People would traditionally think of banks when trying to source for capital to start a venture. While banks are usually reluctant to provide capital to high risk ventures, another alternative is venture capital.

Unlike fixed-income financing, venture capital entails the investing partner taking an active role in the recipient’s venture, sitting on the board of directors and provides not just financial support, but also managerial and marketing support during the entire venture period. All profits and losses will then be divided according to a pre-determined ratio.

A form of active investment, venture capital financing is praised for its role in promoting growth while maintaining financing stability. From an Islamic viewpoint, such arrangements appear very similar to the model of musharakah, which Islamic banks are seeking, but many in reality failed to adopt (Al-Suwailem, 1998).

Literally means ‘sharing’, musharakah is when two or more parties combine either their capital, labour or both, and share in the profits and losses of their joint venture. Historically, musharakah was practised by the Arabs long before the advent of Islam. The system was permitted to continue after Islam, and many scholars consider it to be the most authentic form of Islamic contract.

Hussain G. Rammal writes: “While the concept of interest predetermines a fixed rate of return on a loan advanced by the financier irrespective of profits or losses, musharakah does not envisage a fixed rate of return. Rather, the return in musharakah is based on the actual profits earned by the joint venture. This presence of risk in musharakah makes it acceptable as an Islamic financing instrument”.

In sharing of profits, most Islamic scholars agree that the ratio should be decided in advance and may differ from their investment, but if a partner clearly wished to remain a ‘sleeping’ partner, then his profit ratio should not be more than his investment. In case of losses, it is unanimous that each partner shall suffer the loss exactly according to the ratio of his investment.

Since it also promotes growth while maintaining financial stability, musharakah is seen as an ideal alternative for the interest-based financing with potentially far reaching effects on both production and distribution. It has proven to be capable of playing a vital role in the development of an economy, especially a Halal economy that is based on the principles of Islam.

Lagging Modern Applicability

Despite the appeal and economic significance that it could play, Islamic banks are slow to push for the implementation of musharakah. The existing operational structure of Islamic banks, which mimics that of conventional commercial banks, is said to be the main cause of the hold-up, rendering it vulnerable to two types of risks prevalent in the banking sector.

Dr Habib Ahmed from Islamic Research and Training Institute writes: “From an operational viewpoint, Islamic banks have institutional structures similar to conventional commercial banks. This is not only reflected in the similarities in the balance sheets, but also in their treatment by regulatory authorities in most countries where they operate”.

The root of this problem lies in the improper matching between the maturities of assets and liabilities in the bank’s balance sheet. When there is a mismatch between the two, liquidity risk arises. Therefore, to finance assets using equity modes of financing, the liabilities need to be of long-term maturity to avoid exposure to liquidity risks.

Dr. Habib further explains: “If the financial institutions can invest in assets for longer terms (i.e. equities) that are financed by long-term liabilities, then the risk-adjusted profit for the bank increases. As banks deal mainly with deposits that are short term, complementarities between assets and liabilities indicate that it is optimum (in terms of risk-adjusted profits) to use assets that have relatively short-term maturity”.

Since the availability of long-term liabilities is scarce in many Islamic financial markets, most banks would prefer engaging in short-term fixed income instruments like murabahah and ijarah to avoid liquidity mismatch.

The bank’s possible exposure to credit risk is also another main reason why banks are hesitant to push musharakah. Credit risk arises when the counterparty fails to meet its obligations on time and fully in accordance with the agreed terms. In cases of default in debt contracts, a bank can easily liquidate the collateral to recover its principles. In equity financing, banks can only minimise credit risks by actively engaging in the improvement of the assets and recovering returns through the sale of its share in the project at the appropriate time.

Unfortunately, to dispose of the assets at a fair price is not easy. Then, even with strong monitoring and control, the returns of the financier will suffer. Dr. Habib added, “While the financial institution can sell its shares either to the entrepreneur or other interested parties, one way in which the value of a firm can be enhanced is by launching it in the stock market by issuing initial public offering (IPO). The latter would be possible if a well-functioning and efficient stock market exists”.

Musharakah in Malaysia

From the perspective of a partnership contract, projects may be financed under the concepts of musharakah or mudharabah. Both are based on a profit-and-loss sharing concept, but there is a difference in the capital contribution and management of the business.

In musharakah, all partners contribute capital for the project’s take-off. For this, the partners, including the bank (if it contributes to the capital and becomes a partner), can be involved directly in the day-to-day running of the project. In mudharabah, however, only one party contributes capital, which is the bank, while the client runs the business without direct interference from the bank.

“In a musharakah partnership, a financial institution would inject capital into an entity or company for the business purpose intended. This form of injection can be considered as a direct investment or as a form of financing,” explains K. Salman Younis, managing director of Kuwait Finance House (Malaysia) Berhad.

Understandably, banks would prefer musharakah as it ensures commitment on the part of the client to make the project a success (i.e. from capital invested in the project). This partnership contract can be applied to deals for the supply of equipment to the government departments for example. Due to the fixed time frame of the contract, the profit generated can be easily determined and, to a certain extent, assured.

The musharakah concept is accepted in the Middle East and is being promoted by the Malaysian government. “Musharakah is one of the four approved Shariah principles - together with isti’na, ijarah and mudharabah - that provide certain tax (Malaysian) benefits to the issuer,” said Mohamad Safri Shahul Hamid of CIMB Islamic.

With musharakah’s varied potential in building the Halal economy, one would be hard pressed to ask this question: what then is stopping it from being used by the Halal industry?

K. Salman Younis provide the answer: “Musharakah is definitely one of the most effective ways which can be used to help drive the Halal industry in Malaysia and other countries. However, the success of this form of financing also depends on the Islamic banking community having the expertise in the Halal business.”

“In that regard, we will certainly support the Government’s move to finance viable projects involving the Halal business. We hope to get involved in various business segments such as real estate, construction, manufacturing, plantations, Halal food, automotive and oil and gas,” he added.

Top of Page