COSO

of exited positions among Kenyan-based private equity funds. Where full exits have been recorded, those exits mostly occurred after 5-7 years. Where partial exits have occurred, those exits have in some instances happened after 9 years. These responses were intriguing, and in the framework of face-to-face interviews revealed interesting explanations on the motivations informing this market trend.

Specific questions were put to the fund managers on interview: D

periods increase transaction costs? Would they facilitate complete exit? Would it improve Questions on tax considerations were not put to the respondents in this context in light of the fact that under Kenyan law, there is no capital gains tax on investment earnings.

Source: Fund Manager Survey 2010

As depicted in chart 5.7 above, 78% of the respondents opined that holding investment positions for more than five years tend to facilitate complete exits, as opposed to investments held for a shorter period of time. 11% of the respondents fel

the motivation for price protection by buyers – which could be interpreted to mean higher net returns upon divestment. These first two perspectives are consistent with the

For a fuller discourse on tax policy and private equity in Kenya, see Ch 7, 265.

Lower exit returns Facilitate complete exit Motivate lower price protecction

Chart 5.7: Effects of Long Hold Periods

e equity funds. Where full exits have been 7 years. Where partial exits have occurred, those exits have in some instances happened after 9 years. These responses were intriguing, and face interviews revealed interesting

fund managers on interview: Do longer hold itate complete exit? Would it improve Questions on tax considerations were not put to the respondents in this context in light of the fact that under Kenyan law, there is no capital gains tax on investment earnings.56

78% of the respondents opined that holding investment positions for more than five years tend to facilitate complete exits, as opposed to investments held for a shorter period of time. 11% of the respondents felt that longer hold which could be interpreted to mean higher net returns upon divestment. These first two perspectives are consistent with the

Motivate lower price

Chart 5.7: Effects of Long Hold Periods

general profile of investment life cycles among respondent fund managers, most of whom keep their investment positions on average between 5-7 years.

Another 11% believe the contrary: that longer investment life cycles actually does harm to risk-adjusted returns on equity, primarily through upping transaction costs and heightening losses accruing from opportunity costs. One of the recently established fund managers opined –

“Investment turnover is important. There is an opportunity cost to holding onto investments too long, regardless of whether the investment is performing well. The way I see it, it is better to exit a position as soon as pre- targeted thresholds have been hit, and move onto new opportunities. You might be earning good from the one in hand, but you do not know the prospects of what you are letting go by holding onto this one.”57

This crop of fund managers in the Kenyan market favour a divestment strategy of 2-5 years. It was notable that all of those who held this view started operations as fund managers in Kenya after the year 2005 – as chart 5.1 illustrated. Several of them were in fact in the fundraising stage for their first funds, and keen to break apart from the investment model of older funds.58

In contrast, one of the home-grown funds observed –

“The whole purpose of investing is the opportunity to build great companies and turn a neat profit. If the one investment in my hand is yielding good returns and I can see another potentially lucrative opportunity, it is not a question of ‘either’ ‘or’ – our strategy is to hold onto both. If necessary, we

57_{Interview with FM113, Nairobi, Kenya,( August 2009)}

liquidate a small portion of what we hold to facilitate a new acquisition. A good investment for us is good for the long haul, and that is not necessarily opposed to the private equity strategy.”59

Both viewpoints summarise the interesting mix of private equity intermediaries currently operating in Kenya. From the framework of this study, the issue of investment hold periods simply relates to institutional efficiencies around contract management.

5.7 Capital Structuring in Private Equity

Under the Companies Act of 1962, a company in Kenya can raise capital through share placement, either in public equity markets or among private investors. This is the process termed capital structuring, and there are, under the law, several types of possible shares that a company can issue in exchange for capital investments into the company. These include common equity or ordinary voting stock,60redeemable preference shares61and other special share classes including share warrants,62debentures and other securities bearing debt features.63

Issuing shares alters a company’s capital structure, for which special authority is required under the law. Such authority exists under Kenyan company law. Section 63 of the Companies Act of 1962, provides as follows:

“63. A company limited by shares (…), if so authorized by its articles, may alter the conditions of its memorandum as follows (…) it may –

(a) Increase its share capital by new shares of such amount as it thinks expedient;

(b) Consolidate and divide all or any of its share capital into shares of larger amount than its existing shares;

59_{Interview with FM112, Nairobi, Kenya, (August 2009)} 60_{Companies Act 1962 Cap 486, ss 49, 50.}

61_{ibid s 60.} 62_{ibid s 85(1).} 63_{ibid ss 88, 89.}

(c) Convert all or any of its paid-up shares stock, and reconvert that stock into paid-up shares of any denomination;

(d) Subdivide its shares, or any of them, into shares of smaller amount than is fixed by the memorandum, so, however, that in the subdivision the proportion between the amount paid and the amount, if any, unpaid on each reduced share shall be the same as it was in the case of the share from which the reduced share is derived; (…)”

A company can thus raise capital through new share issuance, and in the process it can consolidate or divide all or any of its existing share capital into new share types and categories, including converting common equity into redeemable preference shares or vice versa, and can subdivide existing shares into lower-denominated securities provided the overall effect is not to reduce the company’s share capital. According to section 69 of the Companies Act of 1962, a special resolution by all shareholders, and court approval, is necessary prior to any share capital reduction. Any capital structuring process following a private equity investment into a venture company therefore needs to ensure the company’s share capital is either varied upwards or preserved after the conclusion of the share re- distribution following an investment.

In practice, a condition attached to private equity investments is the requirement for amendments to a venture company’s memorandum and articles of association to entrench necessary powers and commitments in those constitutive instruments so that the investment can be supported under law.64

Section 61 of the Companies Act of 1962 enables companies to ‘issue shares of difference’, that is to say, shares of the same class but carrying different amounts and subject to different times on payment calls. This is an important instrument in the hands of both the venture company and the private equity investor. It allows for the navigation of potentially

64_{For instance, FM 101 and FM104 and FM112, in their Share Subscription and Shareholders Agreement, all}

carry the similarly worded clause: “The Company shall deliver to …… a certified copy of a duly executed shareholders’ resolution and adopting the new Articles and Memorandum of Association and shall carry out amendment of the said Articles and Memorandum of Assocition to recognize the provisions of the Option Agreement relating to….”

difficult financing propositions, enabling the contracting parties to institutionalise their respective positioning in light of the intrinsic characteristics of the investment opportunity.

Section 74 of the Companies Act of 1962 makes provision for variation of share class rights – a powerful tool in the structuring of relationships within a financial contract framework. The provision reads as follows:

“74. (1) If in the case of a company, the share capital of which is divided into different classes of shares, provision is made by the memorandum or articles for authorizing the variation of the rights attached to any class of shares in the company, subject to the consent of any specified proportion of the holders of the issued shares of that class or the sanction of a resolution passed at a separate meeting of the holders of those shares, and in pursuance of the said provision the rights attached to any such class of shares are at any time varied, the holders of not less in the aggregate than fifteen per cent of the issued shares of that class, being persons who did not consent to or vote in favour of the resolution for the variation, may apply to the court to have the variation cancelled, and, where any such application is made, the variation shall not have effect unless and until it is confirmed by the court.”

What the provision means in practice is that where ordinarily holders of preference shares may not be entitled to voting rights, or to regular dividend payments, a company may under section 74 of the Companies Act of 1962 introduce new class rights for this special share category to allow them a form of voting rights, including veto rights, as well as entitle them to periodic dividend payments. Conditions could also be attached to the vesting of shares, whatever class the shares may fall into. These conditions could include performance indicators, and triggers to conversion based on exigencies defined under the financing agreement (also known as anti-dilution rights).65

Section 85 of the Companies Act 1962 empowers companies to issue share warrants – with or without coupons for the payment of future dividends on the shares included in the

65_{Jack S Levin,Structuring Venture Capital, Private Equity and Entrepreneurial TransactionsMartin D}

warrants. Section 88 grants power to issue debentures, and provides for administrative incidentals integral thereto.

Kenyan company law therefore supports a range of corporate securities useful in capital structuring for private equity investments into venture companies. Chart 5.8 below details the capital structuring preferences observed in Kenyan private equity. It is shown that the capital structures in Kenya favour straight common equity and debt (over 60% of fund manager interviewees), followed closely by both convertible and mezzanine shares (over 40% of respondents). Fewer than 30% of the fund managers employ preference shares in their capital structures, and less than 10% employ warrants.

Source: Fund Manager Survey 2010

0% 10% 20% 30% 40% 50% 60% 70% 80% Commons Preferred Convertibles Debt Warrants Mezzanine Regulatory Environment Contracting Conditions Exit Control Tax Advantage Exit Conditions