Do PLS Financing Methods Solve Asymmetric Information?

Abstract:     
Discussion of Islamic private equity PE financing modes rarely provide detailed analytical insights into their properties: there is no rigorous analysis of their features. The current paper analyzes how Profit Loss Sharing (PLS) financing methods solve asymmetric information problem. We focus on Mudaraba and Musharaka financing schemes and consider an agency models with two agents.

The model shows some interesting features of PLS financing modes. First, in Mudarabah financing, the Islamic PE fund is not actively involved in the project and the project success depends on the entrepreneur's effort. We show that Mudarabah financing provide powerful incentives to the entrepreneur which solves asymmetric information. In Musharakah financing, the project is jointly financed by the two parties and both of them provide non-contractible efforts. Our results provide evidence that Musharaka financing cannot solve moral hazard problem.

Number of Pages in PDF File: 10

Keywords: Islamic Private equity, incentives, financial capital structure

JEL Classification: G23, G24

working papers series