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Private Financing: An Emerging Opportunity

Phenomenal Growth Driven by Structural Changes

The private credit market is experiencing rapid growth. Having risen by over 5x to $1.4 trillion since 2010, private debt has become the fastest growing segment in the credit space. In more recent years, this has been fueled by the combination of more stringent banking regulations, high inflation and rising interest rates.

In pursuit of more stable returns, the option of private debt investing has emerged as a front runner for investors and as long as these macro trends continue, the appeal of private debt is unlikely to slow down any time soon.

Protecting Your Capital from Inflationary Pressures

Investors in high-inflation environments face major challenges in preserving the value of their investments and generating stable real returns. Traditional fixed-income investments, such as bonds or Islamic Sukuks, do have their benefits when inflation and rates are stable. But as rates move higher, given that most of their coupons are fixed, fixed-income securities struggle to keep pace and could actually lose value.

With inflation rates reaching record highs this year, interest rates have, consequently, also moved to their highest levels since 2008 in the UK or 2001 in the US. It is no surprise that private debt investments have become more popular.

Driven by demand for alternative asset classes with low volatility, consistent returns, low correlation against the broader financial market and most importantly to protect capital against inflation, private debt investments offer an attractive alternative.

Private debt investments has the advantage of:

1. Dependable periodic returns

2. A significant return premium over both bank deposits and public fixed income securities

3. Low correlation with public markets, lower price volatility

4. Potential focus on sectors that offer strong growth trends

Trade Finance Funds: Ideal for Shariah-Compliant Investors

Private debt investment is a customizable strategy where investment managers provide companies with non-bank funding with a specifically tailored structure and terms. This is good for Shariah-compliant investors, as its flexibility enables the financing to be structured in a Shariah-compliant way, unlike public debt which is a standard structure. Due to regulatory limitations, these investments are not available through public markets but they are accessible though investment funds managed by specialized asset managers.

Investors adhering to Shariah values can invest in private financing through either trade finance Wakala structures or through equipment leasing vehicles.

Here, we focus on trade finance, which incorporates pre-negotiated trades to finance the processing and shipment of commodities.


So, how does it work (from a Shariah-compliant perspective)?

A commodity trader wishes to purchase a specific commodity and sell it to an interested buyer. To do this, he needs funds to pay for the goods. An investment fund facilitates this by partnering with the trader as an agent, purchasing the goods or commodity and selling it at an agreed profit margin while maintaining a security to safeguard against default and shipping risks.

In this scenario, the targeted return is agreed beforehand and the investment risk is minimized, with the value of the goods themselves providing the security. Due diligence is always carried out and all transactions are monitored using inspections, letters of credit and insurance.  

Shariah-compliant Transaction Structure:

Why is this a preferred solution for Shariah compliant investors?

This form of financing is especially suitable for Shariah-compliant investing because it allows for the actual goods to be traded, as opposed to providing the borrower the funds required against an interest payment. This may include commodities, non-perishable items and Shariah approved natural resources, such as base metals, energy products and soft goods, like corn. All of these are highly liquid, meaning that they can be easily sold on open international markets.

Transactions such as these are typically short-term, allowing profit margins to reset to reflect changes in market conditions. Transactions are also fully secured against the commodity and can be structured so that they’re isolated from the counterparty’s balance sheet and its commitments. With no direct exposure to commodity prices, returns are highly reliable; credit and default risks are also sharply reduced.

From an Islamic finance perspective, by investing into such funds, investors are able to receive consistent monthly income while contributing to the real economy.

In addition, investing in public debt markets as a Shariah-compliant investor is challenging, largely because most Sukuks available for investments are geared towards emerging markets. This hurdle can be overcome within a private financing structure, meaning there’s no need to compromise on economic risks including political, currency and other country specific risks.

Why You Should Consider Adding Trade Finance Funds to Your Portfolio

The inclusion of trade finance funds to an investment portfolio offers several advantages, particularly for those seeking greater certainty in a persistently fragile economic market. At the very least, the presence of a return premium over traditional fixed-income products provides investors with a level of return that counters the downward pressure that exists in high-inflation environments. But with such funds additionally providing liquidity, diversification, and low counterparty credit risk, it makes them an attractive investment option.

With the added benefit of offering strong return premiums along with a predictable risk profile, private financing funds are increasingly gaining traction as suitable for investors seeking stable returns while adhering to Shariah-compliant principles. Volatile traditional equity and fixed income markets have simply not produced adequate returns for many investors in recent periods and we anticipate the flow of funds into alternative asset classes, notably private debt, to continue.


Saad Adada, CFA

Sources: https://www.reuters.com/markets/rates-bonds/private-debt-markets-face-reality-check-companies-grapple-with-rising-rates-2022-12-20/

Important Disclosures

The information contained in this material has not been independently verified and no representation or warranty expressed or implied is made as to, and no reliance should be placed on, the fairness, accuracy, completeness or correctness of this information or opinions contained herein. The views, opinions and estimates expressed herein constitute personal judgments. Any performance data or information shared should not be seen as an indicator or guarantee of future performance. This does not constitute an offer or invitation to purchase or subscribe for any security. Mnaara does not offer any investment advice and nothing in this material constitutes advice or a personal recommendation. Private market investments are only available to qualified investors.

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