Taking a look at Shariah-compliant investment funds

What do we mean by Shariah-compliant funds?

A Shariah-compliant fund is structured and governed in accordance with the principles of Islamic law, known as Shariah. In many respects a Shariah-compliant fund will not be that different from a conventional fund, especially with respect to tax and regulation. For more details on conventional investment funds please refer to our article, 'Navigating the private investment funds roadmap'.

It is possible to establish Shariah-compliant funds across many asset classes (including private equity, real estate, mezz financing and commodities). For the purposes of this article, we will focus on Shariah-compliant real estate funds.

There are natural synergies between real estate funds and Shariah. Most notably real estate is a physical asset which ultimately contributes to the economic growth of society which is aligned with Shariah principles. Furthermore, in a typical real estate fund the investors share in the risks and rewards of the development and/or performance of the underlying property.

We continue to see a rise in interest in the establishment of Shariah-compliant funds both on a "standalone" basis as well as to be parallel to or as feeder vehicles into conventional funds.

• Parallel vehicle / co-invest: this is where a Shariah-compliant vehicle is established separately to the master fund but invests alongside the master fund in any Shariah-compliant investments that meet the applicable investment criteria. The structure allows the master fund the flexibility to invest in a way that is unrestricted from Shariah compliance requirements.

• Feeder fund: this is where a Shariah-compliant vehicle feeds into the master fund by entering into a Murabaha agreement with the master fund. In this way, the Shariah-compliant feeder vehicle is detached from involvement with prohibited, or "haram", activities of the master fund (see below).

Considerations for a Shariah-compliant fund

There are ten main tenets of business that are laid down by Shariah law and Islamic teachings. In this article we will look at the three that are most relevant to a real estate fund. These are:

• the prohibition of "Haram" items. In general terms this means that the fund must avoid making investments in sectors that are not permitted by Shariah law (this is considered in more detail below);

• the prohibition of "Riba". Riba is often defined as meaning interest although it is wider than this and is to avoid the creation of wealth simply on money. Therefore to be permitted, any profit or return needs to be linked to the performance of a real asset and to its associated risk; and

• the prohibition of "Gharar", meaning unacceptable levels of uncertainty, ambiguity or risk.

We will consider these as we look at the below.

Fund terms and operational matters

In addition to the above, Shariah scholars will be required to review the fund documentation to ensure that the fund will operate in a Shariah-compliant way. Particular areas that require consideration include:

• Default: in a conventional fund structure an interest charge would normally apply to an investor if they failed to provide the relevant proportion of their commitment to the fund within the required time. As noted above the charging of interest is regarded as haram and a default mechanism must be structured as an imposition of a fee or through the forfeiture of rights or share of profit.

• Annual Audit: a Shariah-compliant fund must be audited on an annual basis to ensure that it is adhering to Shariah principles. This may be carried out by the Shariah Advisory Board (see above) or an independent body of Shariah scholars.

• Avoidance of Gharar: the arrangements set out in the fund documentation must be sufficiently certain as to their fundamental terms.

• Cash management: any surplus monies held by the fund (usually held for cash management purposes) may not be held in any interest–bearing instruments and must either be placed in a non-interest-bearing account or in a Shariah-compliant deposit account with a bank.

• Use of third-party finance: consideration will need to be given to Shariah-compliant debt if leverage is required. This will often be by way of a commodity Murabaha which has an economic effect that is similar to a conventional loan (please refer to Murabaha Monthly, Episode 1: Purchase Contracts | Foot Anstey for further information).

• Other other areas of the fund documentation that will require particular attention from a Shariah perspective include the equalisation adjustments made on subsequent closings of the fund, the use of inter-company debt in the structure and the carried interest arrangements.

Final thoughts

Shariah compliant funds are by their inherent nature complementary with the recent rapid rise of ESG principles (please refer to Exploring Islamic finance's synergy with ESG/SDG and the role of Islamic fintech | Foot Anstey for further insights in this area) and we are expecting to see a continued increase in the number of shariah complaint and ESG funds across many asset classes and in particular in real estate. The use of technology to be able to carry out due diligence and ongoing monitoring of activities means additional costs for a Shariah compliant fund should continue to come down.

Shariah compliant funds come with a unique set of requirements that need to be considered in the context of the fund that is to be established. It is important to seek the right advice on these matters at the outset of a fund’s development.

Want to know more?

If you have any questions or would like support with your approach to a Shariah-complaint fund, please get in touch.