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Personal Finance

Investing through private equity ETF

Barclays Bank of Kenya CEO Jeremy Awori
Barclays Bank of Kenya CEO Jeremy Awori (left), his Nairobi Securities Exchange counterpart Geoffrey Odundo (right) and former National Treasury PS Kamau Thugge during the bank’s launch of the first exchange traded fund (ETF) in the Kenyan market in March 2017. PHOTO | DIANA NGILA 

Investing through the Exchange Traded funds (ETFs) is a simple way to obtain exposure to the capital markets. An ETF is a type of fund that owns assets like stock, commodities, or futures, but has its ownership divided into shares (or units) that trade on stock exchanges. In other words, investors can buy and sell ETFs whenever they want during trading hours at low trading costs.

An ETF can have a wide range of assets that it can be created from. For example, Kenya can issue an ETF that tracks the Brazilian stock market or Japanese stock market, commodities like maize, crude oil or gold. ETFs and unit trusts have similar characteristics with the exception that the latter are non-exchange tradable. Notably, an ETF is not a derivative. An investor who purchases units of an ETF is purchasing a security that is backed by the actual assets specified by the fund’s charter, not by contracts based on those assets. This distinction ensures that ETFs neither act like nor are classified as derivatives.

The first successfully listed ETF was the US SPDR in January 1993. The SPRD tracks the S&P 500 index, an index made up of the largest of the US stocks. It is still today the largest ETF with assets of over $278 billion. Today thousands of ETFs are trading globally and by the end of 2018 the industry consisted of 12,516 listed ETF funds with a combined market capitalisation of close to $25 trillion.

South Africa, Morocco and Kenya are ranked as Africa’s top hotspots for private equity deals. Private equity is basically investing in companies that aren’t listed on any stock exchange. Normally, sizeable private equity funds and high net-worth individuals buy stakes in private companies or own them outright. It’s a relatively opaque market, has no space for retail investors and stakeholder funds is usually tied up for several years. On the positive side, it’s a sector that delivers good returns as well as weathers recessions fairly well.

Kenya is East Africa’s most popular investment destination, according to a recent report published by the PWC and the East Africa Private Equity and Venture Capital Association (EAVCA). Of the $6.4 trillion private equity funds raised globally between 2007 and 2018, $33.1 billion was earmarked for Africa and $3.3 billion for East Africa. Of the total 84 deals reported, an estimated 73 percent is domiciled in Kenya. Sectors such as crowdfunding, healthcare, agricultural commodities, disruptive technology like blockchain, alternative energy, big data and betting have benefited from capital inflows through private e equities. With a median IRR of 20percent, private equity returns are significantly higher than those of local government securities.

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Given the current bear run in the country’s capital market, how can the securities exchange tap into growth of the private equity sector?

Well, Private Equity ETFs (PE-ETFs) provide investors with an opportunity to gain exposure to private equity companies without having to buy stakes in the PE itself. The participating private equities as a reward, will obtain massive visibility without having to conform to the requirements of direct listing.

Noting existing global PE-ETFs track indices constructed using listed PE funds. For Kenya, a solution for index computation could be to pursue the ‘Appraised value-based Indices’ (AVI) methodology. The AVI is an index computed based on cumulative cash flows and net asset values (NAV) of the underlying PE. To ensure transparency and accountability, a reputable financial data vendor with the blessings of EAVCA can be contracted to be collating data from subscribed PE’s and regularly computing the index.

An ETF listed on an exchange that tracks unlisted PE’s seems far-fetched but remember Safaricom made lemonade out of lemons with M-Pesa.

Indeed, the country has a facilitative capital markets regulator. The Capital Markets Authority has been feted as the most innovative capital markets regulator in Africa four years in row (2015-2018). A notable accomplishment for the CMA is its willingness to receive applications for disruptive and innovative solutions through its Regulatory Sandbox framework. This framework allows successful applicants to live test innovative solutions with the capacity to deepen and enhance the efficiency of the capital market.

ETF’s are extremely popular all over the world and there is no reason why they shouldn’t be used as a framework to on-board exotic securities onto an exchange. To compliment the Gold ETF, it is time for additional innovative ETF’s to be listed on the NSE.

The writer is Head Risk Analysis & Stress Testing - Derivatives, CMA.

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