Deepak Dave analyses which segments of traditional investment banking - asset management, brokerage, corporate advisory and underwriting - have the greatest potential for Kenya to emulate the global reach of South Africa’s financial institutions.
For all its faults, the Kenyan commercial banking industry provides excellent service - if you are lucky enough to actually be able to afford an account with a bank that acts as a custodian of your funds instead of being a pyramid scheme. The investment banking segment, however, still relies on the expertise and sales reach of local franchises of global players such as Barclays and Standard Chartered. The presence of Stanbic is instructive as South Africa has investment banking capabilities so well developed that those banks compete globally. Kenya has one of the most advanced and diversified financial sectors in the region. Is emulating South Africa a realistic and feasible ambition for Kenya?
Business Segments in Investment Banking
There are four primary business segments that investment banks participate in: Asset management, brokerage, corporate advisory and underwriting. Another revenue generator is proprietary trading, although this is by definition not a customer-facing role. None of the local Kenyan players comprehensively operates across all of these segments, even if the large ones, for example Kestrel and Dyer & Blair, all operate haltingly or at the fringes of each. From the following analysis, I generally exclude the operations of the Big Four, i.e. Barclays, Standard Chartered Bank, Stanbic or Citigroup, since their business strategy is almost never driven by local conditions.
Asset management can be active, e.g. a mutual fund that actively tracks stocks likely to make the highest return, or passive, by providing products that track the value of other investments directly without actually being invested in that security, such as an exchange traded fund (ETF). In Kenya, active investment is best understood by looking at players like AIG, although a number of smaller players are now emerging. This line of business is necessarily conducted through a separate subsidiary to avoid conflicts of interest and is closely regulated to make sure that the asset managers are managing the funds they take in prudently and that they are also punctilious about record keeping and segregation of funds. Returns are made through a management fee of typically 1% to 1.5% of assets under management (AUM).
Passive investing has yet to take off in any noticeable way. An exchange-traded fund (ETF) is a share-like instrument that, for example, tracks the price of say tea. If the daily auction price moved in the market, the ETF unit directly replicates that price movement – and the investor does not have to own tea itself or buy shares in a tea farm. However, the product development is expensive as is the operational infrastructure. Given the low fees, typically around 0.25% of AUM, this product only makes sense in a market where volumes will justify the investment. So far, Kenya’s market is too small to interest anyone, but regionalization will give some impetus to this innovation.
Regrettably, a number of Kenyan brokerages have in the past become active fund managers of monies that clients gave them for totally different purposes and as a consequence, there is still considerable hesitation to entrust money to fund managers. Some quality names have to emerge and the market needs to deepen. The opportunity exists for a brokerage with a strong brand name to pursue this line of business - I strongly suspect that well targeted niche marketing might pay off enormously. There is also a substantial investment required up-front on the product and marketing side and, above all, patience. One of my former employers had entered the Kenyan market with some wild-eyed projections for the growth of their AUM and to the best of my knowledge, three years later they have precisely nil to show due to gross over-investment in unnecessary costs while neglecting to pursue a more targeted marketing strategy.
An area that has grown rapidly in the developed markets, but that is surprisingly less pronounced in Kenya is that of alternative investment management. These include private equity and hedge funds, but also encompass funds dedicated to fine art, antique furniture and musical publishing rights, just to name a few. Ignoring the exotic, I am still surprised by the timidity of local investment banks at the quality end of the market to dip their toe into the management of private equity funds. They have client access, local knowledge, managerial capability and the capability to develop innovative financing solutions. It should be an exceptional revenue generator for a bank willing to go down this road.
Brokerage
Brokerage services are familiar – they are the primary activity of the mass of Kenya’s local firms. They involve at their core the execution of purchase and sale orders on the capital markets in return for a commission. They also include the distribution of securities, for example acting as the primary seller of shares during an IPO. The final activities are those of market making, i.e. the guarantee to act as seller or buyer of last resort for particular securities, and proprietary trading, i.e. speculative activity in the markets for the brokerage’s own account.
Brokerage as an activity serves a number of important functions:
- The flow of information that is the trading activity acts as the most important price-signal in capital markets.
- The efficient re-allocation of capital from one to another activity on a macro-economic basis is channelled through individual transactions.
- The brokerage reduce risk in markets by acting as a responsible custodian of clients’ funds and by acting as a counterparty to transactions, thus reducing settlement risk;
- Finally, the brokerage provides liquidity through channelling funds and its role as a market maker.
Each of these functions is served and enhanced through proprietary trading. They require a well connected payments system, secure custodianship and honesty. The failure of a number of brokerages, occasionally linked to bank failure, in recent years has demonstrated the myriad ways in which our local industry has failed appreciably to accomplish a number of their functions:
The price signal function is in disrepute with allegations of market rigging and insider trading. Re-allocating capital is possible only through proper and timely execution of participants’ decisions on whether to buy distributed new securities at a particular price, hold or sell existing securities, and finally remitting that capital to the owners. A number of failures in recent years show that this function is not being properly completed:
- Insider trading distorts the flow of information and dispels the notion of accurate prices;
- Poor execution delays timely trading, thus failing to serve the customer and undermining the market’s smooth operation as a whole;
- Inefficient administration leads to failures to remit payments to clients and keep records with any accuracy, leading to debacles like the liquidity crunch following the Safaricom IPO.
Reducing risk is achieved through both interfaces: The broker acts as a custodian and executor under trust for the client. By not keeping records, failing to pay the clients their money and not executing trades in a timely fashion as well as outright fraud all tend to reduce capital, not to mention confidence, leading to reduced participation and wealth across the economy.
Liquidity flows through the brokerage through its action in the market on behalf of its clients and through its own trading. Again, efficient and timely handling of the levers that send money and orders through the system all work to enhance both the flow – and ultimately the overall stock - of capital. Acting as a market maker also means the broker increases the attractiveness and safety of the capital markets by essentially guaranteeing a floor price.
Market making is a poorly understood concept in Kenya, though more popular shares do benefit from some support, even if the function is often misused as a punitive means by massive discounts being applied to prices particularly on fixed income securities. This gouging fundamentally fails to send an accurate price signal and fails to generate any confidence in participants, reducing overall participation and closing the market only to those who can withstand liquidity blockages and wait for maturity or an acceptable price.
Most regrettable is that proprietary trading has allegedly been badly skewed by fraud. Often client money is allocated for brokerages’ own use. Not only does this create a conflict of interest, but the breakdown of the agency relationship changes the incentive structure so that almost all the key functions are mis-served.
The sector badly needs reform and the hard-nosed attitude of the CMA under the Cheserem/Kilonzo regime is encouraging. Some of their reforms such as forcing publication of annual results may be meaningless in the case of the execution business, but signal a tougher line. However, there is a long way to go with urgently needed changes:
- There has to be considerably stricter regulation of the back office functions, namely administration, execution, record keeping and customer service. Without these, all the macro-level adjustments to capitalisation and exchange membership will make precisely zero difference;
- Chasing higher capitalisation for its own sake will not achieve much. Firms that stick strictly to execution-only trading, providing they can pay exchange margins, have little need of high capitalisation. Market makers and proprietary traders, however, should show increasing levels of capitalisation;
- Stricter and consistent enforcement of insider trading rules would change the perception of the industry, reduce incentives for fraud, and improve public confidence, not to mention radically alter the efficacy of the price signalling mechanism;
- Finally, the CMA needs to change the rules of the game as far as entry is concerned: More execution-only brokerages allied with stricter rules as outlined above and a few nudges to encourage consolidation would have an enormous impact on capital available, liquidity and efficiency in the industry. Changes to the NSE’s ability to control its membership are desperately needed. The demutualisation of the NSE should create great changes.
Advisory
In developed markets, corporate advisory work has generally been accepted to include:
- Mergers and acquisitions (M&A) advice relating to financing, strategy, tax implications and balance sheet management. This is an area of highly lucrative work and is currently poorly developed in Kenya, although there have been impressive exceptions in the work done by Dyer & Blair and Kestrel in particular.
- Balance sheet advisory, i.e. developing, and actually delivering, an optimal balance sheet structure, taking into account views of stakeholders, tax implications and costs of capital. Again, this is an area that is underdeveloped, even if large corporate have always had access to such advice through various sources. Lower down the chain, the advice is missing or too expensive to deliver.
- Specialised advisory in areas of asset finance, hostile take-overs, tax structuring, mezzanine debt and securitisation are also possible fields ripe for expansion, though underlying conditions are such that these are best marked as possibilities rather than probables.
Overall, the advisory arena is likely to remain accessible only to large corporates capable of drawing together complex teams of advisors in various fields and pay for the work. One would hope to see a broadening of the product range and deeper value chains develop as the market for the services is driven by demand and rarely by supply. I firmly believe patience on the part of a bank willing to innovate and develop the demand for their own services will pay handsome dividends, but cannot detect such a long term strategy among the current players.
Underwriting
Underwriting is the act of assisting a company to issue its securities, be they equity or debt. As part of an advisory work package, an investment bank will often have recommended the issuance of such and will earn a fee for distributing the securities and occasionally guaranteeing a price to the issuer. It is both of these that serve an extremely important function but also face constraints:
The first is that of capital to actually make a guarantee meaningful. The key success factor for the development of investment banks in the developed world has been their access to such capital in their own right, thus enabling them to make the guarantee in the first place. Such covered issuance can make a tremendous difference to the volume of securities in the market as confidence rises. The obvious constraint is the actual stock of capital. Given the size of our economy, it will take banks of substantial means to provide the backing for large IPO and bond issues. Though regrettable, it would leave the door open for consolidation of expertise in various areas under one roof as advisers decide to ally with a balance sheet of sufficient strength. It also gives an entry point to a foreign player willing to change the paradigm, though I have yet to see much interest in anyone taking up this opportunity.
The next constraint is that of distribution. With the greatest enthusiasm, Kenyans have repeatedly proven their penchant for being willing to invest in local firms, but we have to be realistic in that our largest firms will still need to be able to access external capital. Thus securities issuance needs foreign distribution channels. The complexity and cost of setting up offices abroad precludes dramatic expansion for our local firms, but foreign firms should be capable of exploiting their regional and global presence better. Again it would take a local firm of great boldness to explicitly develop a network of partners – which would be cheaper than setting up everywhere and entering into business sharing agreements which are viable means of improving distribution.
Perspectives
With the rapid changes of our external economic environment, there is a clear opportunity to make Nairobi a regional financial centre with a well structured financial industry. The starting point for the industry players is to decide whether they can actually graduate to providing a full set of investment banking services through buying small advisory firms, improving their distribution and increasing their capital. Or would they rather be brokerages or asset managers, both successful avenues for a well run business? As the MD of Kestrel recently pointed out, there is benefit in serving a niche and the players need to decide what level of business they want to build. Better engagement with the CMA - which admittedly has enough on its plate at the moment - to develop a long term sector strategy is important. Government’s participation in respect to the right policies in skills development, taxation and legislative underpinnings will be vital.
There was much expected when Renaissance Capital made its dramatic entrance and they certainly had the reach and capital as well as skills available to become Kenya’s first true investment bank outside of the Big Four – but then things slowed so dramatically. Pulling together new products, successfully managing the daily task of running a business and the multi-layered engagement required to develop Kenya’s first true investment bank will require a rare brand of leadership and I wait to see where this mantle will be taken up.
Deepak Dave is a former Director of Risk Management for Renaissance Capital Africa and previously served as Credit Director for investment Banking at Barclays Africa & Middle East. He has worked for a number of Banks, investment funds and NGOs on foreign investment in the African market.
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