Apr 11, 2021
In December 2017, as part of the Big Four agenda, President Uhuru Kenyatta announced provision of Housing as one of the key pillars of the big four agenda. The specific target was provision of 500,000 houses across all the 47 counties by 2022. However, three years later the goal is far from being achieved. It is our view that the main reason why housing will remain a challenge is lack of capital for real estate, hence the focus on Loan Funds in Kenya, which can help with improving the funding crunch in our markets.
In the Capital Markets Authority Soundness Report Q4’2020, the regulator maintained that as part of the post-Covid recovery period the capital markets remained a suitable option for capital raising initiatives. The report also highlighted another publication by the African Housing Finance Year book 2020 which stated that the current construction finance by the capital markets stands at 5.0% with the banking sector taking up 95.0% of the rest. It is our view that to jump start development financing, we need to improve our loan markets, hence our focus on demystifying what Loan Funds are, the various types and how Loan Funds work so as investors can understand the need for having them in the market.
This week we focus on the Loan Funds investments in the Kenyan market, where we shall discuss the following:
Section I: Introduction
Loan funds can be defined as specialized investment vehicles that are formed by fund managers or investment firms with the intention to borrow from investors and allocate the funds into deserving asset classes that will in turn generate returns for the investors. Depending on their particular investment strategy, loan funds can be classified as loan originating funds which grant and restructure loans by prolonging duration and deferral of payments or participating funds which are allowed to partially or fully restructure existing loans from banks and other lending institutions. Loan funds generally provide higher returns than instruments in other asset classes as shown in the graph below which considers a 1-year return:
Some of the Loan Funds Instruments available in the local Kenyan market are stated below but shall be discussed in details later. They include:
Section II: The role loan funds can play in the Kenyan economy
As mentioned above, in well-functioning markets, bank credit makes up 40.0% of total credit with the balance of 60.0% coming from Capital Markets according to the world bank, however, Kenya relies on banks for 95.0% of credit with only 5.0% coming from capital markets, making it difficult for business such as developers to access credit.
Loan funds are crucial for several reasons:
Section III: Background and overview of Loan Funds in Kenya
The Loan Funds market is mostly comprised of unregulated investment vehicles set up as Limited Liability Partnerships (LLPs) and commercial paper vehicles, though there is emergence of some regulated loan funds. The attractiveness of Loan Fund products to investors is due to a number of reasons namely:
Some of the Loan Funds investment products in the Kenyan market include Privately Offered Structured Products, Regulated High Yield Funds, Medium Term Notes, and Commercial Paper.
a. Privately Offered structured products
Structured Products as previously covered in our Cytonn Weekly #43/2017 and Cytonn Weekly #19/2015 are defined as highly customized / tailor made investment product that is packaged by investment professionals to enable the investor access returns or meet investment objectives that are not accessible in the traditional / public / conventional markets such as stocks, bonds and bank deposits. Structured Products are considered as a subset of Alternative Investments. The process of structuring starts by traditional products such as equities, bonds and bank deposits, either alone or in combination with a non-traditional product, such as real estate, and creating cash flows and returns that are supported by the underlying products, but whose features are different from the underlying product because of the structuring that is done.
Here is a very simplified example of two scenarios of how a Traditional / Conventional Transaction can be structured to become a Structured Transaction:
Traditional / Conventional Transaction Scenario: A saver with money takes it to the bank and gets little to no return on their deposit. The bank in turn lends the money to, say, a developer and charges market rate cost of borrowing. The bank enjoys the difference between the cost of the deposit paid to saver and the yield on loan received from the developer. This is illustrated below:
A Structured Transaction Scenario: In the structured scenario, the facts remain essential the same, except that the intermediary is not a bank but an investment vehicle; the saver with money takes it to an investment professional, through an Investment Vehicle, who gives the money directly to the developer. The developer will still pay the usual cost of borrowing, but instead of paying it to the bank, it will be paid to the Investment Vehicle, which this will pass the returns to the saver. By structuring out the bank, the saver has been able to increase the returns from the typical rate of return given on deposits, to the typical rate of borrowing paid by developers. This is illustrated below:
The difference between Traditional Transaction and the Structured Transaction is that the borrower has to come up with a private Investment Vehicle to be able to transact directly, by structuring out the bank. For the party with money, they get a much higher return, and for the party needing the money, the developer, they are able transact very quickly and move faster than other developers relying only on conventional bank funding; that is the key essence of a Structured Product Transaction: using highly customized features, it brings two parties through innovative features and delivers to them superior results than they would otherwise not get in conventional channels.
The best example of structured products in Kenya is the Cytonn High Yield Solution (CHYS) and the Cytonn Project Notes (CPN) which are privately offered investment solutions offered to pre-qualified high net worth investors. The two solutions involve structuring out the bank and borrowing directly from investors for purposes of pursuing investment grade Real Estate developments with returns of 18.0%-20.0% p.a. for a fixed period of 1- 3 years.
b. Regulated High Yield Funds
The Regulated High Yield Funds mostly comprise of Special Collective Investments Schemes with a considerable allocation to a specific underlying asset class. They operate like the conventional Unit Trusts where the funds are managed by a licensed Fund manager who has the expertise on where to invest as well as doing the administrative role of keeping records of unit holders. Other parties with a key role in ensuring the security of the investors’ funds are; The trustee who ensures that the investment policy statement is followed and the funds are invested as per the regulators guidelines and the Custodian Bank which holds the securities of the fund as well as executing transaction orders from the Fund Manager with the approval of the Trustee.
The target market for these specialized funds is sophisticated High net worth individuals with the ability to meet a certain minimum investment in most cases it will be above Kshs 1,000,000.0, as well as investors who are comfortable with a medium to high risk investments, and in return get a high-income yield and capital preservation. The funds are meant to provide a mixture of liquidity and above market returns with a target return of 13.0 -15.0% p.a. which is around the loan market rates. Thus, the funds are more flexible to withdraw as compared to the structured products with only a lock in period of 3-6 months. The main advantage of registering a special fund as Collective Investment Scheme with CMA, is that investors will enjoy a 15.0% final tax on their returns.
The best example of a regulated High Yield Fund in the Kenyan market is the Cytonn High Yield Fund, CHYF, which is allowed to allocate up to 80.0% of the Portfolio in Real Estate Investment Instruments, which in turn invests in well researched, presold, investment-grade real estate assets in Kenya have consistently demonstrated the ability to deliver higher returns than those from traditionally available assets.
c. Corporate Medium term Notes (MTN) Issuances
Corporate Medium term Notes are medium-term, between 3-7 years, secured debt securities issued by companies with approval from the Capital Markets Authority (CMA) and are priced at a premium to Treasury Bonds. They are normally listed on an exchange. Investors stand to gain from periodic interest payment over the life of the bond or capital gains through trading at the securities exchange. Current corporate bonds in the market are yielding from 8.5% to 13.0% per annum. After the issuer has raised the amount the Notes can then be listed at the NSE and the investors can trade them for capital gains.
MTNs provide a cheaper source of funding to developments as compared to Bank Funding. Over the years there has been corporate bonds issued in the market for the purpose of funding Real estate developments they include:
d. Commercial Papers
These are promissory notes issued by companies as a form of raising short-term debt. These securities can be secured or unsecured and are priced at a premium to the Treasury Bills. They are short-term securities for tenors up to one year and mainly target institutional investors. Investors stand to gain from yields which are derived from the difference between the maturity value and price when issued. Unlike the Loan Funds discussed above which are mainly used to fund Real Estate developments, commercial papers are mostly used to fund the working capital requirements of companies which must not necessarily be in Real Estate. Commercial papers in the market currently yield from 12% to 18% p.a. The issuance of commercial papers involves four main players:
Below is a Summary Table of Loan Funds in Kenya
Loan Fund |
Type of Loan Fund |
Issuer rate |
Cytonn Projects Notes (CPN) |
Structured Products |
19.0% -21.0% |
Cytonn High Yield Solutions (CHYS) |
Structured Products |
15% to 18% |
Cytonn High Yield Fund (CHYF) |
Regulated High Yield Fund |
13.0%-15.0% |
Centum Real Estate bond |
Medium Term Bonds |
12.0% -12.5% |
ASL Credit Short Term Note Program |
Commercial Paper |
10.5% - 12.0% |
KK Security Short Term Note Program |
Commercial Paper |
13.25% |
Car & General Short Term Note Program |
Commercial Paper |
12.0% - 13.0% |
MyCredit Limited Short Term Note Program |
Commercial Paper |
15.0% |
Section IV: Regulatory and Legal Framework
Having now clarified how Loan Funds generate superior returns, the next question tends to be the regulatory framework governing the issuance of such Loan Funds. For a Loan Fund to be issued it must meet the test of being classified as a security as summarized in SEC vs W. J Howey Co where it was decided that securities; (i) are an investment of money, (ii) in a common enterprise, (iii) with profits, (iv) to come solely from the efforts of the manager. As such Loan funds, in Kenya are issued as securities by way of either private or public offerings.
Section V: Challenges facing Loan Funds in Kenya
The existences of the Loan Funds in the Kenyan market is not without challenges, especially given that the most of the products are an innovation and are new to the market. Some of the most notable challenges include:
Section VI: Recommendations on how to resolve them
We therefore recommend the following actions so as to speed up the adoption of Loan Fund instruments in the Kenyan market:
Section VII: Conclusion
In conclusion, a proper adoption and utilization of Loan Funds will help developed and deepen our capital market thus creating a sustainable, low-cost distribution mechanism for multiple financial products and services across the country. We cannot achieve our goal of being a regional financial services hub without an active and vibrant Loan Funds and private markets lending activity, which have shown that they can play a crucial role in financing a growing economy and complementing the mainstream bank debt financing, especially for real estate development. To develop Loan Funds, there is a need to align regulatory frameworks for capital markets with socio-economic policies, such as the President’s Housing Agenda, in order to enhance efficient financial intermediation. A well-developed capital market will encourage the flow of loan funded capital investment into infrastructure and real estate development that will go a long way to help achieve socio-economic development goals.
Disclaimer: The views expressed in this publication are those of the writers where particulars are not warranted. This publication, which is in compliance with Section 2 of the Capital Markets Authority Act Cap 485A, is meant for general information only and is not a warranty, representation, advice or solicitation of any nature. Readers are advised in all circumstances to seek the advice of a registered investment advisor.