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WEEK 7: OVERVIEW ON ISLAMIC VENTURE CAPITAL AND ISLAMIC FINTECH

Ronald Rulindo, PhD

Tika Arundina, PhD

INTRODUCTION TO ISLAMIC BANKING & FINANCIAL INSTITUTIONS

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WEEK 7 A: VENTURE CAPITAL

  • Understanding Venture Capital
  • History of Islamic Venture Capital
  • Characteristics of Venture Capital
  • Understanding Islamic Venture Capital
  • Procedures of Islamic Venture Capital
  • Islamic Vs Conventional Venture Capital
  • Challenges of Islamic VC

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UNDERSTANDING VENTURE CAPITAL (1)

What is Venture Capital?

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Activity by which investors support entrepreneurial talent with finance and business skills to exploit market opportunities and thus obtain long term capital gains’. Shilson (1984)

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UNDERSTANDING VENTURE CAPITAL (2)

A venture capital firm manages funds provided by investors and directs it to the most promising ventures, mainly in the form of equity.

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The venture capitalist, who is responsible for managing investors’ funds, provides financial and strategic assistance to the recipient company and actively participates in its management.

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Returns then are distributed back to the investors

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HISTORY OF VENTURE CAPITAL (1)

VC is a form of partnership started even before Islam by Arab traders in the 15th Century (Cizacka, 1995).

After World War II Venture capital institutions currently manage over $30 billion in the U.S. and another $30 billion in Western Europe (Bygrave and Timmons, 1992, p. 23).

On average, about 60% of high technology companies going public in the U.S. are financed through venture capital (Al-Suwailem, 1995).

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HISTORY OF VENTURE CAPITAL (1)

Until late 1970, VS had been primarily a US phenomenon

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Success

    • Ventures funds backed high-technology firms such as Cisco Systems, Microsoft, Netscape and Sun Microsystems, as well as a number of prominent service firms including Federal Express, Staples and Starbucks (Gompers et al., 1998).
    • Apple Computers, Data General, Intel, Prime, Tandem and Digital Equipment also figured among the spectacular success stories of VC investments.

Failure

    • Ovation Technology, Osborne Computers, Ztel and Gavilan, where venture capitalists were left with worthless investments (Sahlman, 1990).

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CHARACTERISTIC OF VENTURE CAPITAL (1)

Characteristics of VC

support for high-growth, high risk ventures

Equity-based financing

Funding linked to managerial assistance

Rewards through capital gains rather that running (dividend) yields

Investment in young and start-up companies

Long-term, patient investment

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CHARACTERISTIC OF VENTURE CAPITAL (2)

    • Investors are limited partners, the venture capitalist is a general partner. All parties, therefore, have in essence the same objective. This structure dramatically reduces possible conflicts of interest and associated moral hazard (Milgrom and Roberts, 1992).

Sharing

    • Sharing has important consequences creates incentives for the capital provider to monitor and assist his partner (Davis, 1992, p. 265).

Monitoring and Assistance

    • Sharing also affects the selection criteria of ventures. The type of information and criteria that venture capitalists look after when selecting a company reflects their preferences as active investors and shareholders.

Selection Criteria

    • In a sharing contract with asymmetric information the entrepreneur always has an incentive to under-report profits By staging capital, such incentive is inhibited, since the entrepreneur has to return to the venture capitalist to obtain capital for the next stage of the project.

Staging Capital Commitment

    • The reason behind these concerns is the relatively high costs of obtaining venture capital. Such costs would greatly affect the type of entrepreneurs seeking venture capital.

Adverse Selection

The following discussion will analyze how the venture capital industry developed its practices and arrangements to minimize these problems.

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UNDERSTANDING ISLAMIC VENTURE CAPITAL (1)

  • VC is risk capital and risk taking involves a willingness to commit a course of action that leads to rewards or penalties associated with success of failure (Welsch and Young, 1982)

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  • Equity investments in permissible sectors are allowed in Islam (Siddiqi, 1985; Chapra, 1992) from the Islamic concept of “mudharabah”

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  • In the 10th century, the concept of mudharabah was taken up by the Italian and spread through Europe

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  • As Islamic culture spread across the world, the mudharabah concept also developed and continued to be used by Islamic businessman until the 19th century.

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UNDERSTANDING ISLAMIC VENTURE CAPITAL (2)

  • Even though this kind of mudharabah partnership form in the Muslim world remained undeveloped, in Europe there were increasing numbers of entrepreneurs who were financed using this method, resulting in organisations becoming larger and larger.
  • About three decades ago, a kind of quantum leap happened and the concept of the modern Islamic bank (mudharabah in the form of the bank managing the funds from the depositors) emerged from these roots.
  • In Islam, money is not a commodity and cannot be traded for profits. It is just a medium of exchange and value storer.
  • Money therefore must be invested in projects and ventures for the generation of activities for the benefits of mankind and in the process, for profits.

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UNDERSTANDING ISLAMIC VENTURE CAPITAL (3)

  • This is precisely why Islamic finance praises and encourages the application of finance in the financing of real economic activities.
  • The returns should be earned by active involvement and participation in the business risks in the investment (and not returns on lending)
  • Islamic banks would apply the same criteria in evaluating projects to invest 🡪 the entrepreneur’s ability and the profit potential of the project.
  • This is the reason why Murabahah (cost plus financing) as an Islamic transaction is considered less risky compared to Mudharabah and Musharakah.
  • Truer form of Islamic financing or investment structure should have that element of sharing of profit and loss.
  • Islamic Bank is supposedly in form of VC, but in real practices, this objective cannot be achieved

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PROCEDURES OF ISLAMIC VENTURE CAPITAL (1)

Screening

    • Fund managers will generate, screen and evaluate potential deals

Valuation

    • Specifying the distribution of prospective profits between the VC funds and entrepreneurs
    • Using Discounting of Future Cash Flow (DCF) method

Structuring

    • Using Mudharabah, Musharakah or Wakalah

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Mudharabah

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  • Mudharabah is one of the typical forms of Islamic (Private Equity) PE/VC
  • It is basically a contract made between two parties to finance a business venture.
  • The parties are a rabb al-mal (investor) who solely provides the capital and mudharib (entrepreneur) who solely manages the project.
  • This is akin to a conventional PE/VC, where there exists a relationship between the capital provider and the manager.
  • If the venture is profitable, the profit will be distributed based on a pre-agreed ratio.
  • In the event of a business loss, it should be borne solely by the capital provider, to the extent of the capital contribution.
  • The key to a Mudharabah structure is the fact that the manager cannot be placed at risk to bear losses, unless proven negligent.

Investor/ Rabb al-Mal

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Co.A

5m

Co.B

7.5m

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Co.C

7.5m

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Others

Private Equity Fund Company (Manager/Mudharib)

Size of Capital 50m

PROCEDURES OF ISLAMIC VENTURE CAPITAL (2)

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MUSHARAKAH

  • Musharakah is a partnership between two parties or more to finance a business venture whereby all parties contribute capital either in the form of cash or in kind.
  • Profits are shared at an pre-agreed ratio while in the event of a loss, the loss shall be shared on the basis of capital contribution.

Investor/ Rabb al-Mal

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Co.A

1m

Co.B

2 m

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Co.C

1 m

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Others

Private Equity Fund Company

(10m Commited Capital)

Investor/ Rabb al-Mal

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Investor/ Rabb al-Mal

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  • Wakalah is basically a contract where a party (“the Principal”) authorises the other party or parties (“the Agent”) to act on his behalf, based on the agreed terms and conditions.
  • Pursuant to the Wakalah contract, it confers the power and rights to the Agent to act on behalf of the Principal as long as the Principal is alive.

Wakalah

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PLAIN WAKALAH FUND STRUCTURE

Investment C

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Investment D

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Investment E

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Investment F

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Islamic Fund

Investment Committe

Investment Guidelines

Sharia Advisor

PE and/ or its affiliate is fund manager to the funds

Investment A

Investment B

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Conventional Fund

Sharia Council

Sharia Guidelines

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ISLAMIC VC VS CONVENTIONAL VC

Conventional PE/VC

Sharia Compliant PE/VC

Equity Investment

Equity Investment

Partnership-Sharing of Risk & Rewards

Musharakah- Sharing of risk & rewards. Ca be informed of Agency too.

Return based on the performance of investment

Return based on the performance of the investment

Long term & Value added investment

Long term & Value added investment

Applicable to all industries

Only Sharia Compliant Industries

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CHALLENGES FACED BY ISLAMIC PE/VC

  • The establishment of legal and regulatory framework or the appropriate guidelines to regulate the industry
  • The support and backing from the government in terms of incentives, tax exemptions, etc
  • The creation of appropriate business structure or investment structure to make the product better understood and accepted by the market players
  • Shortages of well trained high caliber individuals and management teams with expertise in investment strategies and at the same time understand and appreciate the Shariah requirements
  • Innovations and creativity in coming dealing with new investment climate and changing circumstances without compromising the requirement of the Shariah
  • The creation of conducive environment and attracting the deal flows

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WEEK 7 A: ISLAMIC FINTECH

  • Understanding Venture Capital
  • History of Islamic Venture Capital
  • Characteristics of Venture Capital
  • Understanding Islamic Venture Capital
  • Procedures of Islamic Venture Capital
  • Islamic Vs Conventional Venture Capital
  • Challenges of Islamic VC

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DISRUPTIVE INNOVATION VS. SUSTAINING INNOVATION

  • Disruptive innovation significantly revolutionise and improve a product or service in ways that the market did not expect.
  • Sustaining innovation seeks to improve existing products. It merely develops existing markets rather than create new ones.

Clayton Christensen and Michael E. Raynor’ the Innovator’s Solution

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DISRUPTIVE INNOVATION VS. SUSTAINING INNOVATION

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FINANCIAL TECHNOLOGY

The financial technology or ‘FinTech’ includes “any innovative ideas that improve financial service processes by proposing technology solutions according to different business situations, while the ideas could also lead to new business models or even new businesses.”

(Leong and Sung, 2018)

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FINTECH REVOLUTION

  • The financial technology or ‘FinTech’ revolution has enabled financial services to fundamentally change their businesses by allowing firms to offer
    • new products
    • new business processes
    • new business models.
  • To name a few everyday examples of FinTech would include
    • big data analytics,
    • peer to peer lending,
    • digital banking,
    • crowdfunding,
    • cryptocurrency,
    • blockchain, etc.

1.0

    • ATM
    • SWIFT

2.0

    • Internet
    • Internet of Things

3.0

    • Data Technologies

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TECHNOLOGY & OPPORTUNITIES FOR ISLAMIC FINANCE (1)

Source: DS Innovate Fintech Report 2021

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TECHNOLOGY & OPPORTUNITIES FOR ISLAMIC FINANCE (2)

Source: DS Innovate Fintech Report 2021

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THANK YOU