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Nov 6 2008 | 9:29am ET
By Tahir Jawed -- Faced with increasingly wary Western investors, hedge funds are setting their sights on untapped capital pools in the Middle East.
Wealthy families from the region—as well as sovereign wealth funds flush with petrodollars—are looking for sources of investment returns outside the region, and are growing more receptive to alternative investments like hedge funds.
For Western fund managers, however, this financial lifeline often comes with conditions in the form of Islamic laws, also known as Shariah, which lay out a moral code for how money can be used and, more importantly, how it cannot be used.
For hedge fund managers in particular, proving one’s Shariah bona fides will be increasingly challenging as the Islamic community grows both in wealth and its knowledge of the legal and economic teachings of Islam. As a result, the next wave of Shariah-styled hedge funds will find themselves scrutinized more rigorously by a financially savvy Muslim investment community that is mixing its faith with its portfolio.
Growing ranks of Islamic investors are having a major impact on Western financial markets. Sovereign wealth funds have grabbed headlines by scooping up large stakes of global banks, U.S. technology companies and European luxury carmakers. Islamic debt instruments, called sukuks, are quickly becoming permanent fixtures in the global financial markets, and replacing the evaporating sources of capital that private equity managers once depended on.
Much of the capital for Islamic compliant investments is coming from the Middle East, which is where most Western finance managers are concentrating their marketing efforts. However, some are also looking for investors in Malaysia and other parts of Asia.
The number of institutions offering Shariah-compliant investments reached 420 this year, including 194 conventional institutions, according to a 2008 report by the U.K.-based publication The Banker. Among the top institutions, Shariah compliant assets have grown nearly 28% to over $639 billion, the report found.
While several Middle Eastern sovereign wealth funds are not Shariah compliant, the real growth opportunity for alternative asset managers raising funds in the Middle East will come from wealthy families and sovereign wealth funds that want to maintain the principles of Islam within their portfolios.
Hedge funds have been seen as a relatively stable long term investment in the Middle East, a view that has spurred the demand for Islamic products that mimic conventional investments. But hedge funds face particular challenges in marketing themselves to religiously minded investors in the Islamic community. Islamic law, for instance, forbids people from selling something they don’t have. This provision effectively rules out long/short or convertible arbitrage funds that depend on short-selling equities.
Early hedge fund entrants to the Middle East skirted such constraints by establishing a separate fund into which Muslim investors would put their money. As the principles of Shariah-based investing evolved, however, it became clear that these pass-through structures were actually traditional investment vehicles wrapping themselves in a false cloak of Islamic purity.
More recently, fund managers from the United States and Europe have tried to hone their Shariah credentials by enlisting Islamic advisers, called scholars, to ensure that their investing methods pass muster with religiously minded investors. In 2007, U.K.-based Old Mutual allied itself with Ratings Intelligence, an advisory for Islamic investors, in launching a Shariah compliant equity hedge fund.
The role of scholars has become commonplace to ensure compliance with Shariah principles. In some cases, scholars can issues fatwas, or legal opinions, that grant exceptions for certain investments that might otherwise run afoul of strict Shariah adherence.
Recent volatility, however, is likely to cause Muslim investors to discount conventional investments wrapped in Islamic principles and raise the premium on genuine Shariah-based products. As a result, currency and commodity hedge funds may have more success in wooing investors from the Islamic community because their investing styles involve an underlying asset, which is in principle more in line with Shariah standards. Earlier this year, Barclays Capital launched a platform of Shariah compliant products, including hedge funds, based on commodity-backed investments.
Another factor working in favor of hedge funds is the development of Shariah-compliant methods of raising funds, which could in theory help fund managers cope with Islamic restrictions on the use of leverage. In one increasingly common scenario, fund managers purchase a commodity from a seller – the lender – and agree to resell it to the lender at a price to be paid in the future. The fund manager then sells the commodity and invests the proceeds. In some cases, the seller also acts as broker to sell the commodity for the manager and forward proceeds.
But there still remains a diversity of opinion within the Islamic community as to what is Shariah compliant investing, which may lead to stricter guidelines. Scholars have a role in helping managers foresee and adapt to changes in Islamic finance. But for fund managers making the strategic decision to cultivate ties with the Islamic community, the onus will fall most heavily on them to understand their investors’ needs and structure their operations accordingly.
About The Author: Tahir Jawed is a partner with the international law firm Maples and Calder and specializes in offshore structuring of Islamic finance products. From his office in Dubai, Jawed has advised on numerous sukuk issuances as well as multi-billion dollar private equity funds, real estate investment trusts and distressed property funds.
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