Private Equity & Venture Capital as Asset Class
In Islam, it is encouraged to invest in enterprises and assets. Not only does it benefit the investor and business, but it encourages growth and stimulates the economy.
If you don’t invest, you’ll fall into the trap which most sharia-conscious investors do, which is losing wealth to both inflation and Zakat. Therefore, it only makes sense to put your money to use in a halal way to benefit yourself and the economy.
In this article, we'll look at alternative assets, which include hedge funds (HF), private equity (PE), and venture capital (VC) funds.
Alternative Assets Vs. Conventional Assets
Conventional investment classes are things such as cash, bonds, or stocks. These are widely available and easy to get hold of. However, alternative investment classes consist of HFs, PE VC firms, and private credit.
They can be difficult for an individual to get hold of because these are typically marketed to institutions rather than individuals and generally have minimum ticket (investment) thresholds that is beyond the financial means of most individuals.
Sharia-conscious investors need to consider alternatives from the following lenses;
Diversification: Alternatives are a great diversification tool. For example, investment assets such as real estate, oil, and gold can provide an effective inflation hedge. It’s common to find institutional/pension funds invest in these assets for this very reason; and
Sharia compliance: Conventional HFs, PE, and VC firms often engage in haram activities, such as Riba. For example, HFs often engage in short-selling and invest in derivatives such as options and futures. VC funds will engage in preference shares, which are also prohibited and creates injustices between the owners. More on this below and you can read more on this here.
What is a Hedge Fund (HF)?
A hedge fund is a limited partnership of private investors whose capital is managed by experienced fund managers. These managers, who are paid on a fee-for-performance basis, will pool money from investors.
They will invest in securities or other types of investments with the goal of getting positive returns, no matter the state of the market. These managers employ a variety of tactics, such as borrowing money or trading in non-traditional assets, to generate returns on investments that are higher than average.
Investors in HF are considered risky and most likely require a high level to entry, usually only for the High Net Worth Individuals. Risk is further added as it’s down to the fund manager to respond to the market accordingly to ensure positive returns.
What is Private Equity (PE)?
This is a type of investment where partnerships are made, who then buy and manage shares of companies before exiting by selling them for a profit.
PE firms will operate investment funds on behalf of institutional investors and the ultra-rich. The PE firm will create a fund and raise capital for acquisitions through these external investors. They may also use debt to support this fund – something that a Muslim investor should be aware of.
The PE firm will have experts who will help grow the business. They can even create a strategy for the business. For their services, they will charge fees and/or a share of the profit for managing the funds. These are usually quite high – with the industry standard known as “2 and 20” - a 2% management charge and a one-fifth share of returns.
PE is not for everyone. Firstly, they operate for institutional investors and the High Net Worth Individuals (HNI). Secondly, since it requires investors to lock up funds for extended periods of time average tenure of a fund is 10 years, it makes it difficult to sell and get your money back.
PE firms and funds will mostly invest in companies that are well-established in their industry – known as mature companies, rather than start-ups or growth companies. They will aim to increase the value of the company changing the capital structure, cost cutting and aggressive expansion to seize new opportunities.
PE investments are cyclical in nature as they tend to do very well when equity markets are high and interest rates are low. According to the Financial Times, PE over the past 15 years has delivered annualized total returns of approximately 13 percent, on a risk-adjusted basis. They further added that over the past decade, they have made above-average returns in everything from tech ventures to leveraged buyouts.
What is Venture Capital (VC)?
VC is where financing is given to start-up companies or small businesses that have generally been around for a short period of time. These companies have the potential for long-term, high-growth, and high returns. However, not all start-ups or businesses are fit for the VC model which tends to favor innovative businesses that have a scalable business model.
VC fund managers tend to make multiple investments and are aware that 9 out of 10 of their investments can be written off but are counting on making the right bet on 1 company that will deliver outsized returns and compensate for the losses.
Private Equity Vs. Venture Capital
People often confuse PE and VC because of their similarities, which is namely a firm purchasing a company – which is not publicly listed or traded - and seeking a profit on exit.
However, there are key differences between the two, such as:
- PE firms will usually purchase mature companies, whilst VC firms invest in companies that are in the start-up or growth phase.
- PE firms will purchase a controlling stake in companies, whilst VC firms will aim to purchase a minority stake.
- PE firms have the option to purchase companies from any industry, whilst VCs are limited to companies that are highly scalable, typically technology-based businesses.
Is Private Equity /Venture Capital Halal?
Conventional PE/VC firms are non-Sharia compliant. Two reasons as to why:
1. Preference Shares
Generally, you’ll find two different types of shares: common shares and preference shares.
In summary, the two key fundamentals of preference share owners get:
- Pay dividends in preference; and
- Pay a fixed dividend.
Common shareholders do not get the benefit of the above two things. Also, if the company faces bankruptcy, preferred stock shareholders also have a right to be paid first. Other differences include preference shareholders not having the right to vote (common shareholders do).
Preference shares is very common in VC transactions. However, the two key features of preference shares fundamentally disagree with the tenets of Shariah. The basic principles of Shariah assert that profit, loss, and risk should be shared equally.
There is a clear imbalance when it comes to risk. Preferred shareholders have less risk but gain greater profit. Furthermore, in theory, the fixed dividend from the share has an element of Riba, as result, making the shares impermissible if they involve guaranteed payment of capital or of a certain amount of fixed profit.
The International Islamic Fiqh Academy in January 2003 stated: “It is not permissible to issue preference shares with financial characteristics that involve guaranteed payment of the capital or of a certain amount of profit or ensure precedence over other shares at the time of liquidation or distribution of dividends.”
The European Council for Fatwa and Research (ECFR) ruled in agreement with the Fiqh Academy in 2006 with similar wording
Read More about: Angel Investing and Shariah
2. Leverages in PE firms
PE firms use leverage (borrowed funds) in their investments – making them haram. Many of them engage in what is known as a leveraged buyout (“LBO”). This is the purchase of a controlling stake in a private company, often financed with some equity but mainly debt.
One of the most famous examples of this is the acquisition of Gibson Greeting Cards Inc. (Gibson), Where two partners turned their initial investment of $330,000 each into $65 million each. In 1982, a PE firm purchased Gibson for $80 million but borrowed $79 million. They then took the company public - valued it at $290 million only 16 months later, resiling a return of 200x their invested capital.
What are Sharia-compliant funds?
However, over recent years, the market for Islamic asset management has expanded dramatically; at present, there are close to 700 funds listed in the major databases, with an estimated US$70 billion in assets under administration. Some examples include Fajr Capital, Ethos, and more recently Cur8 by Islamic Finance Guru.
These funds operate similarly to conventional funds, the difference being the fund structure, the underlying documentation, and all investments made by the fund, are sharia compliant.
How to invest in PE and VC as an individual investor?
PE has traditionally been for the ultra-rich and institutional investors. However, because institutional and high-net-worth portfolios are facing limited room for expansion, PE managers are looking to a wider variety of individual investors, encouraging them to diversify their portfolios away from bonds, ETFs, and stocks.
KKR, one of the private equity heavyweights, have recently ‘democratized’ investing in some of their PE funds. A fund tokenizing a stake in KKR's Health Care Strategic Growth Fund II has been formed by digital asset securities company Securitize on the Avalanche public blockchain.
Sharia-compliant investors have the option of Cur8 by Islamic Finance Guru, which offers a wide mix of asset classes, including VC, fixed income, and real estate.
Diversification in alternative investment classes like PE and VC is key for investors as it spreads the risk. Both of these have thrived due to cheap money.
Unfortunately, the options for sharia-compliant investors is limited, but there are options out there. For anyone investing in these areas, they should take extra caution due to the risk and changing economic climate.