Venturing Into New Territories: Innovative Islamic Funds' Structures
Ayman H. Abdel-Khaleq
Vinson & Elkins L.L.P (Dubai office)
In recent years, the Islamic banking industry has launched a series of Shariah compliant investment funds - ranging from the relatively straightforward long-only equity funds to the more challenging private equity, venture capital and short-only funds.
The general intention of most fund promoters appears to be to mirror structures familiar to western bankers and investors. This is true with respect to both the form the product takes and the underlying substantive investment objectives sought to be achieved for the investor.
The investment managers, Wakeels or Modarebs, as the case may be, usually adhere to pre-defined investment guidelines that set out the industries in which the fund may invest and the financial ratios it must maintain.
This article provides a brief summary of variations to Islamic long-only equity funds that have been structured and offered successfully to investors in recent years.
Such structures include Shariah compliant variations to typical real estate funds, capital protected instruments, unit-linked products, internal funds and listed equity certificates.
Real estate funds
Although real estate is hardly a new Islamic asset class, it is only of late that financial institutions have been able to package real estate in the form of investment funds for offer to retail investors in the Gulf Cooperation Council.
This is quite an achievement given the fact that traditionally these funds were restricted to prime real estate in Europe and the US and were offered only to institutional and high net worth investors.
Some variations include real estate funds (blind pools) that invest in properties satisfying certain investment criteria and those that invest in the development of a specific property.
Sukuk issues appear to be more common in this context and in fact are probably the more suitable conduit, although there are cases in which investing in a major property has been achieved using an investment fund as a vehicle. (For example, the Durrat Al-Arus Fund of The National Commercial Bank that invested in the Durrat Al-Arous project outside Jeddah, Saudi Arabia).
Another interesting proposition are leasing funds in which the underlying assets are equipment such as computers, cash machines and machinery.
Investment funds which invest in this asset class have to deal with a mixture of legal and Shariah considerations that pertain to the jurisdiction of the assets, the jurisdiction of the offering, scope of due diligence, role of investment managers, fixed and floating rates of return, credit enhancements, residual value, and taxation, among other issues. (For example, in the US there are significant tax advantages if a lease is to be classified as a financial lease).
Capital protected funds
A widely accepted Islamic alternative to conventional capital guaranteed funds are Islamic capital protected instruments. Most Shariah compliant capital protected funds and instruments use two investment mechanisms to achieve the required investment objective namely:
a Murabaha instrument which involves the investment of the bulk of the monies raised from investors in a fixed-term commodity trade transaction or a series of such transactions; and a Bai Al-Arboon* (a Shariah alternative to call options) transaction in which the fund invests a small percentage (for example 10%) of the monies raised from the investors to purchase an option over a basket or portfolio of Shariah-compliant shares or commodities.
The Murabaha transactions, customarily viewed as low risk transactions, are structured to generate the required capital protection, while the Bai Al-Arboon transaction(s) are intended to increase returns. If the basket of shares subject to the Bai Al-Arboon depreciates, the fund manager will not exercise the option and the payment price for the option will have been lost.
The underlying Murabaha transactions, however, are structured to compensate for the lost option payment thereby protecting, but not guaranteeing, the capital.
The process of developing an Islamic alternative to call options was spearheaded by the National Commercial Bank (NCB) in the late-1990s following the encouraging results achieved by conventional capital guaranteed funds launched by NCB.
A joint effort between NCB and Deutsche Bank, supplemented by an active and continuous dialogue with Shariah advisors and legal counsel representing both NCB and Deutsche Bank, has led to the successful offering to retail investors in Saudi Arabia of the first Islamic capital protected fund.
This was an impressive and unanticipated development because a fund that is the outcome of a lengthy (over six months from start to finish) and expensive process would usually, in the first instance at least, be offered only to institutional and high net worth investors, not to retail investors.
However, the fund appealed to investors who desired to benefit from any rise in the market while securing their principal from any downside.
Evidence of the success of the fund included the high level of subscription in the first series (over US$275 million, which led NCB to issue a second series) and the ability of NCB to package the product for other banks in the Middle East by way of private label private placement arrangements.
This product is one example of a highly successful investment product developed and offered successfully by a leading Middle Eastern bank. Also, the involvement of Deutsche Bank serves to prove that financial institutions in the Middle East can benefit from collaboration with premier international financial institutions.
Moreover, regional banks can benefit through entering into private-labelling arrangements that strengthen inter- regional ties and allow the financial institution that developed the product to capitalize on its investment in "research & development".
Unit linked products
The Islamic Takaful industry has come a long way since the Grand Council of Islamic Scholars in 1985 approved it as the Islamic alternative to conventional insurance.
Two primary issues that the Takaful industry currently faces are the unavailability of a product range to which a substantial portion of the Takaful contribution can be linked, and the need to develop Retakaful solutions to supplement the Takaful products.
Despite growth in the Takaful and Islamic investment funds industries, there is an immediate need to bridge the gap that exists between the two.
A successful Islamic unit-linked product would be one that provides products with long-term fixed returns that can provide life insurance and pensions to Islamic investors.
Bank Al-Jazira in Saudi Arabia, for instance, was one of the first banking institutions to develop a Takaful product with an embedded savings plan.
The bank appears to have benefited from the availability of a family of Islamic funds which its investment department had already structured and successfully offered in the Saudi market.
Another pioneer, FWU AG, has adopted a different approach as, unlike the Bank Al-Jazira model, its target clients are bank distribution partners who have either developed or have access to a variety of investment funds to which the Takaful product can be linked.
The development process, in both instances, involved the need to juggle contractual, regulatory and business considerations.
In fact, in the FWU model, it was notable that the product specifications portion withstood most of the legal and regulatory requirements in the relevant jurisdictions, which can be attributed to the investment made by the company to develop a product that satisfied the requirements of the German and, more generally, European Union regulations.
However, the legal implications of using a bank distribution partner presented the need to draft and negotiate a detailed and comprehensive tripartite arrangement among the product developer (licensor), the local insurance company and the bank distribution partner setting out the rights and obligations of each.
Another recent development is the arrangement by FWU of a Retakaful structure whereby the reinsurance-type cover is provided by a top rated European insurance company.
Until this innovation, such cover was structured as a conventional reinsurance cover (due to the unavailability of a comparable Islamic alternative) or was not available from top rated international reinsurance companies.
This recent development would, among other things, enhance the protection afforded to the Takaful policyholder should the Takaful company run into financial difficulty.
The development of this contractual arrangement reflects the willingness of some of the international insurance companies to investigate and invest in developing Islamic alternatives to conventional products and underpins the need to reverse-engineer some of the positive aspects available in the conventional insurance industry of today to satisfy Takaful requirements.
European internal funds
A Takaful company or a successful non-European manager of Islamic funds can, subject to satisfying certain requirements, offer Islamic investors in Europe the option to invest in Shariah compliant investment plans, even if such plans are not registered in the EU, by developing investment schemes in the form of internal funds of a European asset management company.
In such cases, the investment fund can be embedded in the respective Takaful products offered by the Takaful company. Premium Select Lux SA, the asset-management arm of FWU, developed the first Islamic internal fund in 2002.
The development of an Islamic internal fund embedded in a Takaful product was made possible by PSL's commitment of time and resources, the existence of European regulations that permitted the creation of such internal funds.
It was also due to the willingness of the Luxembourg regulators to accommodate an Islamic internal fund (made easier by the fact that the documentation is similar to that used for conventional internal funds) and the encouragement of Shariah advisors who view Islamic internal funds as being a readily available mechanism through which Muslims in Europe would have access to Islamic investment products.
Listed equity certificates Islamic equity certificates, which can be listed on a major European stock exchange and which mirror the performance of an underlying portfolio, would allow Islamic investors to participate in the gains or losses of the relevant portfolio; as well as Western and Middle Eastern fund managers to invest on behalf of their Islamic investors in a branded, transparent and regulated manner.
The first of such certificates were "The Islamic Equity Builder Certificates" developed and promoted jointly between NCB and Deutsche Bank and listed on the Frankfurt stock exchange.
Deutsche Bank, also known for its XAVEX program through which assets are certificated and listed on major stock exchanges, entered into a detailed cooperation, product development and listing agreement with NCB pursuant to which four certificates were issued (three covering three separate international regions and the fourth with global coverage).
Under such detailed agreement, NCB provided Shariah know-how and Islamic equity screening criteria, while Deutsche Bank provided in-house quantitative stock selection strategies and assumed the role of market maker.
The certificates were launched in early 2003 and successfully listed on the Frankfurt Stock Exchange with Deutsche Bank acting as the market maker.
This model constitutes one of very few examples of a leading Middle Eastern financial institution being able to export financial services to regulated Western markets such as Europe through the utilization of its own Islamic "know-how" and track record and through partnering with a leading international financial institution.
In conclusion, the Islamic investment funds industry has come a long way in recent years. One avenue where much work needs to be done involves ensuring that the latest Islamic products are made available to Muslims in non-Muslim jurisdictions such as Europe and the US.
This would allow such institutions to outgrow their traditional and limited regional role by "exporting" their financial and structural "know-how" of the Islamic banking sector.
Venturing into heavily regulated Western markets requires a considerable investment in product development and distribution arrangements.
Most Islamic financial institutions have shied away from making sufficient resources available to facilitate such expansion. However, those who have committed, and are committed, resources towards such vibrant area stand to benefit the most as the above examples have illustrated.
1. For a detailed study of Islamic leasing funds see: Monir Barakat & Robert W. Toan, Islamic Leasing Funds, Islamic Asset Management: Forming the Future for Shari'a Compliant Investment Strategies (2004)
2. Nizar Alshubaily, Latest Developments in Islamic Investments, Islamic Asset Management: Forming the Future for Shari'a-Compliant Investment Strategies (2004).
3. For more information on the Bank Al-Jazira model, see: Dawood Yousef Taylor, At the Heart of the Matter: What is Mutual or Cooperative Islamic Insurance? Misconceptions abound at both industry and Shariah-level; Islamic Banking and Finance (Issue 3).
Note: The author is an associate with the Dubai office of Vinson & Elkins L.L.P. where he advises clients, among other things, on Shariah compliant investment and finance structures including private equity, hedge funds and securitization. Chris Richardson, an associate in the firm's Houston offices assisted in the preparation of this article.