Equity Participation Contracts and Investment Some Theoretical and Empirical Results

Abstract

Profit-sharing contzacts have recently captured the attention of academicians,
bankers, and policymakers, particularly those in the Middle East. These contracts
are characterized by risk sharing, an element that forces the contracting parties
(especially the financier) to fund only sound projects. The theoretical analyses
of such contracts have received a major boost from a variety of models, including
Khan (1986) and Haque and Mirakhor (1986), and empirical support from, for
example, Darrat (1988) and Bashir et al. (1991). The bold claim of these models
is that if the interest payment on financial capital were to be replaced by the profit sharing
arrangement, the level of investment would be enhanced instead of
weakened.
A commonly used profit-sharing financial contract is known as musharakah
(equity participation). This contract is a limited partnership in which the
investor(s) and the entrepreneur pool their capital to finance a specific investment
project. Another version of musharukah involves the investor participating in
an existing enterprise by contributing capital. In both cases, the pro-rata
distribution of profit is stated in the contract and losses are shared according
to capital contribution. The investor is eligible to participate in the project’s
management, but may also waive this right.’
A musharakah arrangement can be modeled as a two-person, two-period
partnership game. In this setup, each player‘s utility depends on the other player’s
action through a commonly observed consequence (profit), which is itself a
function of both players’ actions and an exogenous stochastic environment. The
game is thus one of decentralized decision making in which individual optimizers ...