Part II: Partnership and joint venture (musharaka)
In Part II of our Islamic finance series, we explain the partnership and joint venture arrangement, its structure and some key considerations that parties must be aware of when entering into such an arrangement.
Musharaka translates to ‘partnership’. It is an Islamic mode of finance where financial capital is provided by at least two parties for a particular project, where each partner makes a capital contribution to the partnership, akin to an unincorporated joint venture.
Compliant with Shari’ah principles, banks are able to provide financial capital so long as they abide by the principles of the agreement. The profits from the particular project are distributed among the parties in pre-agreed proportions and losses are distributed as a ratio of each party’s contribution, on the basis of equity participation.
Differences from the profit-share (mudaraba)
Whereas a profit-share agreement does not entail all parties sharing the cost of any loss, a musharaka does. A mudaraba contract also entails one party being a financier (and silent partner) and the other party as the working party who provides labour and entrepreneurship. In a musharaka, all parties contribute some (not necessarily equal) percentage of the four factors of economic production (land, capital, labour and entrepreneurship).
The former of these two are considered the backbone of Islamic finance particularly over the last two decades and short-term murabaha (Shari’ah loans) in particular have been popular amongst Islamic banks. Given the increased demand for long-term finance, some Islamic banks are becoming involved in joint venture (musharaka) financing for projects. The musharaka type agreement in essence is a Shari’ah complicit unsecured funding arrangement and exposes the bank to a risk higher than that of a Shari’ah loan or ijara (lease buy-back) agreement. The risk related to musharaka can, however, be mitigated via the implementation of a security structure.
The flow chart below is an example of a typical Musharaka structure between a client and a bank.
Overview of structure
(1) Many Islamic banks use a musharaka contract to provide working capital and finance trade.
(2) Banks often provide letters of credit to customers that deal in international trade.
(3) Banks usually enter into a musharaka as a limited partnership for customers who lack sufficient funds to import items. The customer and bank jointly supply the monies for the importation and the bank issues the letters of credit accordingly.
(4) After arrival of the imported items, the bank/client either sells its share in the musharaka to the other on cash payment or deferred basis (at an agreed margin) or both on-sell the imported items (or subsequent products) in the market together and share in the proceeds.
Banks involved in joint venture financing (musharaka) products divide them into two categories that are based on how long joint venture partners will continue to be involved. These are:
1. A consecutive musharaka in which each partner can keep his / her share of the joint venture partnership until the end of the project or business. The partners are also allowed to withdraw from the joint venture and transfer their shares, which will not dissolve the whole of the partnership or project.
2. A diminishing musharaka in which one of the partners gradually buys out the other partner’s shares until the whole of the partnership is transferred to the first partner. An example would be for a client and bank to enter into a musharaka agreement for a project or business, which is divided into equity units. The client, aiming to have full ownership of the project, will purchase the bank’s equity over time at a fixed or progressive rate. In this type of joint venture, the profit and loss sharing can be revised after each period that the client repurchases the bank’s equity. The bank has the advantage of deriving income in the transaction in two ways, first through the profits of the project or business, and secondly through receiving cash consideration from the client for the bank’s equity. This arrangement is popular amongst the banks seeking to fund property acquisitions.
Set out below are some issues that need to be considered when entering into a joint venture (musharaka) agreement:
• One partner will usually be a managing agent in the joint venture business who must invest the joint venture assets according to the business plan and underlying agreement:
• The ratio of profit sharing must be agreed from the outset as, unlike losses, this is usually not in accordance to the proportion to each partners’ capital contribution, but the partners’ involvement in managing the business or project. Losses, as stated, are in accordance to the capital contribution; and
• Like other sukuks (Islamic bonds) or Shari’ah compliant enterprises, there is an element of asset tangibility that needs to be considered. Depending on which Shari’ah scholars are followed, 33% to 50% of the assets must be tangible.
Part III of the Islamic Finance series will focus on Shari’ah loans (murabaha).
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Have you ever used a musharaka arrangement? We would love to hear about your experience. Please leave a comment or any questions in the section below.
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