With its limited exposure to the global credit markets, the Middle East and North Africa region has escaped much of the turbulence that has shaken economies in the US and Europe over the last 12 months.

Buoyant oil prices have continued to drive a boom in the region, and have produced a growing potential investor base for both regional and global private equity. Private equity represents a natural fit for Muslim investors, as returns are earned through active participation in the risks of business.

However, viewed through the prism of Islamic law, or Sharia, private equity also presents problems; most notably the fact that conventional private equity funds invariably make use of interest-bearing leverage, which is prohibited under Sharia (for background, see feature article “Islamic finance: unveiling the mysteries”, www.practicallaw.com/0-359-2952).

Other problems include the use of conventional swaps and derivatives, also prohibited by Sharia, and the need to avoid investing in certain prohibited activities (such as the production or distribution of alcohol or pork-related products).

Despite these problems, many Muslims invest in conventional private equity funds. To attract and accommodate these investors, some conventional funds include “excuse” provisions in their limited partnership agreements, permitting investors to opt out of investments in prohibited business activities.

This still leaves a gap in the market and an increasing number of private equity funds in the UK and elsewhere are taking the next logical step: creating funds that are Sharia-compliant. For example, on 11 June 2008, the Kuwaiti investment bank, Global and Dubai Islamic Bank (DIB), announced a $500 million buyout fund focusing on the region.

The key difference between a Sharia-compliant fund and a conventional fund is that a Sharia-compliant fund incorporates a supervisory board, usually comprising three eminent Sharia scholars, to provide advice on Sharia to the general partner of the fund, under the terms of an advisory agreement (the Sharia board).

The identity of the scholars appointed to the Sharia board is of critical importance to the fund. Views on Sharia vary, often along geographic lines, and the views taken by the fund’s Sharia board will affect what investment activities the fund is able to undertake and what investors it will attract.

The main role of the Sharia board is to reassure investors that the fund is properly managed in accordance with Sharia principles. It is most unlikely that it will be appropriate to appoint Malaysian scholars, for example, to the Sharia board of a fund aimed predominantly at Middle-Eastern investors.

The limited partnership agreement and the other fund documents must be adapted to take account of the Sharia board’s role in establishing the fund’s guidelines for Sharia-compliant portfolio investment and its ongoing scrutiny of the fund’s activities. For the fund to be Sharia-compliant, the Sharia board’s rulings must be binding on the fund.

Ongoing scrutiny by the Sharia board usually takes the form of quarterly reviews and, in some cases, annual fund audits. Profits flowing from investments made in breach of the portfolio investment restrictions must be identified and given away to charity, while losses on such investments are typically borne by the general partner.

In some instances, investors insist that proposed investments are presented to the Sharia board for prior approval. This can present problems for the general partner if the fund is also seeking non-Muslim investors, as it may mean foregoing otherwise profitable investments.

In practice, the use of “excuse” rights can offer a compromise solution. Alternatively, it is possible for a Sharia-compliant fund to be set up parallel to a conventional fund, enabling both Muslim and non-Muslim investors to invest alongside each other without non-Muslim investors bearing the costs (or restrictions) of Sharia supervision. DIB’s buyout fund will work parallel to a conventional fund.

The investment restrictions on the fund are set out in the limited partnership agreement, and must be designed to ensure that the investments made by the fund are compatible with Sharia principles, including the prohibitions on interest (riba), gambling (gharar) and uncertainty (maisir).

While equity investment is inherently Sharia-compliant, ownership of a share in a company is considered as a proportionate share in the ownership of the underlying business and assets of the company. This means that it is not permissible to invest in a company that carries on non-Sharia compliant activity such as:

The activities of many companies are touched, if only to a limited extent, by one or more of these sectors, and, as a result, Sharia-compliant investment tends to focus on the technology, telecommunications, real estate, pharmaceutical and oil and gas sectors.

Strictly applied, the restriction on investment in companies carrying out non-Sharia compliant activity would rule out almost every company, as most companies have some form of non-Sharia compliant borrowing, even if it is only an interest-bearing overdraft.

In 1987, a group of leading Sharia scholars developed “screening criteria”, and ruled that Muslim investors could own shares in companies that fulfil each of the following criteria:

The screening criteria were not intended to sanction prohibited activities and investors were under a duty to object to the use of interest-bearing debt.

The criteria were aimed at minority investments in listed companies majority-owned by non-Muslims and were not initially seen as applicable to private equity, where investors have a greater degree of control over the activities of the target company. However, the basic principle of screening is now widely accepted and is used in the context of private equity investment.

Different screening criteria have been issued by, among others, the government of Malaysia and the Accounting and Auditing Organisation for Islamic Finance. Notably, some screening criteria now provide that interest from cash and securities amounting to no more than 33% of income is acceptable, a significant change from the original 5% prescribed in 1987.

Which set of screening criteria a particular fund follows depends on which best reflects the approach of its Sharia board.

Despite applying screening criteria, income received by the fund (and, in the view of some scholars, capital gains on investments) must still be “purified”, a process that involves quantifying the amount attributable to non-Sharia compliant elements and donating that amount to charity. This can be done either by the fund or, more usually, by investors themselves.

The use of interest-bearing leverage at the fund level is obviously problematic for Muslim investors and any leverage used by the fund must be provided in a Sharia-compliant manner.

While funds can make direct equity investments funded using traditional Sharia-compliant finance techniques, there are also a number of Sharia-compliant leverage structures that adapt these techniques to use conventional leverage. The choice of structure will typically depend on tax and commercial considerations. Ijara, or lease, structures can be used in leveraged buyouts but murabaha (cost-plus financing) structures have also been used, notably in the landmark £479 million Sharia-compliant buyout of Aston Martin in March 2007 (see box “Sharia-compliant private equity deals in the UK”).

Sharia-compliant funds cannot invest in or use conventional derivatives. They can, however, make use of the rapidly developing new market in Sharia-compliant derivatives to hedge their investments.

The fund documents will also require a number of minor additional modifications to ensure Sharia-compliance; for example, removing interest charges on unpaid funding obligations and the powers to invest surplus cash in interest-bearing temporary investments and dealing with preference shares, which are problematic because they do not carry equal rights with ordinary shares.