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.

Every real estate fund will have a clear investment strategy. This will be the strategy developed by the fund manager who has spotted an opportunity or particular need in the market and has the right expertise and contacts to be able to make investments in line with that investment strategy. For example, the fund strategy may be focused specifically on student accommodation, PRS/BTR, care homes, retail, logistics, industrial or offices.

As noted above, a key principle for Shariah-compliant real estate fund is ensuring that the activity carried out at the underlying property asset is permitted (“Halal“). A Shariah-compliant real estate fund could not for example invest in real estate that has a lease with a tenant that is involved with:

  • the production or sale of alcohol;
  • the production, slaughter or sale of pork products ;
  • the adult entertainment industry;
  • gambling; or
  • conventional banks and insurance companies.

Other areas of concern from a Shariah perspective would also include the production or sale of tobacco or weapons.

Fund managers are well used to putting in place investment methodologies, criteria and processes to ensure that the fund only invests in line with the agreed investment strategy. However, this comes with unique challenges in the Shariah context to ensure all investments are halal.

If the fund is developing a new single asset to then lease the Shariah prohibitions can be easily managed as the fund (as landlord) will carry out suitable due diligence on the activities of the proposed tenant and ensure that the provisions in the lease prohibit transfer/sub-leases without landlord consent (so that the activities do not change overtime).

Where the fund is seeking to acquire income producing assets the fund manager will need to consider the process closely. For a single asset involving a single tenant, the due diligence process will highlight any potential risk areas (for example where the tenant has the ability to carry out a prohibited activity, or the lease could be sublet or transferred without the landlord’s consent).

It can become more complicated in the case of a multi-let property such as a large commercial building which, for example, contains a small branch of a conventional bank or where a large hotel has a bar that sells alcohol. While such activities are prohibited, Shariah scholars have generally accepted that where they do not form a material part of the primary usage of the property, investments can still be made on a case-by-case basis. The fund manager needs to be able to measure the use of non-permissible activities to ensure that they are and remain nominal (usually below five per cent).

A Shariah Advisory Board made up of Shariah scholars may need to be appointed to provide guidance to the fund manager on matters of Shariah law. The Shariah Advisory Board will, in particular, provide guidance on whether a proposed investments is Shariah-compliant and the has been screened correctly (see above) and in terms of any required purification of haram (forbidden) income (see below).

The role of the Shariah Advisory Board will largely depend on underlying assets of the fund and how much interpretation may be required.

It is inevitable or at least possible that a portion of the income generated by the assets of a Shariah-compliant fund are from non-permissible activities. Income that is derived from non-permissible activities will need be purified or cleansed. The relevant amounts of tainted income can be so purified by being donated to an Islamic charity that has been chosen by the fund manager and approved by the Shariah Advisory Board.

This of course means that unless the income from non-permissible activities is negligible, the returns payable to investors will be impacted in such a way as to not make the fund investment viable.

The fund will seek guidance from the Shariah Advisory Board in determining the types and amount of income that need to be cleansed. This is usually calculated by reference to a breakdown of the net asset value of the fund to establish a Shariah-compliant net asset value and non- Shariah-compliant net asset value.

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.

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