Shari ah-compliant Fund Structures. Private Investment Funds Practice Discussion Papers

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1 The universe of closed ended funds has evolved to provide mechanisms for Shari ah-compliant Fund Structures. Dedicated Shari ah-compliant funds have been set up in growing numbers. Shari ah-compliant Fund Structures Private Investment Funds Practice Discussion Papers Islamic finance is a rapidly growing market. Market estimates place the current volume in the region of $500 billion and this figure is expected to grow to $1 trillion within the next five years. Consequently, also the universe of closed ended funds has evolved to provide mechanisms for Shari ah-compliant fund structures. Dedicated Shari ah-compliant funds have been set up in growing numbers and are on the verge of becoming a common sight in the market place. For fund sponsors, however, it is often a difficult question of when it may potentially pay off to incur additional structuring efforts, costs and changes to their investment policy in order to address potential Shari ah investors.

2 Clearly, the area of Shari ah-compliant structuring of funds is generally complex and demanding in many details. This paper and the suggested structure for a Shari ah-compliant side pocket focuses on addressing two major issues that seem to be common with any real estate fund: Dr. Benedikt Weiser, LL.M. Partner, Frankfurt T: bweiser@mayerbrown.com (i) Leverage The prohibition on payment of interest under Shari ah law results in a general prohibition of leverage by straight debt financing in the acquisition structure of real estate funds (see prohibition of interest payments ). Employing the Shari ah-compliant techniques that economically result in an effective leverage of the investment is often alien to conventional managers and sponsors and, perhaps more importantly, to their investors. Dr. Simon G. Grieser Partner, Frankfurt T: sgrieser@mayerbrown.com (ii) Prohibited areas of investment Numerous areas of investment are prohibited under Shari ah law (see prohibited areas of investment ). For otherwise conventional sponsors and managers of Shari ah-compliant funds, the commitment to avoiding prohibited areas of investment seems onerous, especially in blind pools, where the appropriate assessment has to be made in the process of identifying investment opportunities during the life of the fund. To a certain extent the issue can be addressed by donations to charities (purification). In particular, the projected returns of real estate funds with a core or core plus investment strategy do not tolerate substantial amounts of donations for purification purposes. Therefore, for conventional investors, an investment in a Shari ah-compliant fund means an unnecessary restriction of possible investment opportunities, unless the fund is dedicated for investments in an Islamic market environment. In this context, the structure described below aims at achieving the following: (i) Opening a Shari ah-compliant side pocket for conventional real estate funds in order for fund Sponsors to access Islamic investors without having to completely turning the fund into an Islamic fund. (ii) Avoiding purification donations when investing partially in prohibited areas of investment with blended Islamic and conventional equity. Model Fact Pattern The structure discussed in this memorandum assumes a model fact pattern of a real estate fund investing on a blind pool basis. Investments are likely to include business centers, hotels and retail malls. It is assumed that 20 percent of the income from the investments will constitute income from prohibited investments. The fund applies leverage by debt financing at a ratio of percent. 2 Shari ah Compliant Fund Structures

3 Key Shari ah Principles The concepts that underlie Islamic finance derive from Islamic law or the Shari ah, the roots (usul) of which in turn are derived from the: (1) Qu ran, being the holy book of Islam; (2) sunna, which are the binding authority of his dicta and decisions; (3) ijma, or consensus of the community of scholars; and in some parts of the Muslim world, (4) qiyas, or analogical deductions and reasoning. PROHIBITION OF INTEREST PAYMENTS As stated, one of the most important pillars of Shari ah is the Qu ran which expressly prohibits riba. Riba roughly translates as growth or excess but in financial terms this denotes interest. Therefore, Islamic financing structures must not involve any direct payment of interest. Under Islamic law, money is regarded as having no intrinsic value it is seen merely as a medium of exchange. The return on funds provided by the bank must be the result of a commercial risk taken by the bank. The payment and receipt of interest is prohibited in accordance with this principle. For this reason, a contractual obligation to pay interest is considered void under Islamic law. The ban of interest is the main distinctive feature between an Islamic and a conventional economic system. The abolition of interest is meant to eliminate exploitation in business and to contribute to the realization of the Islamic vision of justice. In addition to these goals, the fundamental concept behind it is that gaining profit without working or taking risk is unacceptable. PROHIBITED AREAS OF INVESTMENT In order to qualify as Shari ah-compliant investments, some investments in companies are usually prohibited which involve, inter alia, conventional financial services (including conventional insurance services), gambling and casinos, alcohol or pork production, certain entertainment and any other immoral or unethical activities from the Shari ah Board perspective. These restrictions would also apply to income generated from leases by shops or financial institution which provide for the mentioned products but in this respect there are certain discussions what percentage of revenue is still allowed to qualify as Shari ah-compliant. SHARI AH BOARD Islamic fund structures will be regulated and supervised by a Shari ah Board in the conduct of their investment activities and the fund structure itself. The Shari ah Board determines whether the transactions of the fund manager wishing to engage in Islamic finance comply with the relevant principles either through a written certification by the Shari ah scholars of Board (fatwa) or by confirming their compliance in the relevant annual accounts. The Shari ah Board also advises on investment objectives and monitors investment activity to ensure that it conforms to the principles of Shari ah in every respect. Furthermore, the Shari ah Board or Shari ah auditors, respectively, are responsible to allocate and distribute non-shari ah-compliant income. mayer brown 3

4 Fund Structure The structure described below should avoid a distribution of non-shari ah-compliant proceeds to Islamic investors based on a combination of a Shari ah structured side pocket and a conventional main fund. The structure is a generic structure that will need modifications in each individual case depending on the tax and regulatory position of the investors, the location of the investments and possible double taxation considerations. STRUCTURE DIAGRAM The structure can be illustrated as follows: SPONSOR GP I Advice/Supervision GP II Shari ah investors Secular investors FUND I SHARI AH BOARD FUND II 100 mio capital 200 mio HOLDING I HOLDING II up to 33 % conventional debt financing/or Shari ah-compliant financing Musharaka or Qard Hassan Advice/ Supervision debt financing % LP GP III non-compliant 20 % 4 Shari ah Compliant Fund Structures

5 THE SPONSOR The Sponsor can be any real estate fund sponsor in any jurisdiction pursuing investment policies that tolerate a defined quota of non-compliant items of income (see defined quota of non-compliant profits ). FUND I AND FUND II The Sponsor sets up two fund vehicles for separated pooling of Shari ah investors ( Fund I ) and conventional investors ( Fund II ). Although the structure does not require a certain type of fund vehicle, for the purposes of this paper it is assumed that Fund I and Fund II will be limited partnerships under a suitable jurisdiction, given that limited partnerships are probably the vehicles used most widely in an international institutional fund environment. Fund I is managed by its general partner ( GP I ) which is a vehicle directly or indirectly controlled by the Sponsor. To ring-fence liabilities and to demonstrate the segregation of the Shari ah and conventional pocket, Fund II will be managed by a separate entity, also directly or indirectly controlled by the Sponsor ( GP II ). HOLDING I AND HOLDING II Fund I will make an equity contribution to a corporate holding vehicle ( Holding I ). Fund II will do the same in a separate holding vehicle ( Holding II ). Holding I and Holding II serve as vehicles to apply the desired amount of leverage to the respective investment sleeves. They could also be used for enhancing the taxoptimized repatriation of profits from target jurisdictions. LEVERAGE At the level of Holding II the fund manager can employ his desired leverage as implied by his regular business model. At the level of Holding I Shari ah law should allow for a leverage of up to 33 percent by conventional debt. If this amount of leverage is not sufficient to support an attractive business model for the fund, Shari ah-compliant structures would need to be applied at the level of Fund I or Holding I to raise the investment ratio. For example, Shari ah-compliant leverage finance could consist in qard hassan: a loan per amore in which there is no interest. Such a qard hassan could be provided by the Sponsor or an affiliate. Capital expenses may be compensated by an increased management fee in the Shari ah fund. Alternatively, a musharaka structure (a form of partnership between an Islamic bank and an etrepreneur where both parties provide capital to the enterprise) could be considered. mayer brown 5

6 THE LP The LP is the holding vehicle for the assets and the purification vehicle, i.e. the vehicle used to allocate (as far as possible) only the Shari ah-compliant items of income to Holding I. To that end, the LP must be interposed directly between the assets and any vehicle that is used for tax purposes to repatriate the profits or for applying leverage. Whether it is actually set up as a limited partnership in a certain jurisdiction will need to be determined in the individual case. It is essential that the law governing the LP provides the feature of allocating special items of income to its partners (tracking stock feature) rather than allocating merely a percentage of total profits of the vehicle. Most jurisdictions such as England, Germany and Delaware award their respective limited partnerships with this feature. Some corporate vehicles also provide for a tracking stock feature. At first instance a tax transparent vehicle (partnership) seems to be preferable in order to avoid a layer of taxable entities in the structure. However, this also depends on the individual case and the jurisdiction the vehicles will be set up in. The LP is managed by its general partner ( GP III ). GP III could be a subsidiary of Holding I and Holding II. The purpose of purification of the income allocated to Holding I will be achieved by the implementation of a private equity style distribution waterfall along the lines of the following: First, 100 percent of Shari ah-compliant profits to Holding I up to its pro rata share in the capital of the LP; second, if compliant profits are not sufficient, then allocation of non-compliant profits to Holding I; third, to Holding II. To determine the profits, all income streams have to be examined and the costs need to be defined that are related to these streams. 6 Shari ah Compliant Fund Structures

7 DEFINED QUOTA OF NON-COMPLIANT PROFITS The second level of the distribution waterfall illustrates that the share of Holding I in the LP provides the threshold for the quota of non-compliant profits that can be routed through this structure without using donations to purify them. In our assumed scenario Holding I holds a share of roughly 28 percent. This means that at least 28 percent of the profits of the LP should be Shari ah-compliant to avoid donations. Consequently, the share of Holding I in the LP depends on two factors: (i) The ratio of Shari ah investors to conventional investors at level of Fund I and Fund II and (ii) the leverage, be it conventional or merely economic, applied at the level of Holding I and Holding II. THE SHARI AH BOARD The Shari ah Board advises and supervises GP I as manager of the Shari ah-compliant sleeve. The Shari ah Board also advises and supervises GP III. Its main task will be to assist GP III in determining on an ongoing basis the items of profits that have to be considered non-compliant. mayer brown 7

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