Islamic finance: The wealth of Khan

When it comes to servicing the human soul, Islam is now the market leader. According to the Vatican, almost 20% of the world’s population is now Muslim, which makes that faith the most popular in the world for the first time in history. That may be bad news for the Catholic Church, which has a 17.4% spiritual market share. But it’s great news for Asif Khan, founder and CEO of FrontierAlt Investment Management Corp., a Toronto-based company out to dominate the tricky world of Islamic finance.

As a sector, Islamic finance is booming. The U.K. is said to be racing to be the first G8 country to issue government debt as a sukuk, a Shariah-compliant Islamic bond. Dow Jones runs an Islamic index with 70 subsectors. A recent analysis in The Banker magazine, meanwhile, suggests that the global Islamic finance sector grew 30% (to $500.5 billion in assets) last year, with much of that money coming from young clients.

Here in Canada, FrontierAlt was the first to launch a domestic Islamic-based, fully Shariah-compliant fund in November 2006, but it also plans to act as a conduit between the Middle East, which, with oil trading at $100 a barrel, is flush with cash. A recent McKinsey report suggests oil-producing countries have become the world’s biggest exporters of capital, and FrontierAlt hopes to redirect some of those funds into Canada.

The company recently sold 20% of its equity to an Oman-based financial services corporation, which solidifies the link between the two regions, and creates deep potential, its executives believe. FrontierAlt has also embarked on a self-proclaimed mission to be the next great Canadian independent investment house, similar even to a Caldwell or a Dundee Bancorp Inc., and Khan could become not only the go-to guy for those looking for an Islamic-finance alternative, but to anyone seeking to do business with the Middle East.

Can he pull it off? Khan has got friends up and down the Street who want to see him succeed — and the macro forces are lined up nicely. But it’s not going to be easy. FrontierAlt has already drawn fire for its non-secular approach to investing. The Muslim Canadian Congress recently criticized those who promote Islamic finance for carrying out the will of foreign “Islamists” bent on overthrowing western secular traditions. And that has put companies like FrontierAlt in the middle of the larger debate taking place in the West about how best to accommodate conservative Muslim populations.

Can the firm find a way through the naysayers and the nitpickers, profit by the Prophet, and still walk a righteous path? As millions of Muslims say every day, inshallah — or God willing.

Symbolic of FrontierAlt’s rising fortunes is its new head office in the very heart of old Anglo establishment capitalism — a lovely heritage building one block up from Toronto’s former stock exchange and directly across from the new KPMG Canada headquarters now under construction. The new digs, top floor, are decorated in modernist style, all-white, and are a hive of activity.

But when Khan enters a boardroom to greet a visitor, it’s almost a shock to discover that his accent is no more exotic than that of the average Canadian. Canada’s pre-eminent Islamic financier? Turns out he’s from Barrie.

Khan’s father emigrated to the city on the shores of Lake Simcoe, in the early ’70s from the Indian state of Uttar Pradesh, and brought the rest of the family over a couple of years later. “It was a great community to be raised in,” says Khan, 39. “People were helpful to us. We were a minority, but some of my best friends are from those days. It was a very important part of our life in Canada.”

Khan’s father bought a chain of fried-chicken outlets, assuming it would be an easy business to run. But the enterprise went bankrupt, and the Khans faced rough times. “That was a lifelong lesson going through a family crisis like that,” says Khan. “But our family unit stayed strong, and we held together. It was tough going. But today I’m better for it. My work ethic is strong.”

As their children approached university age, Khan’s parents rounded up their two sons and two daughters and moved them to Toronto. His father had a desire to preserve the family’s East Indian heritage, which he worried they were in danger of losing in then-white-bread Barrie. “He wanted us to hold on to some of our culture,” says Khan. “As we grew up, my dad taught us all aspects of religion and life based on Shariah.”

Shariah law is a collection of prescriptions derived from the Qur’an and the Sunna, a group of rulings the Prophet Muhammad passed down during his lifetime, which every Muslim is expected to follow. The code lays down the rules for everything from marriage to diet and is the basis of the law in many Islamic countries.

According to Khan, this code of conduct has guided him in his career as he negotiated his way through the pitfalls of the money industry. “As you grow up in the culture, sometimes you carry some of it and some of it you don’t,” he says. “But you never lose your spirituality and who you are. You can always look in the mirror and understand where you came from.”

Khan studied political science and economics at the University of Toronto, and then hit Bay Street after graduation in 1992 to find a job. He was eager to make his mark, and walked into the old Wood Gundy (now part of CIBC), where he offered to work for free. “I said if I’m no good, don’t pay me, but if you think I’m worth it, we can work out a deal,” Khan says.

The firm ended up putting him through a training program, and Khan began learning how to move on the Street. In 1996, he jumped to Dundee, headed by Ned Goodman, where he absorbed all he could. “I learned a lot from Ned and his sons,” says Khan. “I came to understand entrepreneurs.” But he also realized he wanted his own business. And he started thinking about the possibility of starting up a Shariah-compliant mutual fund.

In the mid-’90s, Islamic finance was unheard of in Canada. The concepts of Shariah law had been applied to banking overseas in more fully Islamic societies but had yet to become mainstream in the way they are now. Today, of course, even the most conservative of the big western banks provide Shariah-compliant products. Here in Canada, the Big Five have all developed Islamic finance products. Even in the United States, household names such as JPMorgan and Citigroup are working the beat. All of which is a bit ironic, considering the origins of Islamic finance.

The idea of a distinctively Islamic financial system was a response to European colonialism in countries such as Egypt, Turkey and Tunisia, according to Mohammad Fadel, an assistant professor at the University of Toronto’s law school. He says traditional European finance in these countries was viewed by the locals as a loss of sovereignty. “The entire Egyptian economy was being reorganized to satisfy the claims of British creditors,” Fadel adds. “That’s not going to gain you a lot of support among Egyptians. And that had an impact on the way people viewed interest-based financial systems.”

Many Muslims believe the Qur’an prohibits charging interest. So they developed a system that attempted to redress the traditional balance of power between debtors and creditors. “It wasn’t a leftist critique,” says Fadel. “They didn’t have a problem with private capital. They just thought that commercial lending was predatory, because they thought it only transferred wealth from workers and entrepreneurs to the bankers.”

What small-business owner, entrepreneur or farmer in Canada hasn’t at some point thought exactly that? In the relatively undeveloped financial sectors of some Islamic countries, trailblazers tried a couple of informal alternatives. Muslim landowners (and some Christian ones, too) across the Middle East experimented in an informal way with various alternatives, including a profit-loss sharing model. But what was eventually settled upon by some Islamic bankers in Egypt, Dubai, and other Gulf states was a system called murabaha, which utilized a cost-plus transaction; it received the blessing of an important fiqh council of the time (a body designated with ruling on religious questions) and was adopted. “You’re a merchant. You need to finance inventory. You go to the bank and say, ‘I need to buy these cars for my lot.’ The bank buys them, then immediately sells them to you. You pay on an instalment basis, and then you sell the cars at a slight markup,” says Fadel. Since, effectively, the merchant is only leasing the cars, and then selling them at a markup, no one is making any profit from the money itself, only through trade of goods, which is fine according to the Qur’an.

This alternative banking system found adherents over the ensuing hundred years, but never really took off in any large way until the oil shocks of the 1970s flooded Middle East banks with cash. “That’s when it began to take on momentum and the first commercial Islamically focused banks were established in the Gulf,” says Fadel.

Today, of course, we’re reliving that era. According to a recent report from the Institute for the Analysis of Global Security, a Washington-based think-tank, $700 billion is now being transferred to the sovereign wealth funds of oil-producing countries annually as a result of the high oil prices, and much of that money will end up in just five Mideast states: Abu Dhabi, Dubai, Qatar, Kuwait and Saudi Arabia.

This new wave of liquidity (enhanced by money repatriated to the Mideast from the U.S. in the wake of 9/11) has fuelled the development of new Islamic-finance products, such as sukuk bonds, which go beyond simple murabaha to allow any type of financing. Sukuks take advantage of the fact that you can’t loan money for interest in Islamic finance, but you can earn rent. To create a sukuk, a bank sets up a special-purpose vehicle (SPV) that owns the asset to be financed. The SPV then enters a lease contract to the parent company, which is owned by the investors (the “bondholders”) who get paid when the parent company is paid through the lease on the asset in the SPV. Like murabaha financing, there is no explicit interest payment, only lease payments, and the sukuk holders remain Shariah compliant.

Islamic finance has also spread at the retail level, and Shariah-based mutual funds are popping up all over the place. Like ethical or Christian-focused funds, tobacco, porn and alcohol are forbidden. But in the Islamic versions, so too are pork or companies with a debt-to-equity ratio of more than one-third, Islamic finance being ever mindful of the place of debt in business life.

It’s for these reasons that Khan found the ideas around Islamic finance appealing. “I didn’t really have a background in the investing part of it, but I saw that it was going to make a big impact globally,” he says. “People are going to be looking for these structures. I looked at our own Muslim population here in Canada, and I saw that it was growing. It’s half a million today, and I thought that there’s a business opportunity here…and a chance to doing something right for the community.”

When Khan moved from Dundee to a company called Nova Bancorp, he began working under Harry Knutson, who gave him the space to develop his idea. “He let me do whatever I wanted, and we launched the first Islamic fund in Canada in 1999,” says Khan. Bancorp later sold the fund, but the decision suggested to Khan that it was time to set up his own shop. Gathering all the talent and capital he could, he opened the doors at FrontierAlt in Toronto in 2003.

Not everyone is pleased with Khan’s progress, however. Back in January, the Muslim Canadian Congress (MCC), a group of liberal-minded Muslims, issued a press release criticizing the Canada Mortgage and Housing Corporation (CMHC) for tendering a contract for a research project to determine the role that Shariah-compliant mortgages could play in Canada. Apparently the CMHC wanted to know if there were people staying out of the housing market because they couldn’t find such home financing. To answer that question, they offered $100,000 for a study.

The MCC criticized the tender, suggesting Islamic finance is nothing more than a way for financial services firms to fleece conservative Muslims. The release went on to centre out mutual fund companies (read: the likes of FrontierAlt) that have hired advisers to go into mosques and push their products. “[Islamic Finance] is an attempt by Islamists, with backing from Middle Eastern financial institutions and their Western partners, to scare Muslim Canadians into believing that they should pay more to the banks and demand less in return as an act of religiosity,” read the release.

Khan doesn’t deny the company has been hawking its products in mosques. “The advisers we found were successful were the ones who marketed the product in the community,” he says. Unlike Christianity, which discourages money-changers in the temples, the mosque is considered the centre of the community, and all kinds of business thrives there. In Mississauga, Ont., the Islamic Society of North America runs a mortgage pool from its mosque, along with a bookstore and travel agency.

But the MCC critique also slammed Islamic-focused funds for being more expensive than their traditional counterparts. And in that, there is some truth. The extra paperwork involved in these vehicles adds an extra layer of costs (as is the case for Christian or so-called ethical funds); the Oasis funds offered by FrontierAlt have an MER of 2.35%. But if there is a real criticism of Islamic finance, it’s one that Fadel makes. He points out that sukuks sometimes do not share in downside risk, as was the original intention of Islamic finance. “If I own a sukuk, and the asset doesn’t make any money, and the parent is leasing but losing money, the SPV [the bank] still gets paid,” says Fadel.

An even more devastating criticism is the idea, also pointed out by Fadel, that the values applied to sukuks are typically priced according to prevailing interest rates. That is, although the bonds are structured as a lease, the value of that lease is derived at current rates. So the widely held belief that there is no interest involved (and that banks shoulder more downside risk), is not as crystal clear as many think, and for that reason Fadel suggests current Islamic finance products are often only cosmetic. “Islamic finance started off as a critique of banking as a redistributive transaction that makes the rich richer and the poor poorer,” he says. “But, in practice, what we see is that the economics of their transactions are more or less the same as conventional banks. From my perspective, it’s a more expensive way to do conventional banking. And so instead of Islamic banking being a radical alternative to conventional banking, it’s a more expensive version of the same product.”

It’s a tough argument to refute. Even so, Khan argues that what his company is doing has merit. “Some of these people wouldn’t be banking any other way,” he says. And in that he, too, has a point. Conservative immigrants will often put all of their life savings into, say, a small business (which leaves an investor dangerously undiversified) or simply under the mattress, which sees the value of the nest egg decline as inflation takes its toll. Providing an option that avoids explicit interest and relies instead on lease payments is an alternative for those who worry about such things. “That’s important,” says Khan.

As for the notion, alluded to in the MCC release, that those who push Islamic-finance products are Islamists, that seems a bit harsh. The fact that FrontierAlt has focused on selling its product through an adviser channel is textbook Canadian mutual-fund distribution. Khan himself comes off in person as what he is; a guy who grew up in Ontario, went to U of T, now works on Bay Street, and happens to be Muslim. Islamist is the last word you would use to describe him. Hot-shot up-and-comer is more apt.

The idea that there are shadowy Mideast backers trying to worm their way into Canada also is a bit of a stretch. There are certainly new fears about the rise of sovereign wealth funds. According to the Institute for the Analysis of Global Security, at the end of 2007 these funds had some $3 trillion in assets, but that will balloon within a decade to $15 trillion, an amount roughly equal to projected American GDP. And that has created worry that the West is about to be overrun by state-controlled funds from countries not friendly to it. But on a visit to Toronto, Akbar Habib, the sharply dressed CEO of Onic (the Oman-based company that has taken a 20% stake in FrontierAlt), came off as a businessman here to do just that: business. And for Canadians who choose to engage, there could be vast opportunity. “The last generation of petrodollars went into U.S. markets, but the new money is looking for new markets,” Habib said in a recent interview in FrontierAlt’s boardroom. “There are huge surpluses in Dubai that need to be invested, and people also want to go places they feel welcome.”

There is a fear among many Mideast investors that their money isn’t as safe as it once was in the U.S., according to Habib and Khan. But investors from the region still want to diversify into North America, and this could be good news for Canada. “With high oil prices, we’re going to have another bumper year,” says Habib. “But if you are in the U.S., you’re down 30%.”

FrontierAlt, with its direct relationship with a Mideast organization, seems well positioned to take advantage of the new wave of petrodollars. “Gulf markets have priced themselves at $22 a barrel. Anything after that goes to the bank,” he says. “So they’ve been accumulating immense wealth, and they’ll be deploying that around the world through M&A activity, and if they come to Canada and look at Canada to invest here, FrontierAlt is in the best position to be there. We can facilitate that through Shariah-compliant funds. It’s our entree into the market.”

The company’s Oasis Canada fund, which invests in Canadian corporations, is open to any investor, and is structured to be Shariah compliant, will be an attractive buy for devout Mideast money managers looking for a way to diversify their funds. (Like other funds, Oasis took a hit in 2007, with an annual rate of return of -10.44%.) There are also plans to help Gulf companies get listings here in Canada and to provide back-office data services to financial service firms in the Mideast.

FrontierAlt currently has $220 million in assets under management. “We’d like to be at $3 billion to $5 billion over the next five years or so,” says Khan. “We think 50% of our revenues will come from outside of Canada in three years. The plan is to be the conduit both ways. We’re about to bridge the gap between Canada and the Mideast.” Not bad for a Muslim from Barrie, who just happens to be the new face of Bay Street.