Reforms and new trading options are set to transform the bourse

Headlined by two equities boards and liquid options for bonds both in primary and secondary trading, Kenya’s capital markets stand out for their maturity in comparison to most African markets, although other asset classes are in the early stages of development. Advanced instruments such as derivatives for hedging or speculation are not yet available, but market authorities say new products are set for introduction starting in 2014. Taken as a whole, Kenya’s capital markets are the largest and most visible in East Africa and the third-largest in sub-Saharan Africa, after Nigeria and South Africa.

Plans For Change

The Capital Markets Master Plan (2014-23) outlines a growth programme for the short to medium term, while separately the Nairobi Securities Exchange (NSE) has demutualised and is implementing a strategy that includes self-listing, in keeping with a worldwide trend as bourses seek to evolve to suit changing global market conditions. The exchange also announced a new brand in April 2014 and is planning to spend KSh520m ($5.9m) to upgrade its trading platform and other infrastructure.

The master plan contains three main areas for development, and within each of these areas a further three main objectives are included (see analysis). New trading options, such as derivatives for both hedging and speculation, are a key element. Islamic finance, for example, is at an early stage in Kenya but is also slated for further attention: in March 2014 Dubai Islamic Bank announced a plan to open up in Kenya, citing the master plan’s stressing of sharia-compliant options as an important part of the mix.

Gateway To The Region

Nairobi has for decades served as a jumping-off point for the region, which allows the capital markets to serve as a natural gateway to the broader East African market. Multinationals such as General Electric, Bharti Airtel and Coca-Cola currently base regional operations in Kenya’s capital, and large banks servicing the region tend to establish headquarters there. With media reports also indicating a rise in interest by non-Kenyan African companies to list on the NSE, and Nairobi’s emergence in 2013 on the Global Financial Centre Index, the scope for further growth is significant.

The 2007-08 global financial crisis has been an additional source of momentum working for Nairobi. It largely benefitted Africa as a whole, as the continent had little exposure to the complex securities that caused problems elsewhere. Combined with robust headline growth rates, investors sought refuge in strong-performing African markets. Since the crisis, there has been an increase in new indices that track securities in the continent’s frontier and emerging markets, as well as funds that have a mandate to invest in them. For Kenya, as a key entry point into African markets, this has led to a rise in inbound activity, particularly into the larger listings, including blue-chip stocks such as Safaricom, a telecoms operator that went public in June 2008.

Kenya grabbed the attention of global fixed-income investors with a sovereign bond issue in June 2014, raising $2bn, the largest debut for an African country in the sovereign bond market (see analysis).

Size And Scope

The NSE is in its 60th year as a bourse, having opened in 1954. Trading equity goes back further, however, to the 1920s. Then, the café at the Stanley Hotel in downtown Nairobi was the venue for a less formal type of exchange, in which gentleman’s agreements were made on the spot and physical settlement of trades occurred later. Trading now is fully electronic, and in June 2013 the bourse ended a 60-year presence in Nairobi’s central business district in favour of a new facility in the Westlands neighbourhood. The NSE is currently host to 61 equities, 57 government bonds and 28 commercial ones, according to officials at the bourse. Market capitalisation as of early 2014 was $21.52bn, and the goal is to boost the total to $93.72bn by 2023. That would imply an increase in market capitalisation from 50% of GDP currently to 70% of GDP in 2023, based on the projections of the Capital Markets Authority (CMA), market regulator and implementing body of the master plan for the sector. Total public debt stood at KSh2.37trn ($27.02bn) as of August 2014, according to data from the Ministry of Finance as reported by Reuters.

There are two main domestically created indices that track Kenyan stocks. The NSE All Share Index is a market capitalisation-weighted index of all equities, whereas the NSE 20 is a more exclusive measure of larger and more liquid counters. Members of this latter index are based on weighted market performance with factors including market capitalisation and several liquidity measures. The All Share Index rose 44.05% in 2013, while the NSE 20 climbed 19.21%.

Foreign investors have taken on an increased importance in providing liquidity on the NSE. According to data from Standard Investment Bank, in the first two months of fiscal year 2013/14, which began in July 2013, foreign investors accounted for a majority of turnover. Foreign investment has been climbing steadily since bottoming out at 7.8% of total market capitalisation in 2008, in the wake of post-election violence.

SME Focus

In 2013 a junior board was created called the Growth Enterprise Market Segment (GEMS), which currently has just one listed company, Home Afrika, a developer of residential real estate projects and has a target to have 39 by 2023, according to the CMA’s master plan. GEMS is aimed at small and medium-sized enterprises (SMEs) and venture companies, offering them relaxed minimum eligibility conditions for listing to encourage participation. GEMS companies do not require a history of profitability, for example, as listings rules mandate for the main board. They must have been in operation for at least a year, have paid-up capital of KSh10m ($114,000), be a public company registered under the Companies Act, comply with minimum corporate governance conditions for their board of directors, and appoint a nominated advisor (NOMAD).

The NOMAD concept borrows from the system in place at the London Stock Exchange’s junior board, the Alternative Investment Market. NOMADs are financial advisors, typically firms well versed in providing advisory services on the private and public offering of securities and corporate financial restructuring, which guide the listing firm through the process, including developing a listing statement; holding an annual general meeting; and preparing quarterly earnings reports, annual reports and material disclosures as appropriate. The NOMAD is relied upon to take on the regulatory compliance burden for the listing.

The inauguration of the GEMS board was prompted in large part by calls from SMEs, which face challenges in accessing capital in Kenya, as do SMEs in most other African markets. Interest rates remain high for commercial loans, averaging 17.06% in March 2014, according to the Central Bank of Kenya. In creating flexibility for the listing of venture companies, the new segment also looks to support capital raising and ownership diversification in respect to the growing opportunities in the oil, gas and minerals extraction sectors.

Sector Organisation 

Perhaps the most meaningful change at the NSE in 2014 is its demutualisation, a plan that was first floated in 2008. The NSE began the sale of 66m new shares worth KSh9.50 ($0.11) each in July 2014, offering the public a 34% stake in the business, with plans to raise KSh627m ($7.1m) through the initial public offering (IPO). The listing was expected in September 2014. In the second quarter of 2014 the Cabinet Secretary and National Treasury settled uncertainties over the value on allocation criteria by clarifying that the National Treasury and the CMA Investor Compensation Fund will each have a 5% ownership stake. Stockbrokers and investment banks, of which there are 22, will retain the 4% ownership stake, awarded in 2012, while the remaining 2% has been allocated to the NSE Employee Share Ownership Plan, upon the exchange’s self listing.

As a for-profit concern, the bourse is advocating to be able to set its own transaction and listing fees, and its plan includes reducing reliance on these income streams in favour of a more diversified range of opportunities, such as data vending, interest income and other market services. The exchange has recently reduced market access fees for new trading participants to $287,000 with potential to reduce this even further.

CMA 

The CMA is an autonomous organisation that reports to the National Treasury. The authority is a selffinancing agency, generating income via licensing fees, trading levies and processing of public and private issue approvals. Regulatory reform is potentially on the horizon in the form of a proposal to merge several Kenyan financial services regulatory bodies.

Those include the CMA; the Retirement Benefits Authority, which oversees pension funds; the Insurance Regulatory Authority; and the Savings and Credit Cooperatives Regulatory Authority, which oversees deposit-taking SACCOs. It does not include the central bank, which oversees banks, microfinance banks and currency exchange houses. As of March 2014 the National Treasury was reviewing proposals for how to combine the four regulators. The board of the authority remains focused on full implementation of the master plan, despite the planned consolidation.

The master plan advocates for the development of regulatory frameworks for Islamic finance by relevant regulators for capital markets, banking and other financial services. Of Kenya’s population of approximately 44m people, around 10% are Muslims, but in light of the significant growth in assets by Islamic financial institutions in recent years, and the push from Malaysian and Gulf Cooperation Council funds into new markets, sharia-compliant products are increasingly viewed as a way to attract new institutional investors. Government sukuks(Islamic bonds) and asset-based securities from the public and private sector would also provide a new form of financing for long-term illiquid projects, such as infrastructure investments.

A draft framework for Islamic finance was circulated for comments in the first quarter of 2014 and was reviewed by a London-based team of experts at the end of the second quarter. The proposal features a centralised approach similar to that in Malaysia and Oman, in which a sharia board at the national level sets standards for the entire industry, instead of ceding those decisions to individual financial institutions. The draft notes that guidance will be taken from key global standards-setters such as Bahrain’s Accounting and Auditing Organisation for Islamic Financial Institutions and the Kuala Lumpur-based Islamic Financial Services Board. The CMA has approved Genghis Capital, a member of the exchange, to offer a sharia-compliant collective-investment scheme.

Regulatory Reforms

Another possible change serving the goal of becoming a financial centre that is particularly relevant for foreign investors would be the removal of caps on foreign portfolio investment as recommended in the master plan.

As of now the total foreign holdings in any one stock cannot exceed 75% of the total listed shares. The master plan further recognises that caps may be kept in place in exceptional circumstances for companies whose role impacts national priorities, for example in key extractive industries.

A possible future concern for investors is tax law. Increased government revenue is a focus, and Kenya has been encouraged by the IMF to boost tax receipts. Kenya is considering implementing a capital gains tax, which was introduced as a concept in the 2013/14 budget (the country budgets according to a fiscal year that ends each June 30). No specific tax has been announced, and the expectation is that when one comes it will apply to real estate transactions and not profits from share sales. There is no timetable for a capital gains tax applying to securities transactions.

Other regulatory reforms under consideration include a change in how large block trades of shares are conducted. The CMA is reportedly considering a system in which these share sales would be handled directly between brokers, instead of over the NSE’s platform, and then reported to the exchange afterward. The change would allow investors to offload large holdings without suffering from a lack of liquidity in the market or leading to lowball offers, but would be allowed only after the CMA provides more specific definitions for transaction sizes, acceptable levels of deviation from market prices, and time frames for these trades. “Such rules are needed in order to prevent liquidity moving to a dark pool of trading that is not seen by other investors,” according to the CMA master plan.

Equities 

Stock offerings on the NSE bear similar traits to other frontier and emerging markets. The largest company by market share is a telecommunications provider, and the largest and most influential sector is financial services. Of the 60 equity listings there are 11 banks, six insurers and three investment firms.

In fact, Kenyan stocks were the fourth-best performer as a group in 2013, according to the global indices of the US-based index provider MSCI. The MSCI Kenya Index increased 43.58% on the year, fourth-best among country indexes, after Bulgaria, Argentina and the UAE. In 2012 Kenya’s bourse was the top performer, with a 54.16% advance.

The exchange has experienced a handful of delistings in recent years as traded companies have been bought out by privately held acquirers, including AccessKenya, an internet service provider, and car dealer CMC. REA Vipingo is the subject of a takeover effort that may see it delisted in 2014. The company owns farms that grow sisal, a type of agave plant that yields fibre useful for making goods such as twine, paper and textiles. This takeover has been contested by a number of suitors, with the process before the courts for an interpretation of the applicable takeover laws as of June 2014. The year saw just one new listing: Home Afrika, the real estate firm that became the first listing on the GEMS board. Seven Seas Technologies, an information and communication technology provider which had been expected to launch an IPO in 2013, said in April 2014 that it would instead look to list in 2017, after expanding in other African countries.

Peter Mwangi, former CEO of the NSE, said at the African Securities Exchanges Association conference in December 2013 that the exchange will likely see a more fruitful 2014 in terms of IPOs and is predicting five new listings in the period: three on the main board and two on GEMS. The exchange itself counts as one of those five. Local media have also indicated other firms potentially listing in the coming 12 months include Apollo Group, an insurer that announced its intention to list in November 2013, and the Kenyan operation of United Bank for Africa, one of Nigeria’s largest lenders.

Bonds

Debt remains popular among investors, with demand pushing yields for shilling-denominated government debt lower in comparison with the rest of the continent. A study of three-month treasury bills by Genghis Capital found that in sub-Saharan Africa yields are generally between 8% and 13%. The investment bank found Kenyan costs at the lower end of that range, consistently below 10%. In the first two months of 2014 there were three major sales of public debt, at maturities of two, 10 and 15 years. Kenya’s long-term debt has been aided not only by the return of broader macro stability and strong headline performance but also the prospect of income from oil deposits, with commercial production expected to begin as early as 2016.

Kenya issued sovereign debt in dollars in June 2014, which places it among the handful of sub-Saharan countries that have tapped international markets in recent years. The issue is expected to reduce the burden on domestic debt buyers, as there are concerns about the ability of Kenyan private sector capital to absorb more debt, and about banks preferring government debt to lending to the real economy. The debt burden rose past 50% of GDP in the second half of 2013, and was at 57% in August 2014. Although it remains far below levels in OECD countries, and only modestly elevated against a number of other African countries, there is mild concern over the increase in debt: “the level of borrowing has begun threatening unsustainable levels,” Genghis Capital stated in its analysis.

For the long term, as domestic absorption capacity increases, growth in issuers in the domestic bond market appears likely as corporations tap the market, and expansion in the public sector is likely as well because of the country’s devolution process, which was put in place following the last constitutional revision in 2010. Many key government responsibilities have been shifted from the state to 47 recently created counties, but many face significant financing demands for infrastructure and are expected to turn to bond markets in the coming years. In comments to local press, Mwangi also said that there is an ongoing dialogue with country governors about the possibility of them raising capital through bonds at the securities exchange rather than relying fully on the central government for financing.

The capital market master plan also includes developing a dedicated bond trading platform and a market for hybrid bonds. It also proposes to improve the efficiency of both primary and secondary bond markets by establishing primary dealers – securities firms that would be obliged to serve as market makers by stepping in on either side of a trade when there are not sufficient buyers or sellers and by committing to actively take part in primary auctions.

Advanced Instruments

The CMA’s master plan anticipates the introduction of several types of funds, derivatives and other advanced market instruments. First in line for introduction are real estate investment trusts (REITs), of which the first will arrive in 2014. Several applications to establish REITs have been submitted to the CMA for approval already, and five firms have been licensed as REIT managers. Centum Asset Managers and UAP Investments were approved in the role in December 2013 by the CMA, and in April 2014 STANLIB Kenya, Fusion Investment Management and CIC Asset Management were added to the list. Home Afrika and Housing Finance have said they intend to use REITs as a financing vehicle. Kenya will allow both investment REITs and development REITs.

This pipeline of new products will continue with single-stock futures and other types of derivatives that do not require the physical delivery of a commodity at the end of a contract. There will be risk management tools for currency and interest rate exposure and contracts for commodities that do require physically delivery, which would likely include coffee, tea and other such crops (see analysis). “Our warehousing infrastructure needs improvement before we can do commodities derivatives,” Terry Adembesa, the NSE’s manager for product development, told OBG. “We are looking to start with contracts that can be settled with cash rather than things requiring physical delivery.”

Private Equity

Private equity activity in Africa as a whole remains fairly muted in comparison to markets like the UK and US, but it is growing rapidly as investors seek opportunities in high-growth markets. Among the largest communities of private equity funds on the continent are South Africa, Egypt, Nigeria and Kenya, which has become a staging ground for East Africa-focused funds, as well as impact investors.

One of the lingering questions about the viability of private equity in Africa has been the ability of investors to exit an investment when the time comes, although a spate of recent successful exits are providing templates for future activity. Umeme, the main electricity distribution company in Uganda, is one example. Previously a government-owned electricity distribution company, Umeme was privatised in 2004.

After an ownership change, Actis Capital, the London-based emerging markets private equity investor and a subsidiary of the UK government’s CDC Group, became the sole owner. Actis then sold a 38% stake on the Uganda Stock Exchange in 2012, and it also established a cross-listing on the NSE. “The Umeme IPO proved that an IPO exit is a credible alternative to trade sale in the power infrastructure sector,” according to Fieldstone Private Capital Group, which acted as the transaction advisor.

Regional Integration

The authorities intend to promote regional harmonisation, including the pursuit of identical financial market regulations wherever possible to allow for mutual recognition of products and services within the East African Community (EAC) member states. According to the CMA’s master plan, the benefits of rules and laws that are exactly the same across borders are significantly greater than those that are simply similar in many ways, or close without being identical. The plan cited benefits including lower management, compliance and IT costs for market participants. Each member country (except Burundi) hosts a small bourse, and that may result in a degree of fragmentation that could prevent any of them from achieving the scale and liquidity needed for investment.

The regional model has been instituted elsewhere on the continent, such as with the Bourse Régionale des Valeurs Mobilières in West Africa. The bourse is based in Abidjan, Côte d’Ivoire, and is home to all listings from countries in the West African Economic and Monetary Union. The group pursues a similar regional integration mandate to the EAC’s. The regional scope brings clear benefits to the listed firms which can access a wider range of investors and see higher trading, although the small size of most firms in the region, along with Côte d’Ivoire’s sizable presence among listed companies, constrain expansion – there are just 37 stocks listed, and no new additions since 2010, shortly before Côte d’Ivoire’s post-electoral conflict started.

Based on the size and capacity of EAC exchanges, the NSE appears to be a natural fit for a regional bourse. The NSE is already home to some stocks of companies in the region, and has courted others in East Africa, such as an offering to Ethiopian firms to list, which it extended in March 2014. Kenya is not the only country seeking to develop capital markets and trading facilities. Rwanda has been developing a commodities market, and Tanzania hired South African firm Securities and Trading Technology to upgrade the trading platform of the Dar es Salaam Stock Exchange. Ugandan regulators have approved plans for a new exchange to be run by ALTX Africa Group of Mauritius, which will compete with the Uganda Securities Exchange, where trading is done in a non-electronic format.

Outlook

The year 2014 could prove a pivotal one for the NSE and for Kenya’s capital markets overall. A period of discussion and planning is now poised to end, with the master plan commencing its phased implementation and NSE completing its plan for demutualisation and listing. Investors have appeared supportive of both moves and of Kenya’s prospects in general, as seen by the resilience in demand in the face of terrorism concerns. The government’s sovereign bond sale represented another point to underscore a positive story for capital markets, meaning authorities will enjoy the latitude needed to face any constraints that may emerge as strategies and policies are implemented.