Islamic finance has an array of structures to deal with various commercial needs, but adhering to Islamic law (Shariah) principles. One commonly used structure is Musharakah.
What is Musharakah?
Musharakah is similar to a joint venture. It allows equity participation by the parties, who finance a project in agreed proportions in either cash or kind. They each agree to accept a percentage of the returns and risk, sharing the profit and loss of a project in proportion to their investment. A participant providing management or technical expertise may also charge a fee.
The Diminishing Musharakah contract is an attractive structure for acquisition finance. It is based on the principle of co-ownership and therefore there is risk-sharing.
The structure can be described using the example of property finance. The acquisition of a property is financed by the financier (for example a bank) and the client purchasing the property as co-owners. Their respective ownership shares reflect their respective contributions, the financier usually providing the majority of the capital required, and the client the balance.
The client undertakes to purchase from the financier portions of the financier’s ownership share at periodic intervals. As the client’s ownership percentage increases, the bank’s percentage decreases (this is why it is called Diminishing Musharakah) until the client acquires all of the financier’s ownership shares.
The financier usually leases its beneficial share in the asset to the client during the time in which the client is buying the financier’s portion of the asset. Rent is payable to the financier, based on its percentage interest in the asset. Therefore, as the financier’s percentage ownership of the asset decreases with each acquisition payment made by the client, the amount of rent decreases proportionally as well. This allows for a varying rate of return to the financier. The rental payments are seen as the financier’s profit.
The structure usually includes a purchase undertaking by the client and a lease agreement. When the client has purchased the financier’s entire portion of the asset, title is transferred to the client and the lease is terminated.
The Diminishing Musharakah structure has also been used in construction finance. Typically the financier provides the majority of the finance while the client provides some capital and contributes assets or skills relating to performance of the construction project. A management agreement and lease agreement are concluded. The client manages the project and leases the financier’s share in the assets, and at the same time buys the financier’s percentage of ownership in the assets in terms of the purchase undertaking. After the entire share of the financier’s ownership in the project is purchased, title in the assets is transferred to the client, and the lease is terminated.