneous.

The factors that positively affect the performance of a VC firm can be classified as macro and micro – factors that pertain to the environment and factors that are related to the relationships between the firm and the portfolio invested companies. The American VC industry has outperformed the European industry. Micro factors like the degree of involvement and the size of the investment were the determinants.

Many industrialized countries are in the stage of stagnation while some new stars are on the rise and economic center of gravity is shifting. The evolving VC activity in various markets around the world has generated an industry that in many respects is perceived as global, although some global patterns and trends are emerging, the overall development in venture capital markets cannot really be depicted as global. Venture capital activity entails opportunities to restructure regional markets and respond to growing transnational

demands. The pace of globalization of the VC industry is very impressive, which manifests through an increasing internationalization of fundraising for global investment.

Islamic venture capital (IVC) can be defined as a VC industry that conforms to the requirements of Shariah in the area of transactions. The question is: what is required by an IVC firm to distinguish itself and flourish in both a Shariah and market-driven manner?

The sector of Islamic venture capital has been largely ignored until recently because of the lack of an ‘entrepreneur class’ which is essential for the development of a healthy venture capital environment: young, bright people with great business ideas and a  determination to make a success of their business. As the world becomes more of a global marketplace, and as the education and skills level of young people in the region increases, venture investing along Shariah compliant lines may become more common.

When it comes to IVC, we can’t say the greater MENA region has been bereft of venture capital, as countries such as Egypt, Lebanon and even Turkey have long had an entrepreneur class of their own and the VC industry is consequently more developed in these

countries. In much of the GCC there have been impediments to foreigners owning their own businesses outright and this naturally led to an absence of such businesses in the marketplace. As countries like the UAE have introduced ‘free zones’ where foreign nationals

and corporate can own 100% of their own business, the market for venture capital has opened up. Naturally the business idea that will attract Islamic venture capital has to operate within the constraints of Shariah and must not dabble in Haram areas.

The two sides of VC coin are young entrepreneur and venture investors with risk appetite. It is not only about money, it is also about education and expertise which was previously lacking. The combined effect of this has been that the Islamic venture capital industry

was virtually non-existent. The arrival of financial centers such as the Dubai International Financial Center, Malaysia International Islamic Financial Center, Qatar Financial Center, and Bahrain Financial Harbor has opened up the possibility that expert venture capital talent from more mature financial markets could be transplanted into rapidly emerging Islamic finance markets and bring with it the intellectual wherewithal to do lucrative Islamic venture capital deals.

Islamic finance is now at the threshold of a new dimension in which the industry has an increased capability to strengthen international fi nancial interlinks between nations. IVC has the potential to contribute towards the efficient mobilization and allocation

of funds across regions. Prospects for the Islamic fi nance industry are bright owing to strong demand for financial services from a large segment of the world’s 1.4 billion Muslims and the need to effectively channel rising international savings, including those of high-networth individuals.

Islamic venture capital funds face little or no hindrance from regulatory bodies in terms of Shariah compliance because the only difference from conventional VC is in the selection of firms. Hence the scope of IVC in terms of territory is beyond the Islamic banking sector where regulatory hindrances are high. Also Islamic banking and Islamic venture capital can benefit each other. IVC can promote entrepreneurship and hence the funded firms may be obliged and motivated to use services of only Islamic banks. On the other hand, Islamic banks can become source of funds for Islamic venture capital funds.

IVC firm partnership may take either the Musharakah structure with a ‘selldown’ model where the general partners will eventually buy out the shares of the limited partners at a price valued upon the exit proceeds (i.e. market value) or the Mudarabah structure whereby the partnership is terminated upon the exit. The choice of Musharakah or Mudarabah partnerships depends on whether the general partners will also invest their own funds or not. The integration of this high risk, high return segment into the Islamic finance industry will be of nature to offer a diversify cation and an investment avenue to investors with high risk appetite.

 

Mohammad Asif is the Director of  JaZaa Financial Advisory.

He can be contacted at mohammadasif@jazaafinancials.com

Islamic venture capital: Increasing relevance in promoting entrepreneurship and Islamic finance