The Bahrain-Atlanta connection

The Middle East has long been a region with a surplus of capital. But for the area’s Muslim investors, many sophisticated financial instruments are inaccessible because they violate the statues of Islamic law, broadly known as Sharia, that govern business and finance.

In 1997 the founders of Bahrain-based investment firm Arcapita hoped to tap this pool of capital, looking to put Middle Eastern capital to work on middle market deals, primarily in the US. To do so, they had to learn to structure their deals to comply with Sharia. Arcapita was an early adopter of this type of investing in the private equity space, says Charles Ogburn, executive director and head of the firm’s private equity arm.

“Think of all the innovations around liquidity and risk and the different asset categories that are available to conventional investors in the West,” he says. “Our founders believe that the same choices should be available to Muslims in the Middle East.”

The firm’s investment mandate has since expanded to encompass infrastructure, real estate and venture capital in Europe, the Middle East, India and East Asia. But Sharia compliance is still a cornerstone of the firm’s investment approach.

In practice, this means accepting some restrictions on the types of industries Arcapita invests in. “Vice” industries like alcohol and gambling, as well as media – which can tread thin ice with some of the racier content in films and television shows – are off limits.

Sharia law also forbids interest on loans, which makes using leverage in a deal tricky. Since Sharia does allow the payment of rent, Arcapita structures leverage as a capital lease rather than a traditional loan.

“The bottom line is that it’s okay to lease the assets of a business,” he says. “A lease is okay because it’s linked back to the business assets of a company. Paying rent under a lease arrangement is permissible, and so most of the financing in our deals is structured as a capital lease. So we get the effect of financial leverage, but in a form that’s closely tied to the assets of the acquired business.”

“Investors”, not LPs
Another factor Arcapita had to consider when courting Middle Eastern LPs, many of whom are high net worth individuals or family offices, is that the blind-pool limited partnership isn’t the most popular investment vehicle in the region.

“Like many financial institutions in the Gulf, we have not used a traditional GP-LP structure,” Ogburn says. “The reason for this is that historically the fund model has not been favored in the Middle East, because a fund is essentially a blind pool. Once you’ve made a commitment to the fund, you’re legally bound to fund the capital calls, with no visibility on exactly how the money is being used. And while there are many investors in the Gulf who are comfortable with the fund model, many of them prefer the opportunity to review the deals as they occur and understand the rationale, strategy and attraction of each investment.”

For this reason, Arcapita uses what Ogburn calls a syndication model. The firm invests off its own substantial balance sheet – with total equity of $1.3 billion and total assets of $5.1 billion – and then syndicates economic interests in the deal to its limited partners to replenish capital on the balance sheet. There is a certain amount of underwriting risk inherent in this model, Ogburn says. But Arcapita has a long track record with its hundreds of investors – the firm has completed more than 75 transactions to date. The investors have confidence in Arcapita’s investment decisions, and Arcapita knows what sort of deals are likely to interest the investors, Ogburn says.

Key to Arcapita’s success then is maintaining good relations with all of these investors, who are spread out across the entire Gulf region. Given their number, and the fact that they must be wooed after each deal, this requires a substantial investor relations infrastructure.

“There is an infrastructure required to do this which is different from what a typical firm would have,” Ogburn says. “But on the other hand, we don’t have to stop business every three or four years and go through the process of raising a fund.”

Of course, there are some institutional investors in the region that do have an appetite for traditional fund structures. For this reason Arcapita has recently added a few limited partnership vehicles to its offerings. The firm’s $200 million venture capital fund, launched in 2005, is a traditional blind-pool fund.