Mar 27, 2016

In reference to our Focus of the week in May 2015, where we focused on structured products, it was in the investors’ best interest to discuss the topic again considering the recent poor performance of the traditional investments (equities and fixed income, where we are neutral on their performance). This has led to investors seeking investment opportunities in the alternative asset classes such as structured products, which deliver above average returns over the long term.

Having discussed our view on equities and fixed income investments last week, we will now delve into alternative investments, starting with structured products: we will describe what they are, how the products are able to achieve higher returns, discuss the benefits and challenges of structured products, and give an investable example.

Structured products are investment solutions that are packaged by investment professionals to enable an investor access a return, supported by the performance of an underlying investment, in a form that meets an investor’s need, which would not be met from the standardized financial products broadly available in the market. Structured products tend to have the following characteristics:

1. They involve adding layers or features, the so called “structuring”, to traditional products such as stocks, bonds and bank deposits, as well as alternative products like real estate and private equity, the so called “underlying investment” so that the layers or features converts the underlying into a product that meets the risk appetite of the investor,
2. They generally deliver higher returns than comparable traditional investments,
3. The most popular structured products tend to have principal protection, coupled with an above average yield return, and,
4. They are generally traded in the private markets to qualified or sophisticated investors through alternative investment managers such as private equity managers.

Examples of structured products include structured notes, structured deposit placements, convertible bonds, equity linked notes and cash management solutions, “CMS”.

Structured products tend to offer higher returns because the alternative investment manager, based on their understanding of a riskier and more volatile underlying asset, repackages the asset into a form that an investor is accustomed to but at a higher return than similar alternatives, and the manager enjoys the difference between what is offered to the investor and the actual return of the underlying asset. For example, an investor seeking yield with a one-year investment horizon would get a better return in a CMS product compared to a bank or a money market product:

Locally, private equity firms have resorted to the development of structured products as a source of raising funds for financing high return projects in private equity and real estate and distribute them through private offers, as defined in the capital markets regulatory framework. Examples of such products offered locally include private commercial paper, real estate backed Medium Term Notes (MTN’s) that enable real estate developers to access affordable funds for their projects, and the Cash Management Solutions that take advantage of economies of scale and get better returns for High Net Worth Investors. Specific local examples of successful structured funding through private markets include:

1. Nakumatt’s private commercial paper programme has been an important and significant source of funding the company’s growth even as it has delivered above average return for the investors. With an estimate of over Kshs. 6 bn programme, this demonstrates the potential depths of capital markets in Kenya, we don’t think Nakumatt would have managed the kind of growth that it has managed without access to structured products
2. Centum’s Equity Linked Note (“ELN”) placement to investors was done in a relatively short period of time to raise capital in a timeframe that would not have been possible with a registered offering. ARM has also issued ELNs to investors.
3. Cooperative societies, anchored under the Co-operative Societies Act, have also participated in structured products - Safaricom Investments Cooperative issued a real estate backed MTN yielding 21% for 18-month duration to finance their Ngong Ololua Villas
4. Cytonn Real Estate, our development affiliate, has successfully issues billions of shillings of structured notes, mainly to global institutional investors, to fund developments. The amount of money raised and the speed could not have been possible through mainstream public markets
5. The various privately offered Cash Management Solutions, CMS, structured by various investment houses

The above examples demonstrate that the market for structured products is significant, is gaining broad acceptance and is critical to funding growth.

The attractiveness of structured products to investors is due to a number of reasons namely,

1. Potential for Principal Protection: Structured products are designed to secure the principal of the investor, unlike traditional investments like equities, which may reduce the investor’s principal. Structured products are backed by an underlying asset, which doesn’t negatively affect the principal, such as fixed deposits and real estate, and the structuring manager typically holds the risk incase the underlying asset underperforms,
2. Enhanced Returns: The alternative products manager, given their skills and experience, is able to take an underlying riskier asset, such as real estate, structure it into a yield product, offer a higher return to the investor that is greater than other yield products such as fixed deposits or money market funds,
3. Reduced Volatility: Structured products are usually backed by alternative assets, such as real estate and private equity, which are not subject to market volatility, which in turn reduces volatility over the period of investment, with most structured products offering fixed rates of return to their investors,
4. Inflation Hedge: Structured products have consistently generated returns above inflation rate, ensuring investors are earning a “real return” and increasing the purchasing power of the investor,
5. Diversification: They enable the investors to diversify their portfolio away from traditional assets, which reduces investment risk, and,
6. Enhanced Self Regulation and Protection: Given that the participants in private markets and structured products tend to be more sophisticated and discerning, the due diligence, evaluation and analysis of products tends to be more rigorous.

Structured products are not just critical for investors for the attractiveness discussed above, they are also critical to capital markets development and the economy for several reasons;

1. Attracting local capital seeking high yielding investments: Since they have high risk-adjusted returns, they provide an alternative to investors who have a high-risk appetite for higher returns than they would otherwise get in public markets. Local investors previously had to go offshore for attractive opportunities such as structured notes, but with the recent development of structured products in Kenya, local investors have been able to find attractive investment opportunities,
2. Increase Foreign investments into the country: Structured products have also opened up the Kenyan market to global institutional investors seeking above average returns,
3. Capital market and private markets deepening: Over half of the Kenyan economy is not in the listed markets, which account for only 49% of the economy. The balance of the markets is in the private markets. An active private market, fueled by structured financing, is crucial to the accessing of funding by the private economy,
4. Product development and innovation: The complexity, speed and innovation that accompany structured products helps with product development, enhancement and pricing in the public markets since both markets are complementary,
5. Growth of the capital intensive sectors e.g. real estate. Most of the major real estate developments in the country currently are being funded, in some part, by structured products to sophisticated investors, as a form of fund raising for the various projects. This has in turn led to creation of jobs and improving the living standards of people as well as growing the economy in general. In fact, various banks have recently made a decision to reduce or simply stop funding real estate developments. Without structured products, the already under-financed real estate sector would face further financing challenges

However, like any other initiative, structured products face various challenges:

1. They tend to be complex, opaque and hard to value or even understand. This then limits their growth,
2. Continuous education of potential investors to understand the products and returns prospects of the product and how they fit into their portfolios,
3. The urge to bring the industry under the frameworks of public markets can be tempting, however, this would end up driving away private market capital that is not seeking to play in the widely accessible and generic returns of the public markets

In conclusion, there is significant room for growth of the structured products markets and they shall significantly contribute to the deepening of the capital markets as well as the growth of the economy. We cannot achieve our goal of being a financial services hub without active and vibrant structured products and private markets activity, which are crucial to financing a growing economy and complementary to mainstream bank debt financing.

-------------------------
Disclaimer: The views expressed in this publication, are those of the writers where particulars are not warranted- as the facts may change from time to time. This publication is meant for general information only, and is not a warranty, representation or solicitation for any product that may be on offer. Readers are thereby advised in all circumstances, to seek the advice of an independent financial advisor to advise them of the suitability of any financial product for their investment purposes.