Moral hazard in Islamic profit–loss sharing contracts and private equity

The chapter presents a discussion of the financial literature on Islamic private equity (PE) financing modes under moral hazard. We focus on Mudarabah and Musharakah financing methods based on a contractual approach and analyze how and when profit and loss sharing (PLS) financing methods can solve asymmetric information problems under moral hazard relying on agency models. The models show some interesting results. First, Mudarabah financing provides powerful incentive schemes to the entrepreneur. As the Islamic PE fund is not actively involved in the project and the project success depends on the entrepreneur’s effort, it leads to the first best solution. Second, Musharakah financing cannot solve the moral hazard problem. One explanation could be the fact that the project is jointly funded by the two parties and that both of them provide non-contractible efforts. Accordingly, they have to concede a share of their revenue to increase the effort incentive of the other party, which diminishes their own incentive to provide effort.