Apr 3, 2009 
The prognosis for venture capital in 2009 is fairly bleak, according to most of the conventional sources. In a RedHerring magazine piece this month venture capitalist George Siguler is quoted as saying: “Nine years later [after the dot-com bust-up] there’s still no venture capital industry, as far as I’m concerned”. Tech IPOs are nearly non-existent, the M&A market is likewise comatose and fund managers across the private market lifecycle, from early stage to buyout fund, are sitting on an unprecedented pile of portfolio holdings with nary an exit opportunity in sight. It’s enough to make one start to write epitaphs on the industry, with glowing obits and misty-eyed VC veterans swapping remembrances of the glory days of old.
It is precisely when the opening bars of the swan song start to fill the room – when everyone heads for the exit doors – that I look for the opportunities. So I jumped on a plane and headed down to Malaysia to investigate the world of Islamic finance. There – how’s that for a brilliant non-sequitur? Read on.
Several things intrigued me about Islamic finance (and let me here emphasize for any jittery U.S. readers that Islamic finance is a fully legitimate business area that is not in any way connected with unsavory activity like terrorist financing - should be obvious but I need to say it anyway). First of all, the volume of assets under management or held in bank deposits considered to be Islamic, by which we mean compliant with the traditions and interpretations of Shariah law, is about $750 billion at the present time and growing – yes, this is a corner of the global financial economy that actually grew in 2008 and is expected to be worth over $1 trillion by 2010. Second, the mere mention of something like Shariah law here in the U.S. elicits an interesting mixture of reactions – ranging from fear that someone might be listening to our conversation to an expression of distaste similar to what one might exhibit after eating a really sour pickle, to a blank-eyed stare of outright incomprehension. If something is completely off the radar screen of the conventional discourse, I figure, that’s usually a good sign for me. And third, I came across a publication put out by the Securities Commission of Malaysia called “Guidelines and Practices on Islamic Venture Capital”. So apparently this market has enough substance to it that a regulatory agency thought it a good idea to publish guidelines and standards. Selamat datang di Malaysia!
I hadn’t been to Kuala Lumpur for a number of years and wondered how it was holding up in the economic crisis. On my way to a meeting at the Mandarin Oriental Hotel (by the way there are few things more enjoyable in the world than the service quality of Asia’s top five-star hotels) I walked through the mall that takes up three levels of the Petronas Towers, the iconic twin towers of Kuala Lumpur that for a time served as the tallest building in the world. Asian malls tend to be top-heavy with high-end luxury – more Armani and Chanel, less H&M and Ann Taylor Loft. Crowds of shoppers thronged their way through this little slice of consumer heaven – I don’t know whether these crowds were large or small compared to, say, a year ago but they seemed plenty big compared to the subdued trickle of stressed-out consumers I have been noticing of late in my usual haunts in the DC area.
My meeting at the Mandarin was with an investment banker who was head of Islamic banking for one of the large regional financial institutions. I asked him what his biggest challenge was in the current environment. Without missing a beat he replied “We’re growing too quickly. Can’t find enough good talent to staff our deals”. Yes, this was in March 2009. Later that day I went to a conference on Islamic banking. Everybody said the same thing. But what about the huge talent pool that’s just been dumped overboard from the sinking global economy, I asked. You would think this is a buyer’s market for financial talent – but it turns out that unemployed former experts at running 50-1 leveraged mortgage structures don’t have much to offer the world of Islamic finance, where every transaction is required to have direct linkage to real underlying economic activity (that’s right, direct, as in not 50 times decoupled by increasingly effervescent synthetic securities).
What does fit well into the Islamic finance framework is venture capital. There is a popular Arabic phrase “al ghorm bi’l ghonm” which roughly translated means “with profit comes risk”. Islamic finance seems tailor made for VC. One of the basic structures in Islamic finance is called “musharakah”, meaning equity-based partnership. In traditional Islamic deposit-taking activity (i.e. what we would think of a simple retail banking) one partner acts as the “entrepreneur” while the other acts as the capital provider (this is called “mudharabah”). The reason for this is the Shariah prohibition against “riba”, usually translated as “interest” although there’s a bit more to it than that. In other words, Islamic finance tends have a predilection towards risk-sharing equity-based business models where we would instead have debt and credit instruments.
One fund that has put a footprint in this space is Musharakah Tech Venture, a fund incepted in 2008 with a bit under $10 million in invested capital that is part of Malaysia Venture Capital Bhd, an organization originally established and funded by the Government of Malaysia in 2001. This fund appears to be the first distinctly Islamic venture capital fund, at least in Malaysia. The fund can invest across the spectrum from start-up to buyout, though given the initial funding size I would expect to see more dealflow in the earlier stages of the VC lifecycle.
Here’s my best guess as to what is going to happen in this space. Islamic finance is on a growth trajectory, and that trajectory includes participation by institutions entirely outside the Muslim world. In fact if one looks at the global market for sukuk (Shariah-compliant capital markets instruments structured to resemble conventional bonds) one sees that a large number of the issuers are companies from Western Europe or non-Muslim Asia, while the investor book for these offerings tends to contain about 50% participation from non-Muslim investors with the remainder coming from traditional Middle East / Gulf States sources. As the skill sets develop among Islamic finance participants more of the leading financial institutions will follow the likes of Musharakah Tech Venture into the Islamic VC space, and that relatively modest $10 million will grow by several magnitudes. There is surplus capital to invest in the Asia Pacific Region and most traditional asset markets continue to look fairly depressed – so investors looking for better sources of returns will turn their attention to VC, where the Islamic bankers will have viable fund structures ready to take their capital.
I’m not expecting much from Silicon Valley in the coming months, but I’ll be watching Kuala Lumpur and other Asia Pacific hotspots with a close eye.
