What is project finance?
Project finance is like any other sort of finance, except that it is primarily commercial in nature and the finance is used to fund the development of projects – that could be anything from refurbishing a house for resale, to major infrastructural work such as a rail line, bridge, etc. The difference with project finance as opposed to everyday finance such as mortgages, is that the final project is not yet up and running which makes lending less attractive from the lender’s view.
Put yourself in the shoes of a bank – would you rather lend somebody £1m when they had a house worth £2m against which you could easily secure your loan, or would you rather lend somebody £1m who tells you that in five years time, the income from this new project (currently just a hole in the ground) will be £2m per annum? Herein lies the lender’s risk.
The sharia compliance problem
From an Islamic Finance perspective, the problem is quite straightforward and echoes the same problem experienced by lenders in any type of loan of money. Lenders will only take on the risk of lending if there is some financial benefit to be had. This, of course, cannot take the form of interest in order to be sharia-compliant. This article explores in simple terms the mudarabah structure, which might help a lender and borrower to make their arrangement sharia-compliant and beneficial to all parties. This is the first part in a series of articles which explore different models and structures for sharia-compliant project financing.
This structure can be used by big lenders such as banks, but is particularly of interest to high net worth individuals or anybody with access to a decent amount of money looking for an interesting investment.
The mudarabah structure is most akin to a ‘silent partner’ arrangement. There are typically two players in this type of structure – the rab al maal and the mudarib. The rab al maal is the typical silent partner – they provide the capital injection (although what exactly can constitute ‘capital’ is a jurisprudential issue – money is the most typical and lawful capital injection). The mudarib is the one who puts in the labour to put that capital injection to use. The mudarib is usually the one putting all the hours trying to make the project a success.
The parties will agree a profit share between them. This fairness of the split depends entirely on the project. The financial risk is much greater for the investor so he/she will rightly want more of the profits, since they are bearing all the risk of financial loss (as the mudarib’s contribution is labour only). However, in other cases, the labour might be very specialist or difficult, and so a more even split of profits is justified. This is simply a matter for the parties to agree – but it should definitely be agreed and recorded in a contract before moving on with the deal in order to provide certainty and clarity, and to prevent future disputes.
Let’s look at an example of how the mudarabah structure might work in reality.
Junaid has recently sold some assets and rejigged his finances and now has £500,000 in the bank. He is looking for a sharia-compliant investment. A friend mentions that his son, Muhammad, is looking to start an ice cream shop in the busy town centre but cannot get access to funding due to the interest involved from standard business loans making it impermissible.
Junaid then does some due diligence on the proposed site, sees an ice cream shop as a viable business, and speaks to his friend’s son. They agree the following:
- Junaid to put £500,000 into the project
- Muhammad to be responsible for arranging builders to refurbish the property
- Muhammad to be responsible for working at the ice cream shop
- Muhammad to take 50% of profits and Junaid to take 50% of profits
You can see how this mudarabah structure is really healthy – both parties benefit from the deal, and on a wider level, neither party had to resort to interest-based financing. This sort of structure is a great way to marry up people with money to people with ideas and energy.
The theory, as you can see, is fairly straightforward. However, practically, there are some extremely detailed Shariah guidelines as to how precisely a mudarabah agreement must be formalised, how capital and profit ratios must be dealt with, the obligations on both the parties, how one deals with various disagreements, how one handles risk, and how the Shariah deals with modern legal creations such as the limited liability company. Then, as is normal for an an entrepreneurial project, the parties might want a liquidity solution to help them get started as well. These further add complication to the mudarabah structure and require careful Sharia structuring.
It is vital to draw up legal contracts, which would be effective in a court of law in the relevant jurisdiction, which reflect and put into effect the shar’i principles of mudarabah, tailored to your particular venture. This has two main benefits: 1) Both parties will be fully aware of their obligations and rights as it will be written into the contract (since most people do not have detailed, technical understanding of mudarabah structures and therefore do not fully understand the extent of their roles), and 2) It ensures a truly sharia-compliant solution.
It is also possible to tailor the mudarabah structure to introduce certain conditions on either party’s side. Again, it is crucial here to take into consideration both the legal (law of the land) considerations, and the shar’i considerations.