May 17, 2015

In last week’s report, we showcased alternative investments as an attractive asset class. Alternative investments can be classified as investments in real estate, private equity and structured products. While relatively illiquid and more complex than traditional investments (fixed income and equities), alternative investments offer higher and more stable returns over the long-term as illustrated in our last week’s report.

Alternative investments are also referred to as private investments because you cannot access them from the public markets. For example, public / traditional investments are reported on daily in the press. And some like unit trusts are even required by regulation to report their pricing on a daily basis. On the other hand, alternative / private investments can only be accessed by invitation or by inquiry.

Having discussed alternative investments last week, we will now delve deeper into each type of alternative investment, starting with structured products:we will explain what they are, give an investable example, how the products are able to achieve higher returns and explain the key benefits.

Structured products are investment solutions, which are packaged by investment professionals, typically tailor made for the investor, to enable them access pockets of returns in the market that are not readily accessible through traditional investment avenues. They involve adding a layer of structuring to traditional products such as stocks, bonds and bank deposits. Structured products tend to be highly complex, but that complexity is compensated by significantly higher returns relative to traditional product alternatives.

Because of the two essential aspects of structured products, (i) the adding of a structure / feature to an existing product so that (ii) it fits a tailor made / specific need of an investor; structured products are largely privately manufactured, typically by alternative investment managers such as private equity firms, and privately placed to high net-worth investors and institutions through private placements.

This is not to say we cannot have structured products manufactured by traditional managers and / or publicly placed to the investing public. Examples of publicly placed structured products exist, but they are exceedingly rare. For example, Centum’s and ARM’s equity linked notes are structured products. The issuers took a traditional product, a corporate bond, then added a structure, in this case an “equity link”, to develop an equity-linked note, which was issued to the public.

Examples of privately placed structured products include structured notes backed by high yielding assets such as real estate and commercial paper. The most common examplesof privately structured products in Kenya are real estate backed notes and the cash management solution(“CMS”) which could yield anywhere from 12% p.a. to as high as 16% p.a. depending on the underlying alternative asset and the duration of the investment.

Real estate backed structured notes is where a developer gets high net-worth individuals to finance a development for a specific return. For example, a developer looking for Kshs. 100 million development financing can either go to a bank to get development finance at say 16% per annum or the developer can go to 10 high net-worth individuals, each investing Kshs. 10 million to get the same Kshs. 100 million. The developer can offer the individuals a 13% return, better than the individuals would otherwise get in other products, and for the developer the 13% cost would be cheaper than they would otherwise get with a bank finance.

Another growing example of a structured product is CMS, which is a privately placed high-yield product that offers investors higher returns than they would get in other competing investment cash management options.

There are several ways that enable CMS to offer better returns to the investors:

• Consolidation: where client’s funds are aggregated and then invested. The economies of scale lead to the investment manager having a greater bargaining power with financial institutions than if the investor approached a bank themselves;
• Market knowledge:Investment managers are able to understand liquidity needs in the market for banks and corporates, and hence place funds where they would attract the highest risk-adjusted return;
• Quick decision-making:Some investment opportunities require quick decision-making capability, and with investment managers having analysis and dealing capabilities, it is easy to execute faster hence taking advantage of the glaring opportunities;
• Credit analysis: Some privately placed opportunities such as high yielding private commercial paper and real estate mezzanine notes require specialized analytical capability to incorporate into a portfolio.

To enhance the security of this product, the investment managers have to put in place a strong governance structure. Some of the key things that would be important to get right are:

• Ensure a well-diversified portfolio across various investments and deposits in banks which have been analyzed and rated for financial health;
• Having a custodial arrangement where client funds are not directly handled by the investment manager;
• Having a trustee who oversees the performance of duties by all the service providers, including the investment manager;
• Simple but comprehensive incorporation and governance documents that protect all the parties inthe investments, especially the investors.

Structured products are essential to private markets development and the economy for several reasons:

• Structured products offer an option to investors that want more risk for more returns than they would get in public markets. In Kenya, these investors have typically had to go off-shore for attractive opportunities such as structured notes, but development of private markets is now keeping their money on-shore.
• Structured products encourage alternative investors from abroad to invest in the country. Allocations for alternative investments will not go into equities and fixed income. If we do not develop alternative investments, such as structured products, foreign investments targeting structured products will have limited investment opportunities.
• With Kenya’s goal to develop as a regional financial services hub, it is critical that we develop our private markets to complement our public markets. We do not know of a regional financial hub that has developed with public markets alone. The complexity, speed and innovation that accompany structured products require an active private market. In more developed markets, they have even developed specialty private trading platforms for alternative investments.
• Most of our private market players in real estate and private equity tend to be foreign founded firms. There is no reason why local talent cannot be active drivers and participants in private markets. This would increase job creation and keep the profits from being repatriated.

A concerted effort to support the development of the private markets sector is critical and urgent.

Next week we will focus on private real estate investment product opportunities.

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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.