Shariah in the spotlight I: Shariah-compliant investors, ESG and fund finance
By Emily Fuller, Deborah Low, Ellen McGinnis and Emma Russell, Haynes and Boone – ‘Sustainability’ and ‘ESG’ have become trendy buzzwords in the finance world of late, but is the concept that wealth creation and management should be beneficial to the environment and society really that new? This article will look at the similarities and differences between ESG investment guidelines and long standing principles of investment practiced under Shariah law and discuss the implications of such restrictions for fund finance.
In the context of capital call facilities, where investors are unwilling to participate in certain investments due to ESG or Shariah law concerns, these investor restrictions (and the related excuse rights bestowed on such investors) can impact how lenders evaluate investors for purposes of calculating a borrowing base.
'Shariah’, which literally translates from Arabic as ‘the path to water’, is a set of principles derived from Islamic sources including the Quran and Sunnah which govern all areas of life, including financial transactions in the Muslim community. In general, Shariah law encourages investment as it helps grow the economy but places a focus on investing in a manner that will facilitate projects and development that benefit society as a whole. Shariah law dates back over a thousand years, but the recent growth in Islamic finance over the last few decades has made understanding it in that context increasingly relevant for lenders and borrowers alike.
Where the term ‘Islamic financial institutions’ is used in this article, it is a reference to financial services providers (for example lenders, fund managers and insurance providers) that operate in compliance with Shariah law. These Islamic financial institutions may be Shariah-compliant because they are looking to provide a service to Shariah-compliant customers or they may be part of a banking system which is wholly Shariah-compliant; for example, the banking systems in Iran and Sudan, where Shariah law has been codified into legislation.
It is worth noting that financial services institutions that are not bound by Shariah law can offer Shariah-compliant services through different models. For example a bank can offer Shariah-compliant services through a separate subsidiary, which will be a separate legal entity with its own capital and operations policies but still operates under the overall strategy of its parent company; Citi Islamic Investment Bank is an example of a separate entity operating in this manner.
Alternatively, a bank can offer Shariah-compliant services through a branch model where a separate branch of the institution offers Shariah-compliant services with separate accounts, operation policies and capital; for example, HSBC Amanah operates in this way, a windows based model where Shariah-compliant services are offered through the same distribution channel as traditional services, but accounts and capital are still separated, or on a transaction-by-transaction basis where individual transactions are assessed by a Shariah advisory board; this latter approach is more popular with investment banks, such as Morgan Stanley.
ESG, which stands for “environmental, social and governance”, refers to a set of principles that may be used by companies to evaluate the societal impact of an investment. ESG policies vary from company to company, but environmental elements will focus on an investment’s environmental impact, including energy and resource consumption, waste production or sustainable elements, while the social prong examines a company’s relationships with various parties, including its employees, vendors, contractors and the broader community.
Finally, governance will seek to measure whether a company is governed in a manner that promotes transparency, accountability, accuracy and fairness, with an emphasis on avoiding corruption and illegal practices.
Ultimately the aim of investing in accordance with ESG criteria or Shariah law is to maximise returns for the investor, but to do so in a manner that follows certain ethical or, in the case of Shariah, religious guidelines. While ESG has risen in prevalence recently and its application and definition continue to develop, as discussed below, ESG principles mirror Shariah law practise that has been in place for over a millennium.
This four-part series will also discuss how investment restrictions on ESG compliant or Shariah-compliant investors will impact capital call facilities. When a lender provides a capital call facility to a fund, the right to call on investors for capital contributions and the right to receive those contributions will be provided as collateral.
If investors with investment limitations accept a capital commitment into a fund that is a borrower under such a capital call facility, these investment limitations will be an important factor in a lender’s underwriting.
In order to determine the availability of loans, the lender and the fund will develop a borrowing base, comprised of the unfunded capital contributions of investors that the lender deems to be credit-worthy. Where ESG and Shariah law compliance result in an investor’s inability to participate in an investment being made by the fund, the fund and lender need to account for this excuse when calculating the value of the borrowing base.