Alternative funding for cash-starved UK firms

Islamic finance could help smaller UK companies bridge the high-street funding gap, as Christian Doherty discovers


Raising finance has become a struggle for British businesses in recent years as the financial crisis sapped enthusiasm among high-street lenders. Burned by defaults, the housing slump and the need to rebuild balance sheets, traditional banks have tightened lending criteria to such an extent it can seem they only lend to the biggest and safest bets.

It is little wonder that against this backdrop, alternative finance sources have emerged. While options from crowdfunding platforms to retail bonds have gained in popularity among small and medium-sized enterprises (SMEs) on the hunt for financing, there is one source of funding that remains relatively untapped – Islamic finance.

London is no stranger to Middle-East oil dollars. Qatar, in particular, has been aggressively putting its capital to work with high-profile investments, such as its 20 per cent stake in London Heathrow operator BAA. But Sharia-compliant financing for UK SMEs has taken a more circuitous route.

“It’s true that there has been a large amount of the money coming in from the Middle East,” says Massoud Janekeh, director, head of Islamic Capital Markets at Bank of London and the Middle East (BLME). “But that is mainly being invested in real estate, especially in London. But it has also been invested in Islamic banking in the UK, in particular BLME, where we have a mandate to serve the mid-caps.”

Trade finance is a perfect opportunity for Islamic banks to bring the real economy closer to the financial economy and to benefit UK firms

Mid-market investment has so far taken the form of Islamic investment funds, which follow a Western investment model, albeit with a Sharia element, says Tarek El Diwany, a partner at London-based Zest Advisory.

“A small amount of Islamic finance does involve the investor taking a risk on the profitability of the client, but that’s a tiny amount of the total,” he says. “That little niche is the Islamic funds business, which will invest in company shares, and those funds are in the low hundreds, with maybe 50 registered in Western jurisdictions. Some of those invest in equities of businesses traded on Western stock exchanges.”

In order to access that capital, non-Muslim companies would need to become Sharia-compliant, a process that involves rigorous legal work as well as engaging a religious scholar. It’s a costly business and size matters. “You need to be looking at raising a significant amount,” Mr El Diwany says.

“Given the cost of the legal fees and the Sharia advice and so on, there’s no point doing all that for a £1-million deal. A £50-million real-estate financing? Yes, absolutely, there will be an audience, but otherwise forget it.”

Part of the challenge for UK businesses is understanding the intricacies of a Sharia-compliant document that differs from the standard documentation that has been in the conventional system for decades, says Mr Janekeh.

Without standardised documents, legal costs can pile up. “The majority of clients will use lawyers that aren’t used to this, so the cost can escalate,” he says. “So typically it is more expensive than conventional finance and that is a disadvantage, and we have to bear the cost of that.”

Despite these barriers, there are potential avenues for Islamic-finance providers to work with UK SMEs. Working capital finance, in the form of commercial, asset or trade finance, where banks play the role of intermediary in a transaction, is actually very close to the Sharia model. This may provide a ready-made route of financing smaller UK companies, says Cordoba Capital’s Harris Irfan, a seasoned Islamic finance professional.

“Trade finance is a perfect opportunity for Islamic banks to bring the real economy closer to the financial economy and to benefit UK firms,” he says. “It fits neatly into the Sharia system because, rather than providing a loan and charging interest on it, the bank effectively buys the asset and then sells it to an end-buyer, with the mark-up being the profit. And that’s an ethical deal – it’s a solid asset being sold.”

Using that logic, Islamic banks could begin to offer a whole range of financing tools that would comfortably comply with Sharia law. Invoice discounting, asset or inventory finance and other working capital products now form part of the funding mix for a growing number of UK SMEs, and Mr Irfan believes this type of finance, which offers a fixed return for the bank and cash-flow solutions for companies, can deliver real benefits to both banks and clients.

“We’re looking at helping businesses finance their activities and it’s easier because they wouldn’t need to be Sharia-compliant since the bank isn’t buying into the business, but is developing a trading relationship, and making a profit that way,” he says.

Mr Irfan explains that, given the goods are tangible and ready to be traded, there is no due diligence needed. Rather than a bank financing the business itself, there is a buying and selling of a commodity.  “For banks with maturity mismatches on their balance sheets, trade finance’s short-dated nature actually helps them manage the liquidity on their balance sheet,” he adds.

Zest’s Mr El Diwany agrees that commercial finance is a good way for Islamic banks to work with UK SMEs. “The two go hand in hand,” he says. “They fit well together, albeit a little bit clunky as the bank has to intermediate the trade but, because they don’t charge interest, they can make a profit on the trade.”

The challenge now, however, is to bridge the gap that still exists between bank and customer. Mr Irfan says he’d like to see Islamic banks partnering with established UK lenders to deliver this type of service to businesses – Muslim and non-Muslim alike – in need of finance. Whether that happens remains to be seen but, for the far-sighted bank, it is a potentially rewarding future revenue stream.