This article is the latest in a series of articles focused on basic Islamic finance concepts and structures. This article will focus on Mudaraba transactions.
What is Mudaraba?
Mudaraba is a technique in which an investor (known as 'rab al maal') and a manager (known as 'mudareb') establish a form of partnership with a view to undertaking a business or investment activity.
The rab al maal will usually provide capital for the business venture and the mudareb will provide the expertise and management to carry out the business venture.
The mudareb invests the capital on a Shari'ah compliant basis and, consequently, generates a return for itself, which is usually deducted from any profits. Any profits accrued are shared between the two parties on a pre-agreed basis, whilst any loss is borne by the provider(s) of the capital.
How is it structured?
Mudaraba is similar to private equity fund structures that utilise a limited partnership arrangement. Under a Mudaraba, the rab al maal provides capital and invests in the Mudaraba. The mudareb operates as the manager (similar to a general partner) and uses its expertise and know-how to advise on how to invest the capital.
Certain requirements have to be met in order for the Mudaraba to be valid. These include having the capital provided in cash, which needs to be in a clear and known amount, and the mechanism for distributing profit must be clearly known and in pre-agreed percentages.
The mudareb manages the capital in exchange for a fee and is not liable for any losses that may occur (other than negligence). The mudareb returns the capital to the rab al maal less any losses and fees at the end of the contract.
When is Mudaraba most often used?
Mudaraba is very flexible and can be used in a variety of commercial scenarios. Typical examples include fund structures, savings accounts, financing mechanisms, interbank lending and regulatory capital raising. It is most often used by private equity, venture capital and financial institutions.
Security position
Depending on the type of transaction, a performance guarantee may be provided in respect of the mudareb in order to ensure the performance obligations of the mudareb are fulfilled.
For further advice on Islamic finance, please feel free to get in touch.
