Shariah investors in PE: Tailored exposure

Shariah compliance is routinely characterized as a spectrum rather than a set of absolutes. Beyond certain baselines, interpretations vary as to what is acceptable from an investment perspective, which means the industry leans towards customization rather than standardization. Private equity is no exception.

"Shariah compliance involves several different dimensions of complexity, so is not set in stone; there are different ways to implement it,” says Kevin Lu, Asia chairman at Partners Group. “Is there enough demand that is standardized for us to do a global shariah-compliant private equity product? Probably not at this moment. Due to the complexity and differentiated nature of how people look at it, we currently focus on providing bespoke solutions to clients.”

Partners Group started providing solutions to shariah-compliant investors 14 years ago. Its $109 billion in assets under management are split equally between co-mingled funds and separate account mandates (SMAs). Comingled funds have never been offered to shariah investors. A more notable development, according to the firm, is the evolution of a primarily family office-focused demand base to include more institutional investors.

Within Asia, this was recently underscored by Malaysia’s Employees Provident Fund (EPF) awarding $600 million across three co-investment SMAs to BlackRock, HarbourVest Partners, and Partners Group. The pension fund, which has MYR998 billion ($246 billion) in investment assets, described it as the world’s largest shariah-compliant private equity direct or co-investment fund.

Global Islamic finance assets are estimated to be $2.5 trillion but only a sliver of that has made it into mainstream private equity. There are two routes: shariah-lite, which is typically a side letter alongside a commitment to a conventional fund that permits exclusion from deals involving assets like alcohol, tobacco, pork processing, and interest-based finance; and shariah-heavy, which might be a dedicated vehicle such as an SMA with more far-reaching compliance provisions.

“We’ve seen a steady stream of demand in the past 15 years, most of the time it’s side letters,” says Gavin Anderson, a fund formation partner at Debevoise & Plimpton. “There has been a bit more impetus in the last few years. When people are fundraising, they are always trying to access new pools of capital and to some extent shariah-compliant money can be harder to access and opaquer than other areas. But it’s not gone crazy.”

Demand and supply

One explanation for more shariah money targeting private equity is the general increase in appetite for private market assets among institutional investors; in a low-interest-rate environment, everyone is looking for return premiums. Lu of Partners Group adds that the performance of private equity relative to other asset classes might have turned heads.

“A lot of those investors have two portfolios – conventional and shariah,” he explains. “In the past, they might have looked at it on an overall basis, for example a 10% allocation to private equity. If the conventional portfolio is outperforming the shariah portfolio because of that private equity allocation, maybe the shariah portfolio should have private equity as well.”

EPF has generally followed this path, according to a source close to the pension fund. In 2015, it started offering members the choice between compliance and non-compliance. Two years later, Datuk Mohamad Nasir Ab Latif, who was at the time deputy CEO of EPF, announced plans to increase shariah-compliant private equity exposure.

At the time, 47.7% of its assets were deployed in shariah-compliant investments, including half of the 4% overall private equity allocation. Most of that was domestic and the goal was to give shariah investors exposure to international private equity. EPF had approximately $12 billion deployed offshore at the end of last year through four non-shariah SMAs that are now in their fourth iteration.

Mohamad Nasir observed that the main challenge was finding appropriate products. “We would like to encourage more shariah-compliant funds to be available in the market,” he said in 2017. The international portfolio is primarily in buyout funds, but this was a non-starter for the shariah allocation because there would be limits on the amount of leverage used in deals.

Having settled on customized SMAs, it took the pension fund more than two years to award the current mandates. COVID-19 impeded progress, but a paucity of supply was also a factor, the source close to EPF adds. Other sources with private equity firms note that offering shariah-compliant products – as opposed to side letters – represents a much larger undertaking. Thus far, most have been more shariah-lite in their approach.

“There is a reason why shariah-compliant products are not more widely available – the money might be there, but the level of difficulty is high,” one of the sources says. “For a lot of GPs, introducing shariah-compliant products just isn’t a priority. There are greater profits in doing more of what they are already doing.”

Setting parameters

Establishing a shariah-compliant SMA involves consulting specialist advisors who help with structuring and formulating quantitative screening processes that comply with general shariah methodology. There is a standard set of assets that are off-limits, but beyond that, parameters vary based on a client’s priorities, or indeed which methodology forms the baseline.

For example, there are financial ratios companies must adhere to if they are to be included in shariah-compliant stock market indexes. FTSE follows the international standard that requires debt and cash and interest-bearing items to be less than one-third of total assets. However, the Jakarta Islamic Index permits leverage of up to 49%, while Malaysia’s Islamic Capital Market only introduced quantitative screening of financial ratios relatively recently.

Customization extends to purification, which typically involves calculating the investment return that has come from non-compliant and making a charitable donation of equal value. There must be agreement on situations that require purification and which causes receive donations.

A Europe-based investor relations professional who covers the Middle East recalls negotiating with a shariah-compliant family office that wanted exposure to a comingled vehicle that had already made a dozen investments, some of which had been written up. Some of these were positions in financial services businesses, so it was suggested that returns from those investments be ringfenced. Purification was also explored as a remedy, though ultimately the negotiation came to nothing.

When the IR professional put the same ringfencing solution to other shariah investors, it received short shrift. They didn’t want to be seen investing in any comingled product that included non-compliant investments.

Most fund managers offering shariah-compliant products have in-house resources that assess whether investments meet participation criteria and handle monitoring and reporting. Nevertheless, external shariah advisors are retained by the ultimate investors to provide periodic compliance updates. Signing off on deals considered for inclusion in SMAs may also fall within their remit unless the investors are comfortable with a manager’s in-house advisor doing this.

“A fund manager might know an investment will probably make it based on the agreed guidelines, but they send it to the advisor for confirmation,” says Aida Othman, a director at Malaysia-based Zico Shariah Advisory Services. “If there is complexity in the proposed deal it is important that they consult the advisor. They give a certain deadline and ask us to confirm it falls within the guidelines.”

Adding another layer of approval is potentially problematic when investments must be agreed upon within a set timeframe, but few industry practitioners recall being blindsided in this way. A more pressing concern is post-deal implementation.

“The biggest challenge is maintaining compliance,” says a managing director with one of the other firms that received an EPF mandate. “It is easy to say an investment is shariah-compliant and invest in it, but what happens six months down the road if the business becomes non-compliant?

If, for example, a company involved in the transportation of soft beverages branched into the alcoholic segment – a not illogical expansion angle – one solution is to transfer the shariah-compliant SMA’s piece of that investment to another conventional SMA. While not unfeasible, it does raise conflicts of interest issues because SMAs have different economics as well as different investors. EPF will address this by moving the offending position to an SMA in its own non-shariah portfolio.

Beyond that, the managers mandated by the pension fund will deal with problems in ways that reflect their own approaches to co-investment. While Partners Group positions itself as a direct investor that allocates deal exposure across various pools of capital, HarbourVest tends to work alongside partner GPs in a minority capacity. BlackRock might be somewhere in between.

Partners Group emphasizes the importance of control in its screening process. “If you get into a business as a control investor and you know that your plan for the business will take it into a space that might be sensitive for shariah investors, you can decide that it is not appropriate for them even though it looks reasonable today,” says Lu. “You would not have that luxury when following someone else’s lead.”

Adverse selection?

Potential conflicts of interest don’t just disappear. The curbs on business scope and leverage that come with including a shariah-compliant investor in a deal could impair the portfolio company’s ability to maximize profit, to the detriment of any conventional SMAs also participating in the transaction. The EPF mandates recognize that fund managers have obligations to other investors, which may result in EPF missing out on opportunities, the source close to the pension fund explains.

Partners Group stresses that it does everything it can to minimize the tracking error between what it thinks a shariah-compliant SMA will get and the firm’s global deal flows, but while staying under the constraints of what clients want. In this sense, being a large-scale investor unencumbered by fixed fund vintages helps because it gives the flexibility to slice and dice a wide variety of deals.

However, there remains the conundrum of shariah SMAs being limited to transactions where there is a very low risk of non-compliance, resulting in underperformance relative to conventional SMAs. Disaffection could lead to questions being asked about how exclusion decisions are taken and whether information was provided to advisors in a timely fashion.

Sticking to growth investments removes the leverage issue, but it isn’t necessarily a panacea. First, classic VC and growth rounds are seldom pure equity; they include features like liquidation and profit participation preferences, which could render an investment non-compliant. Second, business models can be fluid and a start-up might end up pivoting in a way that makes it non-compliant.

“It can be difficult to ensure that a shariah-compliant product will have access to the same opportunities as investors that do not have a shariah requirement,” says the managing director with the firm that also received an EPF mandate. “GPs must be very transparent with the LP about what is and isn’t possible, and how processes are managed to ensure investors have equal access to deals.”

Should institutional demand for dedicated shariah private equity products increase, global managers must provide answers to these questions if they want to boost supply. EPF, for its part, expects to put more capital to work in the space. Each round of commitments to its conventional private equity SMAs is $2.5-3 billion, so the first phase of shariah-compliant mandates is tiny by comparison.

Moreover, the pension fund introduced a shariah-compliant option for members in response to rising underlying demand. The country’s population will reach 45.2 million in 2050, up from 28.4 million in 2010, according to the US-based Pew Research Center. The proportion of Muslims is expected to jump from 63.7% to 72.4%. On a global basis, Muslims will be nearly equal to Christians in number by 2060, based on current growth trends.

This doesn’t translate into an immediate shift in wealth patterns, but shariah investors as a group will be able to write larger checks and speak with a louder voice.

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• Topics
• Southeast Asia
• MENA
• Fundraising
• LPs
• Regulation
• Malaysia
• Separate accounts
• Asia
• Partners Group
• BlackRock
• HarbourVest Partners