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Mudarabah contracts are one of the main types of Islamic finance contracts widely being used today. It has seen significant interest across the Islamic world,
as its flexibility allows it to be used in a variety of transactions and partnerships, allowing for a Shariah-compliant means to execute a myriad of banking, finance and investment agreements.
Mudarabah is a type of Islamic finance contract based on the concept of profit-sharing. In it, a lender, financier or investor (dubbed Rab Al Mal) enters into a partnership with a borrower or recipient of the financing (the Mudareb),
whereby the Rab Al Mal provides the funding for a project or business, while the Mudareb offers their expertise, know-how and management of the project. Both parties then distribute the profits from the project based on agreed upon terms.
Usually, the Mudareb is paid a fee from a portion of the profits, but how the profits are shared is flexible and can be agreed upon with the Rab Al Mal, allowing for a diverse range of activities to be funded in this way.
The project or business in question must adhere to Shariah principles and avoiding haram or forbidden products and activities (alcohol, gambling, drugs, interest-bearing transactions, and overly speculative and risky transactions).
One major factor in mudarabah contracts is that the Rab Al Mal assumes the entire financial risk of the project,
while the Mudareb doesn’t assume any financial responsibility for the project failing. The Mudareb is only obliged to put in time and work on the project and isn’t obliged to put in any capital of their own.
There are two main types of mudarabah contracts that determine the flexibility of how the capital is invested and managed by the Mudareb based on the needs of the business and the level of control desired by the Ras Al Mal.
In a restricted mudarabah (or Mudarabah Muqayadah), the Rab Al Mal determines the business type or place where the capital is to be allocated. The Mudareb is obligated to invest the funding according to the terms set about by the financier.
In an unrestricted mudarabah (Mudarabah Mutlaqah), the Rab Al Mal gives little to no restrictions (beyond the investment being Shariah-compliant) to the Mudareb,
giving the latter the freedom to invest the funds as they see fit. While the Mudareb under this agreement has the authority to conduct business decisions, major financial decisions such as the lending or disbursing of large sums of money will usually need approval from the financier.
Mudarabah contracts are be used in a variety of different financial partnerships. These include:
Many Islamic banks use mudarabah contracts for savings and investment accounts. In this scenario, depositors act as the Ras Al Mal, while the bank acts as the Mudareb. Profits are shared based on an agreed upon ratio.
Islamic mutual funds – funds that pool capital from many different investors in a diversified portfolio of Shariah-compliant assets – use mudarabah contracts,
with the investors acting as the Ras Al Mal, and the fund manager acting as the Mudareb. The latter can also set mudarabah contracts of their own when investing these funds.
Read more about: Mutual Funds vs. Index Funds. vs. ETFs
In this example, there are two ways by which mudarabah contracts can be used.
-The first kind is when looking at the structure of the private equity firm, whereby a group of investors allocate funding to an institution that will then go on to invest in a portforlio of companies.
Similar to a mutual fund, the investors act as the Ras Al Mal, while the firm managing the investment acts as the Mudareb. However, the investment thesis and strategy is usually determined by the private equity firm, and the investors have a choice on whether to adopt the model or not invest.
-A second use case of mudarabah in private equity is between the private equity fund manager and the target company. In this scenario, the private equity firm acts as the Ras Al Mal – setting up its capital allocation,
and bearing the financial burden of a loss – while the target company can act as the Mudareb, which will manage the investment and receive a share of the profit as agreed with the private equity firm.
Similar to private equity funding, mudarabah contracts can be used in two ways when funding startups and SMEs.
In the first case, investors in a venture capital fund act as the Ras Al Mal, while the fund manager acts as the Mudareb. On the other side of the equation, the VC firm itself can act as the Ras Al Mal, while the startup or SME acts as the Mudareb.
Read more about: Private Equity vs. Venture Capital As Asset Class
Mudarabah contracts can be used to fund specific, one-off projects. In this case, the financiers (whether a financial institution or the development company) looking to develop a project (real estate, a factory, infrastructure, etc.)
will act as the Ras Al Mal. Conversely, the builder or operator of the project will act the Mudareb and will be paid through a share of the project’s expected returns.
Businesses can obtain working capital through a mudarabah contract, with the bank acting as a financier, and the company managing the funding and splitting the profits with the bank.
As noted in a previous entry, a takaful (or Islamic insurance) is itself a profit-sharing mechanism whereby the policy-holders are investors and the takaful operators manage their investments.
This makes them highly conducive to mudarbah contracts, with the policy holders acting as Ras Al Mal, and the takaful manager acting as the Mudareb.
Learn more about: Comparing Conventional Insurance And Takaful "Islamic Insurance"
Disclamer:
This post is for educational purposes only, and the Firm does not directly or indirectly provide these services.
