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PRIVATE EQUITY IN KENYA: AN ANALYSIS OF EMERGING
LEGAL AND INSTITUTIONAL ISSUES
BY
Tuimising, Nathan Ronoh
A Thesis Submitted in fulfilment of the requirements for the award of
the Degree of Doctor of Philosophy in Law (Research)
University Of Warwick, School Of Law
April 2012
ii
TABLE OF CONTENTS
List of Tables, Charts, Figures and Cases xii
Acknowledgements xv
Declaration xvii
Abstract xviii
Abbreviations xix
CHAPTER 1 – SETTING OUT THE PROBLEM AND SCOPE OF STUDY
1.1 Introduction 1
1.2 The Question 5
1.2.1 Main Question 5
1.2.2 Legal Instruments in Public Policy for Private Equity 9
1.2.3 Private Equity: A problem in Law 14
1.2.4 The Secondary Questions 18
1.3 Why is a Study of Private Equity Important to Kenya? 21
1.4 Scope of Study 26
1.4.1 Legal and Institutional Elements 26
1.4.2 Originality and Contribution to Knowledge 27
1.4.3 Why Kenya is Selected as a Case Study 28
1.5 Key Terms 31
1.5.1 Venture Capital 31
1.5.2 Growth Capital 33
1.5.3 Management Buyouts (MBOs) and Management Buy-ins (MBIs) 34
1.5.4 Leveraged Buyouts (LBOs) 35
1.5.5 Institutional Buyouts (IBOs) 35
1.5.6 Secondary Buyouts (SBOs) 36
1.5.7 Private Equity for Infrastructure 36
iii
1.5.8 Real Estate Private Equity 37
1.5.9 Distressed and Special Situations Private Equity 38
1.5.10 Mezzanine Funds 39
1.5.11 Emerging Markets 40
1.6 Structure of the Thesis 41
CHAPTER 2 – RESEARCH METHODOLOGY AND EMPIRICAL DESIGN
2.1 Introduction 44
2.2 Conceptual Reflections 45
2.3 Methods 49
2.4 Research Model 50
2.5 Applying Model to Data 52
2.6 Data Sources 53
2.7 Instrumentation 56
2.8 Data Description 58
2.9 Analytical Strategy 60
2.10 Limitations to Chosen Methodology and Impact on Results 61
2.11 Conclusion 64
CHAPTER 3 – HISTORY AND NATURE OF PRIVATE EQUITY
3.1 Introduction 65
3.2 The Evolution of Private Equity 67
3.2.1 Very Early Private Equity 67
3.2.2 Government Venture Capital and Public Policy in Private Equity 68
3.2.2a USA 69
3.2.2b UK 72
3.2.2c The Netherlands 74
iv
3.2.2d Israel 76
3.2.2e Chile 78
3.2.2f Spain 79
3.2.2g Taiwan 80
3.2.2h Lessons from Competing Models 81
3.2.3 Institutionalisation and Segmentation of Private Equity 82
3.2.4 Drivers of Private Equity Fundraising Since 1950s 88
3.2.5 Negative Corporate Practices 91
3.2.6 Globalisation of Private Equity 94
3.3 Transactional Features of private Equity 96
3.3.1 Specialised, Adaptive Enterprise Capital 96
3.3.2 Overcoming Business Uncertainties 97
3.3.3 Unlimited by the asset Characteristics of venture Companies 100
3.3.4 Elements of a Private Equity Transaction 101
3.4 Conclusion 103
CHAPTER 4 – SOURCES OF ENTERPRISE CAPITAL IN KENYA
4.1 Introduction 105
4.2 Supply and Demand Drivers to Risk Finance – Some Issues 108
4.3 Kenya’s Financial and Money Market Institutions 110
4.3.1 The General Financial Infrastructure in Kenya 110
4.3.2 Micro-Finance 112
4.3.3 Savings and Credit Cooperative Societies 115
4.3.4 Bank Loans 117
4.3.5 Public Equity Markets 119
4.4 Analysing Kenya’s Capital consumers: the private Sector 123
v
4.4.1 High-Level Demographics 123
4.4.2 Selected Economic Indicators 126
4.4.3 Business Informality 129
4.4.4 Preponderance of Small Companies 130
4.4.5 Negative Business Practices 131
4.4.6 Bureaucracy and Other Constraints 133
4.5 Barriers to Finance 134
4.5.1 Collateral Quality 134
4.5.2 Cost of Bank Credit 137
4.5.3 Business Informality and Financial Reporting Standards 138
4.5.4 Negative Business Practices 144
4.5.5 Weak Financial Institutions: History of Bank Failures 145
4.5.6 Narrow Range of Creative Financial Products 149
4.6 How Private Equity Intermediation Resolves Identified Barriers 149
4.7 Conclusion 151
CHAPTER 5 – FEATURES OF KENYA’S PRIVATE EQUITY INDUSTRY
5.1 Introduction 153
5.2 Private Equity in the Public Consciousness 154
5.3 PE Funds: Kenya Statistics 158
5.4 Fund Characteristics 159
5.5 Investment Strategy 170
5.6 Investment Life Cycle 173
5.7 Capital Structuring in Private Equity 177
5.8 Syndicating Transactions 185
5.9 The Exit Framework 186
5.10 Future Outlook of Kenyan Private Equity 190
vi
5.11 Conclusion 195
CHAPTER 6 – THE REGULATORY FRAMEWORK FOR PRIVATE EQUITY
6.1 Introduction 198
6.2 Regulating PE – which way? 200
6.3 Private Equity in Kenyan Law 203
6.3.1 Definition of Private Equity 203
6.3.2 The Law on Registration 205
6.3.3 A Dual Regulatory Framework 213
6.3.4 Control of Mergers and Acquisitions 214
6.3.5 Regulating Corporate Governance in Fund Management 219
6.3.6 Reporting Obligations 220
6.3.7 Investment Restrictions 221
6.3.8 Fundraising Rules 223
6.3.9 Restrictions on Financial Assistance 223
6.3.10 Conflict of Interest – Directors 228
6.3.11 Limitations on Multiple Directorships 230
6.3.12 Minority Shareholders 234
6.4 State of Regulatory Compliance 235
6.5 International Perspectives on the Regulation of Private Equity Activity 239
6.5.1 Experience of the European Union 239
6.5.2 Experience in the UK 241
6.5.3 Experience in the USA 243
6.5.4 Distilling Lessons from International Practice 246
6.6 Analysing the Kenyan Experience 247
6.7 Conclusion 249
vii
CHAPTER 7 – TAX PLANNING FOR PRIVATE EQUITY
7.1 Introduction 251
7.2 How Tax Law and Policy Impact Private Equity 253
7.3 General Principles of Taxation in Kenya 256
7.3.1 Tax Liability 256
7.3.2 Tax Avoidance and Evasion 257
7.3.3 Tax Planning Principles 258
7.4 High Impact Tax Elements for Private Equity 260
7.4.1 Corporate Tax 260
7.4.2 Taxation of Management and Professional Fees 263
7.4.3 VAT and Other Business Tax 264
7.4.4 Capital Gains and Dividends 265
7.4.5Compensating and Withholding Tax on Dividends 268
7.4.6 Deductible Expenses for tax Purposes 270
7.4.7 State Subsidies 272
7.4.8 Risk of Double Taxation 273
7.4.9 Taxing Stock Options 273
7.4.10 Fiscal Incentives for Research and Development 275
7.5 Evaluation of the Tax Environment for Private Equity 278
7.6 Conclusion 281
CHAPTER 8 - THE ROLE OF COURTS IN FINANCIAL CONTRACTING
8.1 Introduction 282
8.2 Classification of Contract Terms 286
8.2.1 Conditions and Warranties 286
8.2.2 Doctrine of Reliance 291
viii
8.2.3 Doctrine of Expectancy 293
8.3 Conflict Management in Private Equity : The General Principles 294
8.4 Commercial Arbitration in Kenya 299
8.5 Commercial Litigation 312
8.5.1 Constitutional Basis for the Kenyan Judiciary 312
8.5.2 Fund Manager Attitudes to Local Litigation 314
8.6 Constraints in the Judiciary 318
8.7 Some Reflections on What the Findings Mean 322
8.8 Conclusions 323
CHAPTER 9 – CONCLUSIONS
9.1 Introduction 328
9.2 Issues on the Design of a Law on Private Equity 331
9.3 Issues on Tax Policy for Private Equity 334
9.4 Issues on Private Equity Fundraising 336
9.5 Issues on Capital Markets Development for Private Equity 338
9.6 Issues on the Integrity of Financial Contracts 341
9.7 Synthesising Findings 344
9.8 Future Research 347
BIBLIOGRAPHY 349
ix
LIST OF TABLES, CHARTS, FIGURES AND CASES
Tables
Table 1: Cross-Country Evidence of Policy Interventions in Private Equity 9
Table 3.1: USA Legal Policy for Private Equity 1934 - 2010 71
Table 3.2: Summary of Elements in a Private Equity Transactions 101
Table 8.1: Kenya - Contract Enforcement 314
Charts
Chart 3.1 Fundraising and Investment Trends, Emerging Markets 95
Chart 4.1 Selected Economic Indicators 123
Chart 4.2: GDP Per Capita in Current Prices – Comparative View (in USD thousands) 128
Chart 4.3: Structure and Practices: Kenyan Private Sector 129
Chart 4.4: Likelihood of Corruption Impacting Private Equity 132
Chart 4.5: Reliability of Financial Statements 141
Chart 4.6: Impact of Improved Disclosure Standards 143
Chart 4.7: Bank Failures: 1963 – 2010 146
Chart 4.7: Bank Failures: Trends 146
Chart 5.1: Number of Private Equity Firms in Kenya 155
Chart 5.2: Fund Structures and Key Personnel Trends 162
Chart 5.3: Fund Sources 164
Chart 5.4: Geographic Source of Funds 169
Chart 5.5: Investment Sector Focus 171
Chart 5.6: Average Life Cycle for Post-2008 Investments 174
Chart 5.7: Effects of Long Hold Periods 175
Chart 5.8: Security Design 180
x
Chart 5.9: Syndication Drivers 186
Chart 5.10: Preferred Exit Strategy Under Local Market Conditions 187
Chart 5.11: Fund Performance Drivers 188
Chart 5.12: Controlling for Exit by Contract 189
Chart 5.13: Key Market Dynamics 190
Chart 5.14: Constraints to Private Equity Uptake in Kenya 191
Chart 5.15: 18-Month Fund Manager Projection on Investment Climate 193
Chart 8.1: Contract Enforcement Trends 307
Chart 8.2: Why Fund Managers Reject Local Arbitration 308
Chart 8.3: Contract Enforcement Trends 315
Chart 8.4: Push Factors to Litigation in Kenya 317
Figures
Fig 8.1: Typical Private Equity Conflict Management Continuum 294
Fig 8.2 Judicial Structure 313
Fig 9.1 Private Equity Growth Model for Kenya 346
Cases
Abbott Labs. v. Young, 920 F.2d 984, 988 (D.C. Cir. 1990)
Aid Ass’n for Lutherans v. United States Postal Serv., 321 F.3d 1166, 1174 (D.C. Cir. 2003)
Azim Virjee & Two Others v Glory Properties Limited [2007] HCC559/1999, eKLR
Baird Textiles Holdings Ltd v Marks & Spencer plc, [2001] EWCA Civ 274, [2001] 1 All ER
(Comm) 737 (CA)
Balston v Headline Filters [1990] FSR 385
Bowerman v Association of British Travel Agents Ltd [1996] CLC 451 (CA)
xi
Bristol and West Building Society v Mothew [1998] Ch 1 18 CA
Caparo Industries plc v Dickman [1990] 2 AC 605.
Carlill v Carbolic Smoke Ball Company [1893] 1 QB 256 (CA)
Chevron Kenya Limited v Tamoil Kenya Limited [2007] HCCC 155
Christ For All Nationals v Apollo Insurance Co. Ltd [2002] 2 EA 366
City and Westminster Properties (1934) Ltd v Mudd [1959] Ch 129
David Thuo & 8 Others v First America Bank of Kenya Ltd [2005 HCC 494/2005] eKLR
Don-Wood Co. Ltd v Kenya Pipeline Ltd Civil [2004] HCCC 104
Edwards v Skyways Ltd (1964 1 W.LR. 349)
Epco Builders Limited v Adam S. Marjan-Arbitrator & Another [2005] HCC 248
Estate Finance Company of Kenya Ltd v Narok Transit Hotel Ltd & 2 Others [2011] HCCC
No.710/1999 eKLR
George M Musundi & 2 Others v Small Enterprises Finance Company Ltd [2007] eKLR,
Civil Case No.1861/1995
George M Musundi & 2 Others v Small Enterprises Finance Company Ltd [2007] eKLR
Hedley Byrne & Co. Ltd v Heller & Partners Ltd, (1964) AC 465 (HL)
Helmet Integrated Systems v Tunnard [2007] CA
Henderson v Merrett Syndicates Ltd [1995] 2 AC 145
International Standard Elec. Corp (ISEC) v Bridas Sociedad Anonima Petrolera Industrial Y
Comercial, 745 F. Supp. 172, 178 (S.D.N.Y. 1990) in VII Y.B. COM.ARB.312(1982)
xii
J. Evans & Son (Portsmouth) Ltd v Andrea Merzario Ltd, [1976] 1 WLR 1078 (CA)
Kenya Institute of Management v Kenya Reinsurance Corporation [2008] eKLR
Kundan Singh Construction Ltd v Kenya Ports Authority, HCC 794/2003
L. Schuler v Wickman Machine Tool Sales (1974) AC 235 (HL)
Lombard North Central plc v Butterworth (1987) QB 527 (CA)
London and Mashonaland Exploration Co. Ltd v New Mashonaland Exploration Co. Ltd
[1891] WN 165
McRae v Commonwealth Disposals Commission (1951) 84 CLR 377
Mumias Sugar Company Ltd v Freight Forwarders (K) Ltd Nairobi CA 297/2003
Nakumatt Holdings Limited v Kenya Wildlife Services [2001] HCCC 1131
National Bank of Kenya Ltd V. Wilson Ndolo Ayah [2009] eKLR
Nokes v Doncaster Amalgamated Collieries Ltd [1940] A.C. 1041
Pamela Akora Imenje v Akora ITC Intenational Ltd & Another [2007] eKLR
Peter Muema Kahoro & another v Benson Maina Githethuki [2006] eKLR
Phillip Goldstein, et al, Petitioners, vs. Securities and Exchange Commission, Respondents
District of Columbia Circuits, No. 04-1434
Rawal v Mombassa Hardware Ltd [1968] EA 398
Reading Intl, Inc., v Oaktree Capital Management LLC, 317 F.Supp. 2d 301 – 331 (S.D.N.Y.
2003)
xiii
Robert F. Booth Trust v Crowley et al & SEARS Holding Corporation, No. 09 C 5314
N.D.I.[2010]
Robinson v Harman (1848) 1 Exch 850, 855
Ruxley Electronics & Construction Ltd v Forsyth [1960] 1 AC 344 HL
Shepherds Investments Ltd v Walters [2007] 2 BCLC 202
Standard Bank Ltd v Mehotoro Farm Ltd & 2 Others CC 54 [1972] CA
Thermascan Ltd v Norman [2009] EWHC 3694 (Ch)
US v Dairy Farmers of Am., Inc., 426 F.3d 850 – 855 (6
th
Cir. 2005)
xiv
ACKNOWLEDGEMENTS
First and foremost, my gratitude goes to my God for the gift of life, good health,
mental sanity and spiritual stability – the very values that nudged me to this finish line.
This work could not have been completed without the faith and constant support of
my supervisor and friend, Dr. Dalvinder Singh, Associate Professor of Law at the Warwick
University School of Law. In addition to his incisive and direct academic criticism of my
thinking and writing, he was a pillar of faith and basic common sense when it came to my
staying the course.
I acknowledge in a special way my examiners – Prof. Charles Chatterjee (internal)
and Dr. Nicholas Ryder (external), for interrogating the quality and consistency in this work,
and for the lively engagement and profoundly insightful recommendations on how to improve
this work at the publication stage. Their experience and wise judgement brought this work to
an illustrious conclusion.
I especially acknowledge all individuals and institutions in Kenya that supported the
empirical aspects of this study: without their granting access, this work could not have taken
the practical form that it has.
But most of all, my affectionate and lovely wife, Beverlyn, and our two children,
Tanya and Nate-Jr., for their steady love and unfailing belief in the end of this road
(especially during the long periods when days fused into nights before the computer screen,
and weekdays into weekends). In many ways, this achievement is theirs: we came, we saw,
we accomplished, and together we are better than either one of us.
My journey through Warwick undeniably bears the positive impact of various
individuals who, in their different ways, have their indelible influences woven into the fabric
xv
of this academic achievement. They include my parents and family, the Government of
Kenya through Mr. Wanjuki Muchemi, CBS, Solicitor General of the Republic of Kenya
(2002-2012 – whose vision and selflessness facilitated my continued engagement with
advanced education), Dr. Jorge Guira, my first supervisor, Dr. Lydia Schulz, my friend and
mentor, Dr. Rodrigo Olivares Caminal (member of my upgrade panel in 2008), Prof. Istvan
Pogany (Director of Post Graduate Research at the Law School, 2010), Ms Jennifer Mabbett
(the gentle and indefatigable Post-Grad Secretary at the Warwick Law School), the Students
Finance Office, the Warwick Board of Graduate Studies, my doctoral colleagues at the Law
School, Dr. Ambreena Manji and Dr. Upadhya Radha both of the British Institute for Eastern
Africa, and Prof. Yash Pal Ghai of Katiba Institute, Steve Sitienei and Dr. Billingsley
Kaambwa (my friends), as well as Mrs. Joy Warmington, CEO Brap Ltd, Mrs. Siobhan
Harper-Nunes, Ghiyas Somra, Amy Wilkins, Emma Wright, Safia Lul, Dr. L Sitienei - for the
various parts they each played to support me through.
xvi
DECLARATION
I, the undersigned, hereby confirm that this thesis is my own original work and does not
include any material already submitted for another degree at the University of Warwick, or
material I have previously had published. I also confirm that the thesis has not been submitted
for a degree at another university.
TUIMISING, Nathan Ronoh
xvii
Abstract
In Kenya, like in many other countries around the world, private equity’s
emergence as a creative method for financing companies, is attracting
attention as the government seeks new ways of financing its private sector –
which it now recognises as the engine for Kenya’s economic development.
This policy outlook is undermined by the reality of a yet extensively under-
capitalised private sector, and the lack of a coherent body of knowledge and
experience on Kenyan private equity. This study, for the first time, brings
together that dispersed body of knowledge to facilitate coherent analysis of
the emerging legal and institutional issues that private equity introduces.
Using case law and statutory analysis, documentary reviews, interviews and
surveys to construct the complete picture of Kenyan private equity, this
empirical legal inquiry finds that the law on private equity in Kenya is
incomplete: it is patchy and dispersed, and is not uniformly applied among
and across all private equity market intermediaries. Secondly, the institutions
charged with supervising the implementation of the law are under-
capacitated, with the result that regulatory supervision within the private
equity industry remains weak and largely unfelt. Thirdly, the legal
institutions supporting private equity practice in Kenya (security of property
rights, security of financial contracts and integrity in financial reporting) are
in a nascent state of development. Fourthly, there is no clear policy on
alternative investments generally, and private equity particularly, in Kenya,
undermining precision in regulatory objectives. These realities combine to
blunt the impact of private equity in driving creative entrepreneurship. These
realities support the need for structured national capacity enhancement
across all spheres of private equity practice, such as would strengthen
regulatory supervision, the emergence of a ‘home brand’ to private equity,
the increased visibility of structured government engagement in channelling
private equity into economically productive sectors linked to the nation’s
development strategy. These findings mirror earlier research investigating
the under-performance of private equity in emerging markets, with the
upshot that a Law and Institutional Growth Model for Private Equity in
Kenya is the necessary catalyst that will trigger the rapid expansion of the
Kenyan private equity industry in aid of national development.
xviii
ABBREVIATIONS
ARDC American Research and Development Corporation
AVCA Africa Venture Capital Association
CBK Central Bank of Kenya
CMA Capital Markets Authority of Kenya
EMPEA Emerging Markets Private Equity Association
ERS Economic Recovery Strategy for Employment and Wealth Creation
EVCA European Venture Capital Association
GP General Partners
ICAP Investment Action Master Plan
ICAP Investment Climate Action Plan
LLP Limited Liability Partnership
LP Limited Partners
MAPSKID Master Plan Study for Kenyan Industrial Development
MFI Microfinance Institution
MoTI Ministry of Trade and Industry
MSME Micro Small and Medium Enterprises
NSE Nairobi Stock Exchange
NVCA National Venture Capital Association
PE Private Equity
PSDS Private Sector Development Strategy
SACCO Savings and Credit Cooperatives
SASRA SACCO Societies Regulatory Authority
SBIC Small Business Investment Companies
SBIR Small Business Investment Research
SME Small and Medium Enterprise
SMEx Small and Medium Enterprise Exchange
VC Venture Capital
1
1
SETTING OUT THE PROBLEM AND SCOPE OF STUDY
1.1 Introduction
Private equity - a financial and investment intermediary between holders and
providers of capital on the one hand, and specific types of private companies, on the other
1
-
can be catalytic in transforming the way in which a country’s most productive economic
sectors develop.
2
This is particularly true in a developing country context like Kenya, a sub-
Saharan African country whose private sector is still under-capitalised and under-developed.
3
Development research indicates that the private sector is the main driver of economic
growth,
4
a position adopted in development literature
5
as well as in Kenya’s ambitious
economic development plans which seek to transform Kenya into a middle-income economy
by the year 2030.
6
Yet to be an effective partner in development, the private sector needs to
be adequately and appropriately capitalised.
1
Douglas J. Cumming and Sofia A. Johan, Venture Capital and Private Equity Contracting: An International
Perspective (Elsevier, USA, 2009) 3, 4
2
Richard Kitchen, ‘Venture Capital: Is It Appropriate for Developing Countries?’ In Business Finance in Less
Developed Capital Markets (1992) Klaus Fischer and George Papaioannou (eds), Hofstra University– private
equity is (a) a type of investor, (b) a financial contracting strategy through which equity capital is made
available to private companies, and (c) an investment management service.
3
Mukhisa Kituyi, Improving the Investment Climate and Participation of the Private Sector in the Economy
(Ministry of Trade and Industry, Policy Briefing Paper, Nairobi, 11-12 April 2005) 2,3
accessed 29 December
2011; also: IMF Financial Access Survey (2009) - accessed 5 February 2012 – key
indicators are that out of 1000 adults, less than 74 have access to a bank loan, and less than 370 own a savings
account. There are 2 bank branches in every 1000 square kilometres (or 7 ATMs to every 100,000 adults), and
lending to private sector stood at 32.6% of GDP, while deposits were 46% of GDP.
4
Yochanan Shachmurove, ‘An Introduction to the Special Issues on Financial Markets of the Middle East’
(2004) 9(3) International Journal of Business 213
5
DfID, ‘The Engine of Development: The Private Sector and Prosperity for Poor People’ (DfID, 2011)
accessed 5
October 2011. Also: Asian Development Bank, ‘Overview’ (ADB, 2011) accessed 20 October 2011 – ‘private sector has been, remains and will be the engine of
growth’.
6
Government of Kenya, ‘Vision 2030’ accessed August
2007.
2
There is extensive evidence from multilateral development institutions that financial
infrastructure in emerging markets remain under-developed.
7
‘Financial infrastructure’
includes all the institutions, technologies, standards and rules that support financial mediation
in a country.
8
Bossone, Mahajan and Zahir find that weak financial infrastructure tends to
drive selection bias, that is, providers of enterprise capital tending to withhold financing from
borrowers deemed to carry too much risk.
9
Rajan and Zingales had earlier lead evidence
suggesting that efficient financial infrastructure improved quality and quantity of business
finance.
10
A World Bank and IFC study in 2010 suggested that laws and regulations support
the efficient operation of a country’s financial infrastructure and financial system, thereby
indirectly the direction in which a country’s private sector develops.
11
This study argues that private equity can be a useful partner in expanding sources and
types of business finance, enabling private companies to more efficiently access the types of
enterprise capital in the right amounts.
Why is private equity uniquely well-suited to resolve these challenges?
7
Margaret Miller, Nataliya Mylenko and Shalini Sankaranayanan, ‘Financial Infrastructure – Building Access
Through Transparent and Stable Financial Systems’ (2009) International Bank for Reconstruction and
Development and International Finance Corporation,
accessed 23 January
2012 – “access to finance is the result of a complex interplay of different financial intermediaries, the right kind
of financial infrastructure, and a sound legal and regulatory framework”, 1
8
Penelope J Brook, ‘Foreword’ in Margaret Miller, Nataliya Mylenko and Shalini Sankaranayanan, ‘Financial
Infrastructure – Building Access Through Transparent and Stable Financial Systems’ (2009) International Bank
for Reconstruction and Development and International Finance Corporation,
accessed 23 January 2012
-‘Institutions’ in this context include payment remittance and securities settlement systems, collateral registries
and credit reference bureaux.
9
Biagio Bossone, Sandeep Mahajan and Farah Zahir, ‘Financial Infrastructure, Group Interests and Capital
Accumulation: Theory Evidence and Policy’ (2003) IMF Working Paper 03/24
10
Rajan Raghuram and Luigi Zingales, ‘Financial Dependence and Economic Growth’ (1998) 88 (3) American
Economic Review 559-86
11
Miller, et al., ‘Financial Infrastructure’ (2009) (n 7), 1 “access to finance is the result of a complex interplay
of different financial intermediaries, the right kind of financial infrastructure, and a sound legal and regulatory
framework”
3
Industry studies
12
on the one hand, and development literature,
13
on the other, have
urged the argument firstly that private equity drives economic development because it
promotes innovation. European studies, however, suggest a less optimistic impact, finding
mixed results in Italy
14
and UK.
15
The general weight of opinion nonetheless suggests a
positive relationship between the introduction of private equity into a company and its rapid
growth.
16
The argument is that this type of finance improves corporate performance by
increasing productivity
17
and disciplining management efficiency.
18
These studies ascribe
these outcomes to the private equity contracting model, which introduces close monitoring of
management action – and the overall impact, it is argued, is stronger business entities in the
economy.
Private equity, unlike collateral-based business credit, does not operate on a lending
basis – it becomes a shareholder in a business, strengthening balance sheets, providing
financing for a company’s most risky ventures, and enabling a company to unlock matching
traditional credit where needed, aiding promising new businesses to blossom. Research
12
Samuel Kortum and Josh Lerner, ‘Assessing the Contribution of Venture Capital to Innovation’ (2002) 31(4)
RAND Journal of Economics 674-692
13
Josh Lerner, Morten Sorensen and Per Stromberg, ‘Private Equity and Long-Run Investment: The Case for
Innovation’, The Global Economic Impact of Private Equity Report (2008) World Economic Forum, January
2008.
14
Stefano Caselli, Francesco Corielli, Stefano Gatti and Francesca Querci, ‘Corporate Governance and
Independent Directors, Much Ado About Nothing? The Evidence Behind Private Equity Investment
Performance’ (2008) CAREFIN-Universita Bocconi (unpublished); cf: Francesco Perrini, Ginevra Rossi, and
Barbara Rovetta, ‘Does Ownership Structure Affect Performance? Evidence from the Italian Market’ (2008) 16
(4) Corporate Governance: An Intenational Review 312-325 - explores the cause-effect relationship between
private equity and innovation; inconclusive whether innovation follows private equity, or vice versa.
15
Robert Cressy, Federico Munari, Alessandro Malipiero, ‘Creative Destruction? Evidence that Buyouts Shed
Jobs to Raise Returns’ (2011) 13(1) Venture Capital: Journal of Entrepreneurial Finance, 1-22
16
Johan Per Stromberg, ‘Private Equity, Industry Performance and Cyclicality’ (2010) The Global Economic
Impact of Private Equity Report, World Economic Forum, 19 part 2
17
Kevin Ames, ‘Management Buyouts and Firm-Level Productivity: evidence from a panel of UK
manufacturing firms’ (2002) 49(3) Scottish Journal of Political Economy, 304-317 – studies 78 UK buyouts
between 1986-1997; Richard Harris, Donald Siegel and Mike Wright, ‘Assessing the Impact of Management
Buyouts on Economic Efficiency: Plant-Level Evidence from the UK’ (2005) unpublished working paper –
studying 979 UK buyouts between 1994-1998.
18
Oliver Hart and John Moore, ‘Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining
Management’ (1995) (85) 3The American Economic Review 567-585; Cf: Matthias Dewatripont and Jean
Tirole, ‘A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence’ (1994) 19
(4) The Quarterly Journal of Economics 1027-1054
4
suggests that private equity is effective in introducing new technologies and new ideas into
the marketplace and dispersing them across an economy.
19
Such investments, it is said,
encourage and spur innovation,
20
generate good returns to investors thereby aiding in the
mobilisation of capital,
21
encourage robust corporate growth and expansion.
22
It is also
argued that it improves corporate governance
23
and promotes research and development as
lucrative commercial undertakings.
24
With all this promise, private equity does warrant serious academic investigation, a
pursuit that would model options for its growth within a developing country context. This is
all the more pertinent given its origins in North America and Western Europe, countries with
highly developed legal systems and institutions, compared to the relative under-development
of legal systems in developing countries.
25
This chapter does five things. Firstly, it sets out, in section 1.2, the main research
question underpinning this thesis and motivates it through a reflection on how various
governments around the world have employed legal instruments in public policy targeted at
private equity, and an exploration of private equity as a problem in law. Section 1.2 ends with
a statement of supporting questions that help in focusing the scope of the study. Secondly, In
19
Richard Kitchen, Venture Capital in Developing Countries (n 2) 1
20
Marcos A. Mollica and Luigi Zingales, ‘The Impact of Venture Capital on Innovation and the Creation of
New Business’ (2007) Working Paper Chicago University; cf: Josh Lerner, Morten Sorensen and Johan Per
Stromberg, ‘Private Equity and Long-Run Investment: The Case for Innovation’ (2008) The Global Economic
Impact of Private Equity, World Economic Forum Alternative Investment Working Paper Series
accessed January 2011.
21
European Private Equity and Venture Capital Association, ‘Survey of the Economic and Social Impact of
Venture Capital in Europe’ (2002)
accessed 20 October 2011
22
Shai Bernstein, Josh Lerner, Morten Sorensen and Johan per Stromberg, ‘Private Equity, Industry
Performance and Cyclicality’ (2010) The Global Economic Impact of Private Equity Report, World Economic
Forum, 19 accessed January 2011
23
George P Baker and Karen H Wruck, ‘Organisational Changes and Value Creation in Leveraged Buyouts:
The Case of OM Scott & Sons Company’ (1989) 25 Journal of Financial Economics 163, 190
24
European Private Equity and Venture Capital Association, Special Paper on Technology Success Stories
(2002) accessed 4 June 2011 - research and
development is especially important to growing economies that need innovative solutions to long-standing
economic challenges.
25
ch 3, 65, for a succinct history of private equity.
5
section 1.3, a number of justifications are offered why a study of private equity is important
to a developing economy like Kenya. Thirdly, in section 1.4, the study is delimited through
ascribing meaning and context to the two central themes of the inquiry, that is to say, ‘laws’
and ‘institutions’. This section also sets out the claims to originality, and justifies the choice
of Kenya as a case study in this investigation. Fourthly, in section 1.5, some of the key
concepts underpinning the study are defined, notably the richly nuanced and contextual
meaning of the term private equity, and the meaning of emerging markets. Lastly, in section
1.6, the chapter concludes with an outline of the way in which the remainder of the thesis has
been organised.
1.2 The Questions
1.2.1 Main Question
The general reflections in the preceding section suggest the existence of a dependency
between the state of a country’s economic , financial and private sector development. If
private equity offers a viable part solution to the unlocking of a nation’s private sector
potential in driving economic growth, a fundamental policy question becomes how can a
country grow private equity? In other words, what factors must a country secure for a robust
and economically significant private equity industry to grow – that is deepen its financial
infrastructure and its financial system?
26
What would those factors mean for a country’s law
and institutional development process?
26
Miller et al., ‘Financial Infrastructure’ (2009) ( n 7) 1
6
Opinion is generally united among private equity practitioners,
27
investors
28
and
academics
29
that the following four broad country characteristics influence the emergence of
private equity markets:
(i) economic growth rate and size of the economy;
(ii) size of stock markets and or depth of debt markets;
(iii) levels of entrepreneurship; and
(iv) quality of the legal system and regulatory practices.
The first three determinants are macro-economic in character, while the fourth is
socio-legal in nature. There is much less agreement, unfortunately, on which, if any, of the
four factors wields the greater influence – the deterministic effect, so to say – in catalysing a
sure start to the industry’s emergence and robust growth. This mix of factors, it is clear,
transcend any single academic discipline, but the fourth set of factors (legal system and
regulatory practices) to varying degrees appear to influence the manner in which the first
three conditions develop. In light of the foregoing, this study asks the following main
question -
Are laws and legal institutions really relevant to the growth of private equity
in an emerging market like Kenya? If so, what are the key emerging legal
and institutional issues?
This thesis argues that in an emerging market context, the law, and its legal
institutions, are likely to be more influential than macro-economic factors in nurturing
fortuitous environments for a robust private equity industry to emerge and expand. In
27
Heino Meerkatt and Heinrich Liechtenstein, ‘New Markets, New Rules: will emerging markets reshape
private equity?’ (IFC, November 2010)
accessed 11 October 2011.
28
International Finance Corporation, ‘The Case for Emerging Markets Private Equity’ (IFC, February 2011)
accessed 16 October 2011
29
Marina Balboa and Jose Marti, ‘Conceptual Model for Private Equity Markets: Proposal and Empirical Test
on Fundraising’ (EFMA London Meetings 2002)
accessed 16 November 2011.
7
adopting this proposition, this study views the first three elements as the ‘external factors’
that create the economic opportunity, while the fourth element is viewed as the ‘internal
factor’ that qualitatively unlocks both demand and supply of private equity through creating
crucial platforms for efficient financial contracting. In effect, the law is viewed as an
‘enabler’, hence the question what can a country do to enable the emergence of conditions
that support the growth of private equity.
30
As chapter 5 discusses in detail,
31
Kenya has a nascent private equity industry,
suggesting it is still a new form of financial contracting and intermediation in Kenya. The
second part of the main question, hence, seeks to explore the legal and institutional issues that
private equity raises and how the practice of private equity is anchored in the law. To what
extent are the issues raised by private equity efficiently resolved within the Kenyan legal and
institutional system? These are the central themes holding this investigation together.
This study thus unpicks the fourth element from among the four broad country
characteristics for private equity set out above – from the perspective of its likely
disproportionate influence on how the other three factors develop.
32
A discernible theme
arising from the literature, as far as emerging markets private equity is concerned, is the
notion that socio-economic environments, with particular emphasis on legal and regulatory
conditions, are especially crucial to private investment. This line of thinking argues that “the
most attractive markets for investors are determined (…) by the relative sophistication of (…)
their regulatory and legal systems.”
33
Without prejudice to the thesis statement set out above, the macro-economic factors
(economic growth rate, size of the stock market, depth of local debt markets, levels of
entrepreneurship and infrastructure), which are styled ‘the external factors’ in this chapter,
30
Miller et al., ‘Financial Infrastructure’ (2009) (n 7) 1 – laws and regulations support financial infrastructure
components to perform optimally
31
ch5, 158
32
Miller et al., ‘Financial Infrastructure,’ (2009) (n 7), 1-2
33
Meerkatt and Liechtenstein 2010 ( n 27) 1
8
are not unimportant in the wider scheme of private equity growth.
34
The argument in this
thesis, however, is that for these external factors to be highly effective, a supporting legal and
regulatory framework is necessary.
35
Evidence by Armour and Cumming
36
that stock markets do play a role in the growth
of private equity, also places heavier weight on the impact of laws that support
entrepreneurship, tolerates business failure, and protects shareholders, in addition to
supporting a low-tax environment. These, they find, play a potentially larger role in
determining whether private equity markets deepen in an economy. Their finding on taxation
resonates with earlier work by Porteba,
37
while their findings on the legal determinants
(including pension fund regulations and tax policy) extend similar findings by Jeng and
Wells.
38
These notions have certainly found currency in public policy, as the next section
illustrates. Studies by the private equity industry itself lend support to the core argument in
this study: the Latin America Venture Capital Association,
39
the British Venture Capital
Association (BVCA),
40
as well as the European Venture Capital Association (EVCA)
41
all
agree on the importance of law and legal institutions in culturing conducive environments for
private equity to emerge and grow.
34
Maria Ahmed, ‘Strong Prospects for African Private Equity’ (Emerging Markets, 24 April 2006)
accessed
16 October 2011
35
Wei Xiao, ‘The New Economy and Venture Capital in China’ OYCF (2002) 3 (6) Perspectives
36
John Armour and Douglas Cumming, ‘The Legislative Road to Silicon Valley’ (2006) 58 Oxford Economic
596-635
37
James M. Porteba, ‘Venture Capital and Capital Gains Taxation’ in LH Summers (ed), Tax Policy and the
Economy, (Cambridge, MA, MIT Press, 1989) ch 347-67
38
L.A. Jeng and P.C. Wells,’ Determinants of Venture Capital Fundraising: Evidence Across Countries’ (2002)
6 Journal of Corporate Finance 241-89
39
Jenna Gottlieb, ‘Evolving Regulation’ (LAVCA, 8 March 2011) accessed 23 January 2012
40
British Venture Capital Association, ‘A Guide to Private Equity’ (2010)
accessed 23 January 2012
41
EVCA Benchmarking Tax and Legal Environments (2008)
accessed 23 January 2012
9
1.2.2 Legal Instruments in Public Policy for Private Equity
Governments across North America and Western Europe, as well as others around the
world (see table 1, below), have adopted varied public policy measures targeted at crafting
more conducive national environments for private equity. A strong tenet of these public
policy responses has been the employment of legal instruments.
The first column in the table shows the year when governmental responses to private
equity was undertaken. The second column shows the country implementing the measure,
and in the third column, the policy measure is depicted. Column four summarises the impact
each policy measure helped deliver.
Table 1 Cross-Country Evidence of Policy Interventions in Private Equity/Venture Capital
Year Country Policy Intervention Impact
1958 USA Small Business Investment Companies Act
42
Larger fund pools, PE/VC
Professionalization
1974 USA Employee Retirement Investment Scheme Act
43
Chocked off pension
Investments in PE/VC
1978 USA “Prudent Man” ERISA clarification
44
Triggered rapid investments in
PE/VC
1980 USA Small Business Innovation Research Programme
45
Channelled billions into
PE/VC
1992 Israel Yozma Programme – USD100m Govt VCF
46
Rapid co-investing by private
Sector
2000 UK Numerous specialist government funds
47
Targeted small firms
42
U.S. Small Business Administration, ‘Small Business Investment Act of 1958’ accessed 24 October 2011
43
ERISA, Pub. L. 93-406 - USCS s1002 of 2 September 1974
44
Title 29-18 1B-4 USCS s1104 – ‘Fiduciary Duties’, s1104(a)(1) ‘The Prudent Man Standard of Care’.
45
Joshua Gans, and Stern Scott, ‘When does funding Research from Smaller Firms Bring Fruit? Evidence from
the SBIR Programme’ (2003) 12 (4) Economics of Innovation and New Technology 361-384
46
Gil Avimelech and Morris Teubal, ‘Israel’s Venture Capital Industry: Emergence, Operation and Impact’ in
David Citendamar (ed.), The Growth of Venture Capital: A Cross-Cultural Analysis (Westport Praeger 2002)
47
British Venture Capital Association, ‘A Guide to Private Equity’ (2010)
8-13
10
2001 Denmark Danish Growth venture Fund
48
Market Stimulated
2001 EC European Investment Fund
49
Euros 2 billion fresh capital
2003 France Plan Innovation
50
Targeted at innovative firms;
2006 Netherlands Regulatory Harmonisation
51
More investments into PE/VC
2002 Singapore
52
Tax Incentives (Silicon Valley Model) Rapid growth of local PE
2002 Taiwan
53
Tax Incentives/Business Regulation Explosive growth in VC
2003 India
54
Venture Capital Regulations / Capital Markets Rise of Technology Valley
2003 China
55
Changes to PE Laws – 2003; 2006; 2007 Increased fundraising for China
2003 Japan
56
1998 Brazil Various regulatory improvements since 2003
57
Brazil more attractive to global
Private equity firms
The role and influence of public policy in the emergence and growth of markets for
risk finance is thus well documented. It is telling that a substantial number of the foregoing
public policy responses employed legal instruments, and were targeted at shoring up the
supply, or quantity, of private equity/venture capital in an economy.
48
Vækstfonden’s (Danish Growth Fund), ‘The Best Market for Innovation Finance in Europe’ (2001)
accessed 25 October 2011
49
Europa, ‘European Investment Fund’ (1994) accessed 8 December 2007
50
Marco Da Rin, Giovanna Nicodano and Alessandro Sembenelli, ‘Public policy and the creation of active
venture capital markets’ (2006) 90 (8-9) Journal of Public Economics 1699-1723
51
Douglas Cumming and Sofia Johan, ‘Regulatory Harmonization and the Development of Private Equity
Markets’ (2007) 31 Journal of Banking and Finance 3218-3250 – see chapter 3, section 3.2.2c for detailed
discussion.
52
Winston T.H. Koh and Francis Koh, ‘Venture Capital and Economic Growth: An Industry Overview and
Singapore’s Experience’ (2002) Singapore Management University, school of Economics and Social Sciences
Workong Paper 21 /2002
53
L Songtao, ‘The Stage and the Character of Venture Capital Development in Taiwan, Asia and Pacific
Economies’ (2000)
54
Mike Wright, Andy Lockett and Serika Pruthi, ‘Internationalization of Western Venture Capitalists into
Emerging Markets: Risk Assessment and Information in India’ (2002) 19 (1) Journal of Small Business
Economics 1 – 62 Springer Netherlands
55
Lutz-Christian Wolff, Mergers and Acquisitions in China: Law and Practice 2008 (2
nd
edn, CCH Hong Kong
Limited 2008), ch 5, 6, 7, 8 and 15 - These include the Regulations on the Administration of Foreign-Invested
Venture Capital Enterprises, 2003 (which sets out express prohibitions on the types of investment activities
foreign-invested enterprises cannot undertake), the Interim Measures for the Administration of Venture Capital
Funds, 2006, which apply to non-foreign invested venture capital undertakings, and revisions to the Chinese
partnership law in 2007, which had revisions impacting foreign-invested partnerships. Chinese law distinguishes
between onshore and offshore funds, and subjects offshore funds and special purpose investment vehicles to
specific restrictions.
56
Masaki Kuroki, Mark P. Rice and Pier A Abetti, ‘Emerging Trends in the Japanese venture Capital Industry’
(2000) Journal of Private Equity 39 -49
57
Generally,[Editor], Latin America Venture Capital Association, ‘Evolving Regulation’ (8 March 2011),
accessed 23 January 2012
11
Korosteleva et al
58
suggest that regulation is an important catalyst of start-up capital
into the economy, but find that ‘over-regulation’ has a stifling effect. However, ‘over-
regulation’ within that study is not precisely defined, and it is doubtful whether the term
means the same thing in different economic contexts, casting some doubt over the ‘stifling
effect’ argument. From a public policy perspective, nonetheless, the effectiveness of a
country’s financial system’s regulatory model would seem to have a strong impact on how
financial markets develop.
Bose, Panini and Chitralekha find that while there is broad consensus that enforcing
property rights accounts for the emergence of financial markets, causation could run in the
opposite direction as well: so that financial development can trigger or catalyse property
rights reforms.
59
Other factors include, on the one hand, taxation policies and how the capital
gains system is organised,
60
and, on the other, the assurance of an exit framework from
investments.
61
These issues have been categorised by other commentators among the
qualitative elements of public policy.
62
The main line of inquiry in this work is motivated by the notion that at the heart of the
private equity investment decision in emerging markets lie perhaps two fundamental worries:
firstly, the extent to which property rights in financial investments are secure, and secondly,
58
Julia Korosteleva, and Tomasz Mickiewicz, ‘Property Rights, Supply of Formal Informed Finance and
Business Start-up Financing’ (2008)
accessed 25 October 2011
59 Niloy Bose, Antu Panini Murshid, Chitralekha Rath, ‘Finance and Property Rights: Exploring Other
Directions’ accessed 25 October 2011
60
James Porteba, ‘Capital Gains Tax Policy Toward Entrepreneurship’ (1989) 42 (3) National Tax Journal 375,
90; Christian Keuschnigg and Soren Bo Nielsen, ‘Public Policy for Venture Capital’ (2001) 8 (4) International
Tax and Public Finance 557, 72; Christian Keuschnigg and Soren Bo Nielsen, ‘Start Ups, Venture Capitalists
and Capital Gains Tax’ (2004) 88 (5) Journal of Public Economics 1011,1042
61
Claudio Michelacci and Javier Suarez, ‘Business Creation and the Stock Market’ (2004) 71(2) Review of
Economic Studies 459, 81
62
Colin Mason, ‘Public Policy Support for the Informal Venture Capital Market in Europe: a critical review’
Working Paper 08-07/2008
Accessed 25 October 2011
12
the extent to which acceptable investment returns can be earned, from such markets. Both
worries have been mainstreamed by a literature strand backing a role for law and legal
institutions in financial market development,
63
and secondly, links contract and divestment
efficiency to earnings or realized returns.
64
The main question is also motivated by the experience of private equity in emerging
markets.
65
Once an exotic and limited investment and financial contracting activity, it has
rapidly globalised,
66
having first appeared in North America and Western Europe, where it is
also highly sophisticated and well developed.
67
According to Preqin,
68
the industry raised
over USD1.8 trillion
69
globally between 2006 and 2008 – the highest in history, and a period
that came to be known as the ‘golden age of private equity’.
70
During the same period, the
number of private equity fund managers doubled – from 918 fund managers in January 2007
to 1,673 in March 2009.
71
Statistics collated by the Emerging Markets Private Equity Association (‘EMPEA’)
on fundraising, the number of active funds and fund managers, and the geographic spread of
63
For example, Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails
Everywhere Else (Black Swan, Bantam Press, Great Britain, 2000).
64
Douglas Cumming and Grant Flemming, ‘A Law and Finance Analysis of Venture Capital Exits in Emerging
Markets’ (2003) Australian National University Working Paper Series in Finance.
65
Emerging Markets Private Equity Association Accessed 16 September, 2010 –
these markets, for private equity, are Latin America, India, China & Asia, Eastern Europe, Middle East and
North Africa, and sub-Saharan Africa - South, East, Central and West Africa
66
Mike Wright, Sarika Pruthi and Andy Lockett, International Venture Capital Research: From Cross-Country
Comparisons to Crossing Borders (2005), Nottingham University Business School Centre for Management Buy-
Out. See also: W. Megginson, Toward A Global Model of Venture Capital? The University of Oklahoma
( 2002) 2, 5, 23-28 accessed 2 April 2008.
67
Steven M Davidoff, ‘The Failure of Private Equity’ (2009) 82(3) Southern California Law Review 481-546 -
for history of private equity, go to chapter 3, 65.
68
Preqin, ‘Global Quarterly Private Equity Fundraising 2004-2009’ (USA, 1 July 2009) 1
accessed 15
September 2010
69
ibid
70
Richman Lou and Elaine Cummings, ‘Global Private Equity Report’ (Bain & Company Inc. , 2010) 2
accessed 30 September, 2010
71
ibid.
13
private equity, indicate phenomenal growth in emerging market private equity activity.
72
Indeed, by 2008, the OECD observed that ‘private equity is the African investment story to
watch’.
73
Private equity has thus become a global phenomenon.
It is unsurprising, hence, that Kenya has in the last decade witnessed an increasing
number of private equity companies setting up office in the country.
74
The quality of financial
transparency – ultimately a question of business and securities regulation – is already
recognised as one of the areas relevant to private equity that calls for development to promote
access to enterprise finance.
75
Other barriers stem from firm characteristics such as family
ownership of business, especially the impact of relinquishing control of family businesses.
76
Amidst this fast-changing space, Kenyan investment managers are setting up funds of their
own, riding on their stellar investment records.
77
Private equity’s arrival on the world stage has not induced similar economic impact
across countries, however, with industry statistics demonstrating its early underperformance
in emerging markets.
78
Research continues to vex the question why it has not always
‘transplanted’ successfully in emerging markets.
79
The general question that arises is whether
72
EMPEA, ‘Emerging Market Private Equity Industry Statistics: Fundraising and Investment’ (Q4 2009) accessed 6 April 2010
73
Thomas Dickson, OECD, Policy Insight No.60, Private Equity: An Eye for Investment under African Skies?
(OECD African Economic Outlook, 2008) accessed 6 April 2009
74
Wanjiru Waithaka, ‘Kenya Becomes a Magnet for Private Equity’ (BiD Network, 7 March 2008)
accessed 5 April 2008. See chapter 5 for a full discussion of the
Kenyan private equity industry.
75
George Omondi, ‘Lack of Disclosure Blocking SMEs from Funds’ (All Africa, 22 April 2010)
accessed 22 April 2010.
76
George Omondi, ‘Small Firms Shy Away from Private Equity Lenders’ (All Africa, 4 May 2010)
accessed 4 May 2010.
77
Emanuel Were, ‘Kenya’s New Capitalists Go Big on Private Equity’ (Business Daily, 5 June 2009)
accessed 5 June 2009.
78
Emerging Markets Private Equity Association, ‘Emerging Markets Private Equity Fundraising and Investment
Review 2008’ (2009) 22
Accessed 27 July
2010
79
Josh Lerner and Antoinette Schoar, ‘Private equity in the developing world: the determinants of transaction
structures’ (2003) Harvard Business School/Massachusetts Institute of Technology Working paper, cf: Douglas
Cumming and Grant Fleming, ‘The impact of legality on private equity markets: evidence from the Asia-Pacific
(2004), EFMA Conference, Glasgow, unpublished)
14
the experience of emerging markets private equity is a case of an investment model that has
proven unsuitable to emerging market conditions, or of incomplete market institutions in such
markets that cannot effectively support the asset class, or primarily a problem in law – legal
frameworks with structures that cannot support the needs of the specialised financial
contracts that underwrite private equity?
80
These issues underpin the main themes of this
study.
1.2.3 Private Equity: A Problem in Law
To amplify the preceding issues, it is observed that in practice, private equity occurs as a
set or series of financial contracts that define ‘the private equity cycle’.
81
The ‘cycle’ has
three main phases of occurrence –
(i) the fundraising phase when investors make funds available for private equity
ventures;
(ii) the investment stage when specialist fund managers identify, select and invest in
private companies;
82
and
(iii) the divestment stage when fund managers unlock the value in their investments
through a range of liquidation strategies.
83
Each stage is underwritten by a specific type of financial contract, hence there are three
main sets of contracts: contracts governing the relationship between capital holders and fund
managers, contracts between fund managers and investee (venture) companies, and contracts
80
Daniel Berkowitz, Katharina Pistor and Jean-Francois Richard, ‘Economic Development, Legality and the
Transplant Effect’ (2003) 47 European Economic Review 165-95
81
Paul Gompers and Josh Lerner, The Venture Capital Cycle, (MIT Press, Cambridge, Massachusetts 2004) ch
2 (An Overview of Venture Capital Fundraising) 23; ch 3 (What Drives Venture Capital Fundraising?) 33
82
ibid 157
83
ibid 345 ch 3 s 3.3 for an exposition of the nature of private equity.
15
between fund managers and third-party acquirers of fund manager-held securities at the time
of divestment. At the level of the venture company (stage II of the cycle, above), three
specific sale and purchase agreements underpin the private equity ‘event’.
84
They are –
(i) a share acquisition transaction;
(ii) an equity finance transaction; and
(iii) a debt finance transaction.
The research question asks in effect: at each of the key stages of the private equity
cycle, what role do (or can) laws and legal institutions play in expanding fundraising, or
driving demand for private equity, or creating efficient conditions for the conclusion and
execution of financial contracts?
85
At first glance – and as economists readily argue - the very design and nature of
private equity as a monitoring-based financial contracting strategy would seem to discount a
central role for the law and by extension its legal institutions in the emergence and expansion
of the industry.
86
This argument rides on the much-flaunted ability of private equity to
effectively assess investment risks through thorough pre-investment screening processes,
overcome informational asymmetries, and align ownership and management interests thereby
ruling out or sufficiently internalising agency risks through negotiated compensation
structures embedded in the investment agreement.
87
It is upon this basis that arguments have
been advanced that macroeconomic factors that drive the external environment for private
84
Jack S Levin, Structuring Private Equity, Venture Capital and Entrepreneurial Transactions (Aspen, 2011),
5-12, and for background: 1-3, 1-8, 1-10, 2-10, 4-4 and 4-68
85
Ronald J Gilson, ‘Engineering a Venture Capital Market: Lessons from the American Experience’ (2003) 55
Stanford Law Review 1067-1103
86
Michael Gorman and William Sahlman, ‘What Do Venture Capitalists Do?’ (1989) 4 Journal of Business
Venturing 231-248
87
From the framework of an economic conception of property rights – for instance: starting with Coase 1937
(contract theory of the firm); Alchian and Demsetz 1972 & Jensen and Meckling 1976 (incentives theory and
residual claims); Klein, Crawford & Alchian 1978; Williamson 1979 (limitation of post-contract alienations);
Grossman and Hart 1986, and Hart and Moore 1990 (detangling of hold-ups); Aghion and Bolton 1992
(incomplete contracts).
16
equity (availability of investment opportunities and exit avenues), rather than internal factors
(legal factors such as systems for contractual integrity) play a deterministic role in the
occurrence and growth of private equity markets.
This thesis takes the view that an exclusivist approach to the subject’s study, either
economic and fiscal, or legal, would yield misguided results in an emerging market context
for at least five primary reasons.
Firstly, private equity is structured as a set of financial contracts, and as such, raises
issues in contract law.
88
The mere fact that lots of resources are devoted to a pre-investment
discovery process that leads to the adoption of financing agreements that in some cases run
into hundreds of pages suggests not only the critical importance of pre-investment covenants,
but also the importance of clarifying a logical basis for the allocation of rights and obligations.
It would be folly otherwise.
89
As much, therefore, as other environmental factors such as
macro-economic determinants may be important variables in a country’s attractiveness to
investment, the foregoing argument asserts that legal determinants could be the decisive
variable, in the investment decision.
Secondly, as a monitoring-based contracting and investment strategy, the private
equity financial contract is a relational contractual coalition that relies on external agencies
for the resolution of contract-based disagreements – which introduces a role for dispute-
88
To illustrate the intensely law-based private equity process, model private equity contract templates can be
found at the American National Venture Capital Association website at
(current as of
February 2011) accessed 17 February 2012 – These include a term sheet, a stock purchase agreement, a
certificate of incorporation, investor rights agreement, voting agreement, rights of first refusal and co-sale
agreement, management rights letter, indemnification agreement and legal opinions.
89
id – the USA private equity industry is estimated to spend over USD200 million annually in pre-investment
contract negotiations.
17
resolving institutions. These institutions include courts, but also norms of behaviour
supporting positive reputations.
90
Thirdly, by virtue of its methodology - share capital and acquisition-type
investments – private equity raises issues under both corporate and securities laws.
91
Fourthly, in an emerging context where legal and market institutions are still nascent
or absent, and macroeconomic instability common, an important role arises for the law in
organising market structure and behaviour.
92
Fifthly, macroeconomic factors depend on legal instruments. Thus to achieve deep
debt markets in a country, that country will rely on bank sector regulation and capital markets
regulations in organising market activity, establishing trading and other rules of exchange,
punishing errant behaviour – in effect, employing the law to deliver the macroeconomic
effect of ‘confidence’ in a financial system.
93
It can be observed that in an inter-disciplinary industry such as private equity, no one
academic discipline in isolation is able to deliver a definitive model for growth. Nonetheless,
this thesis argues that legal and institutional factors are likely to wield a stronger influence
than the other competing explanations to the emergence and growth of private equity in
developing countries like Kenya.
90
Eric A. Posner, ‘A Theory of Contract Law under Conditions of Radical Judicial Error’ (August 1999)
University of Chicago Law School, John M. Olin Law & Economics Working Paper 80
accessed 23 October 2007.
91
Luc Renneboog, and Tomas Simons (2005), ‘Public-to-private transactions: LBOs, MBOs, MBIs, and IBOs,’
Finance Working Paper 94/2005 European Corporate Governance Institute.
92
Douglass C North, ‘Institutions’ (1991) 5(1) Journal of Economic Perspectives 97-112
93
Joseph J Norton, Taking Stock of the First Generation of Financial Sector Legal Reform, (2007) SMU
Dedman School of Law Legal Studies Research Paper 9, 32 accessed 28
October 2011; cf: JJ Norton, ‘Financial Sector Reform and International Financial Crises: The Legal Challenges’
(1998) 16 Essays in International Financial Economic Law; Davide Lombardo and Marco Pagano, Law and
Equity Markets: A Simple Convergence and Diversity of Corporate Governance Regimes and Capital Markets, J.
McCahery, P. Moerland, T. Raaijmakers, L. Renneboog (eds.) (Oxford University Press, 2002)
18
The foregoing themes are central to this inquiry for two reasons. Firstly, economic,
94
financial economists
95
and legal
96
scholars have and continue to clash over attempts to
answer the main question in this study, with the former two pointing to macroeconomic
factors as the deterministic elements, while the latter holds up the defining role of the law and
legal institutions in facilitating private transactions. All disciplines lend forceful and
persuasive arguments in support of the divergent views. Secondly, for Kenya, which is
seeking to unlock channels for financing its private sector in an effort to catalyse economic
development, and given private equity’s promising emergence in Kenya, modelling
approaches could not be more confusing and uncertain.
97
This is thus an important question
from both academic and practical perspectives.
1.2.4 The Secondary Questions
To fully explore the variables to the research themes outlined above, the following
secondary questions appear pertinent to the totality of this inquiry:
? Firstly, if the law is relevant, whether it plays a deterministic or supporting
role.
? Secondly, if relevant, in what ways it is so.
94
Alexander I. J. Dyck and Luigi Zingales, Private Benefits of Control: An International Comparison (2002)
CEPR Discussion Paper 3177
A Thesis Submitted in fulfilment of the requirements for the award of the Degree of Doctor of Philosophy in Law (Research).
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PRIVATE EQUITY IN KENYA: AN ANALYSIS OF EMERGING
LEGAL AND INSTITUTIONAL ISSUES
BY
Tuimising, Nathan Ronoh
A Thesis Submitted in fulfilment of the requirements for the award of
the Degree of Doctor of Philosophy in Law (Research)
University Of Warwick, School Of Law
April 2012
ii
TABLE OF CONTENTS
List of Tables, Charts, Figures and Cases xii
Acknowledgements xv
Declaration xvii
Abstract xviii
Abbreviations xix
CHAPTER 1 – SETTING OUT THE PROBLEM AND SCOPE OF STUDY
1.1 Introduction 1
1.2 The Question 5
1.2.1 Main Question 5
1.2.2 Legal Instruments in Public Policy for Private Equity 9
1.2.3 Private Equity: A problem in Law 14
1.2.4 The Secondary Questions 18
1.3 Why is a Study of Private Equity Important to Kenya? 21
1.4 Scope of Study 26
1.4.1 Legal and Institutional Elements 26
1.4.2 Originality and Contribution to Knowledge 27
1.4.3 Why Kenya is Selected as a Case Study 28
1.5 Key Terms 31
1.5.1 Venture Capital 31
1.5.2 Growth Capital 33
1.5.3 Management Buyouts (MBOs) and Management Buy-ins (MBIs) 34
1.5.4 Leveraged Buyouts (LBOs) 35
1.5.5 Institutional Buyouts (IBOs) 35
1.5.6 Secondary Buyouts (SBOs) 36
1.5.7 Private Equity for Infrastructure 36
iii
1.5.8 Real Estate Private Equity 37
1.5.9 Distressed and Special Situations Private Equity 38
1.5.10 Mezzanine Funds 39
1.5.11 Emerging Markets 40
1.6 Structure of the Thesis 41
CHAPTER 2 – RESEARCH METHODOLOGY AND EMPIRICAL DESIGN
2.1 Introduction 44
2.2 Conceptual Reflections 45
2.3 Methods 49
2.4 Research Model 50
2.5 Applying Model to Data 52
2.6 Data Sources 53
2.7 Instrumentation 56
2.8 Data Description 58
2.9 Analytical Strategy 60
2.10 Limitations to Chosen Methodology and Impact on Results 61
2.11 Conclusion 64
CHAPTER 3 – HISTORY AND NATURE OF PRIVATE EQUITY
3.1 Introduction 65
3.2 The Evolution of Private Equity 67
3.2.1 Very Early Private Equity 67
3.2.2 Government Venture Capital and Public Policy in Private Equity 68
3.2.2a USA 69
3.2.2b UK 72
3.2.2c The Netherlands 74
iv
3.2.2d Israel 76
3.2.2e Chile 78
3.2.2f Spain 79
3.2.2g Taiwan 80
3.2.2h Lessons from Competing Models 81
3.2.3 Institutionalisation and Segmentation of Private Equity 82
3.2.4 Drivers of Private Equity Fundraising Since 1950s 88
3.2.5 Negative Corporate Practices 91
3.2.6 Globalisation of Private Equity 94
3.3 Transactional Features of private Equity 96
3.3.1 Specialised, Adaptive Enterprise Capital 96
3.3.2 Overcoming Business Uncertainties 97
3.3.3 Unlimited by the asset Characteristics of venture Companies 100
3.3.4 Elements of a Private Equity Transaction 101
3.4 Conclusion 103
CHAPTER 4 – SOURCES OF ENTERPRISE CAPITAL IN KENYA
4.1 Introduction 105
4.2 Supply and Demand Drivers to Risk Finance – Some Issues 108
4.3 Kenya’s Financial and Money Market Institutions 110
4.3.1 The General Financial Infrastructure in Kenya 110
4.3.2 Micro-Finance 112
4.3.3 Savings and Credit Cooperative Societies 115
4.3.4 Bank Loans 117
4.3.5 Public Equity Markets 119
4.4 Analysing Kenya’s Capital consumers: the private Sector 123
v
4.4.1 High-Level Demographics 123
4.4.2 Selected Economic Indicators 126
4.4.3 Business Informality 129
4.4.4 Preponderance of Small Companies 130
4.4.5 Negative Business Practices 131
4.4.6 Bureaucracy and Other Constraints 133
4.5 Barriers to Finance 134
4.5.1 Collateral Quality 134
4.5.2 Cost of Bank Credit 137
4.5.3 Business Informality and Financial Reporting Standards 138
4.5.4 Negative Business Practices 144
4.5.5 Weak Financial Institutions: History of Bank Failures 145
4.5.6 Narrow Range of Creative Financial Products 149
4.6 How Private Equity Intermediation Resolves Identified Barriers 149
4.7 Conclusion 151
CHAPTER 5 – FEATURES OF KENYA’S PRIVATE EQUITY INDUSTRY
5.1 Introduction 153
5.2 Private Equity in the Public Consciousness 154
5.3 PE Funds: Kenya Statistics 158
5.4 Fund Characteristics 159
5.5 Investment Strategy 170
5.6 Investment Life Cycle 173
5.7 Capital Structuring in Private Equity 177
5.8 Syndicating Transactions 185
5.9 The Exit Framework 186
5.10 Future Outlook of Kenyan Private Equity 190
vi
5.11 Conclusion 195
CHAPTER 6 – THE REGULATORY FRAMEWORK FOR PRIVATE EQUITY
6.1 Introduction 198
6.2 Regulating PE – which way? 200
6.3 Private Equity in Kenyan Law 203
6.3.1 Definition of Private Equity 203
6.3.2 The Law on Registration 205
6.3.3 A Dual Regulatory Framework 213
6.3.4 Control of Mergers and Acquisitions 214
6.3.5 Regulating Corporate Governance in Fund Management 219
6.3.6 Reporting Obligations 220
6.3.7 Investment Restrictions 221
6.3.8 Fundraising Rules 223
6.3.9 Restrictions on Financial Assistance 223
6.3.10 Conflict of Interest – Directors 228
6.3.11 Limitations on Multiple Directorships 230
6.3.12 Minority Shareholders 234
6.4 State of Regulatory Compliance 235
6.5 International Perspectives on the Regulation of Private Equity Activity 239
6.5.1 Experience of the European Union 239
6.5.2 Experience in the UK 241
6.5.3 Experience in the USA 243
6.5.4 Distilling Lessons from International Practice 246
6.6 Analysing the Kenyan Experience 247
6.7 Conclusion 249
vii
CHAPTER 7 – TAX PLANNING FOR PRIVATE EQUITY
7.1 Introduction 251
7.2 How Tax Law and Policy Impact Private Equity 253
7.3 General Principles of Taxation in Kenya 256
7.3.1 Tax Liability 256
7.3.2 Tax Avoidance and Evasion 257
7.3.3 Tax Planning Principles 258
7.4 High Impact Tax Elements for Private Equity 260
7.4.1 Corporate Tax 260
7.4.2 Taxation of Management and Professional Fees 263
7.4.3 VAT and Other Business Tax 264
7.4.4 Capital Gains and Dividends 265
7.4.5Compensating and Withholding Tax on Dividends 268
7.4.6 Deductible Expenses for tax Purposes 270
7.4.7 State Subsidies 272
7.4.8 Risk of Double Taxation 273
7.4.9 Taxing Stock Options 273
7.4.10 Fiscal Incentives for Research and Development 275
7.5 Evaluation of the Tax Environment for Private Equity 278
7.6 Conclusion 281
CHAPTER 8 - THE ROLE OF COURTS IN FINANCIAL CONTRACTING
8.1 Introduction 282
8.2 Classification of Contract Terms 286
8.2.1 Conditions and Warranties 286
8.2.2 Doctrine of Reliance 291
viii
8.2.3 Doctrine of Expectancy 293
8.3 Conflict Management in Private Equity : The General Principles 294
8.4 Commercial Arbitration in Kenya 299
8.5 Commercial Litigation 312
8.5.1 Constitutional Basis for the Kenyan Judiciary 312
8.5.2 Fund Manager Attitudes to Local Litigation 314
8.6 Constraints in the Judiciary 318
8.7 Some Reflections on What the Findings Mean 322
8.8 Conclusions 323
CHAPTER 9 – CONCLUSIONS
9.1 Introduction 328
9.2 Issues on the Design of a Law on Private Equity 331
9.3 Issues on Tax Policy for Private Equity 334
9.4 Issues on Private Equity Fundraising 336
9.5 Issues on Capital Markets Development for Private Equity 338
9.6 Issues on the Integrity of Financial Contracts 341
9.7 Synthesising Findings 344
9.8 Future Research 347
BIBLIOGRAPHY 349
ix
LIST OF TABLES, CHARTS, FIGURES AND CASES
Tables
Table 1: Cross-Country Evidence of Policy Interventions in Private Equity 9
Table 3.1: USA Legal Policy for Private Equity 1934 - 2010 71
Table 3.2: Summary of Elements in a Private Equity Transactions 101
Table 8.1: Kenya - Contract Enforcement 314
Charts
Chart 3.1 Fundraising and Investment Trends, Emerging Markets 95
Chart 4.1 Selected Economic Indicators 123
Chart 4.2: GDP Per Capita in Current Prices – Comparative View (in USD thousands) 128
Chart 4.3: Structure and Practices: Kenyan Private Sector 129
Chart 4.4: Likelihood of Corruption Impacting Private Equity 132
Chart 4.5: Reliability of Financial Statements 141
Chart 4.6: Impact of Improved Disclosure Standards 143
Chart 4.7: Bank Failures: 1963 – 2010 146
Chart 4.7: Bank Failures: Trends 146
Chart 5.1: Number of Private Equity Firms in Kenya 155
Chart 5.2: Fund Structures and Key Personnel Trends 162
Chart 5.3: Fund Sources 164
Chart 5.4: Geographic Source of Funds 169
Chart 5.5: Investment Sector Focus 171
Chart 5.6: Average Life Cycle for Post-2008 Investments 174
Chart 5.7: Effects of Long Hold Periods 175
Chart 5.8: Security Design 180
x
Chart 5.9: Syndication Drivers 186
Chart 5.10: Preferred Exit Strategy Under Local Market Conditions 187
Chart 5.11: Fund Performance Drivers 188
Chart 5.12: Controlling for Exit by Contract 189
Chart 5.13: Key Market Dynamics 190
Chart 5.14: Constraints to Private Equity Uptake in Kenya 191
Chart 5.15: 18-Month Fund Manager Projection on Investment Climate 193
Chart 8.1: Contract Enforcement Trends 307
Chart 8.2: Why Fund Managers Reject Local Arbitration 308
Chart 8.3: Contract Enforcement Trends 315
Chart 8.4: Push Factors to Litigation in Kenya 317
Figures
Fig 8.1: Typical Private Equity Conflict Management Continuum 294
Fig 8.2 Judicial Structure 313
Fig 9.1 Private Equity Growth Model for Kenya 346
Cases
Abbott Labs. v. Young, 920 F.2d 984, 988 (D.C. Cir. 1990)
Aid Ass’n for Lutherans v. United States Postal Serv., 321 F.3d 1166, 1174 (D.C. Cir. 2003)
Azim Virjee & Two Others v Glory Properties Limited [2007] HCC559/1999, eKLR
Baird Textiles Holdings Ltd v Marks & Spencer plc, [2001] EWCA Civ 274, [2001] 1 All ER
(Comm) 737 (CA)
Balston v Headline Filters [1990] FSR 385
Bowerman v Association of British Travel Agents Ltd [1996] CLC 451 (CA)
xi
Bristol and West Building Society v Mothew [1998] Ch 1 18 CA
Caparo Industries plc v Dickman [1990] 2 AC 605.
Carlill v Carbolic Smoke Ball Company [1893] 1 QB 256 (CA)
Chevron Kenya Limited v Tamoil Kenya Limited [2007] HCCC 155
Christ For All Nationals v Apollo Insurance Co. Ltd [2002] 2 EA 366
City and Westminster Properties (1934) Ltd v Mudd [1959] Ch 129
David Thuo & 8 Others v First America Bank of Kenya Ltd [2005 HCC 494/2005] eKLR
Don-Wood Co. Ltd v Kenya Pipeline Ltd Civil [2004] HCCC 104
Edwards v Skyways Ltd (1964 1 W.LR. 349)
Epco Builders Limited v Adam S. Marjan-Arbitrator & Another [2005] HCC 248
Estate Finance Company of Kenya Ltd v Narok Transit Hotel Ltd & 2 Others [2011] HCCC
No.710/1999 eKLR
George M Musundi & 2 Others v Small Enterprises Finance Company Ltd [2007] eKLR,
Civil Case No.1861/1995
George M Musundi & 2 Others v Small Enterprises Finance Company Ltd [2007] eKLR
Hedley Byrne & Co. Ltd v Heller & Partners Ltd, (1964) AC 465 (HL)
Helmet Integrated Systems v Tunnard [2007] CA
Henderson v Merrett Syndicates Ltd [1995] 2 AC 145
International Standard Elec. Corp (ISEC) v Bridas Sociedad Anonima Petrolera Industrial Y
Comercial, 745 F. Supp. 172, 178 (S.D.N.Y. 1990) in VII Y.B. COM.ARB.312(1982)
xii
J. Evans & Son (Portsmouth) Ltd v Andrea Merzario Ltd, [1976] 1 WLR 1078 (CA)
Kenya Institute of Management v Kenya Reinsurance Corporation [2008] eKLR
Kundan Singh Construction Ltd v Kenya Ports Authority, HCC 794/2003
L. Schuler v Wickman Machine Tool Sales (1974) AC 235 (HL)
Lombard North Central plc v Butterworth (1987) QB 527 (CA)
London and Mashonaland Exploration Co. Ltd v New Mashonaland Exploration Co. Ltd
[1891] WN 165
McRae v Commonwealth Disposals Commission (1951) 84 CLR 377
Mumias Sugar Company Ltd v Freight Forwarders (K) Ltd Nairobi CA 297/2003
Nakumatt Holdings Limited v Kenya Wildlife Services [2001] HCCC 1131
National Bank of Kenya Ltd V. Wilson Ndolo Ayah [2009] eKLR
Nokes v Doncaster Amalgamated Collieries Ltd [1940] A.C. 1041
Pamela Akora Imenje v Akora ITC Intenational Ltd & Another [2007] eKLR
Peter Muema Kahoro & another v Benson Maina Githethuki [2006] eKLR
Phillip Goldstein, et al, Petitioners, vs. Securities and Exchange Commission, Respondents
District of Columbia Circuits, No. 04-1434
Rawal v Mombassa Hardware Ltd [1968] EA 398
Reading Intl, Inc., v Oaktree Capital Management LLC, 317 F.Supp. 2d 301 – 331 (S.D.N.Y.
2003)
xiii
Robert F. Booth Trust v Crowley et al & SEARS Holding Corporation, No. 09 C 5314
N.D.I.[2010]
Robinson v Harman (1848) 1 Exch 850, 855
Ruxley Electronics & Construction Ltd v Forsyth [1960] 1 AC 344 HL
Shepherds Investments Ltd v Walters [2007] 2 BCLC 202
Standard Bank Ltd v Mehotoro Farm Ltd & 2 Others CC 54 [1972] CA
Thermascan Ltd v Norman [2009] EWHC 3694 (Ch)
US v Dairy Farmers of Am., Inc., 426 F.3d 850 – 855 (6
th
Cir. 2005)
xiv
ACKNOWLEDGEMENTS
First and foremost, my gratitude goes to my God for the gift of life, good health,
mental sanity and spiritual stability – the very values that nudged me to this finish line.
This work could not have been completed without the faith and constant support of
my supervisor and friend, Dr. Dalvinder Singh, Associate Professor of Law at the Warwick
University School of Law. In addition to his incisive and direct academic criticism of my
thinking and writing, he was a pillar of faith and basic common sense when it came to my
staying the course.
I acknowledge in a special way my examiners – Prof. Charles Chatterjee (internal)
and Dr. Nicholas Ryder (external), for interrogating the quality and consistency in this work,
and for the lively engagement and profoundly insightful recommendations on how to improve
this work at the publication stage. Their experience and wise judgement brought this work to
an illustrious conclusion.
I especially acknowledge all individuals and institutions in Kenya that supported the
empirical aspects of this study: without their granting access, this work could not have taken
the practical form that it has.
But most of all, my affectionate and lovely wife, Beverlyn, and our two children,
Tanya and Nate-Jr., for their steady love and unfailing belief in the end of this road
(especially during the long periods when days fused into nights before the computer screen,
and weekdays into weekends). In many ways, this achievement is theirs: we came, we saw,
we accomplished, and together we are better than either one of us.
My journey through Warwick undeniably bears the positive impact of various
individuals who, in their different ways, have their indelible influences woven into the fabric
xv
of this academic achievement. They include my parents and family, the Government of
Kenya through Mr. Wanjuki Muchemi, CBS, Solicitor General of the Republic of Kenya
(2002-2012 – whose vision and selflessness facilitated my continued engagement with
advanced education), Dr. Jorge Guira, my first supervisor, Dr. Lydia Schulz, my friend and
mentor, Dr. Rodrigo Olivares Caminal (member of my upgrade panel in 2008), Prof. Istvan
Pogany (Director of Post Graduate Research at the Law School, 2010), Ms Jennifer Mabbett
(the gentle and indefatigable Post-Grad Secretary at the Warwick Law School), the Students
Finance Office, the Warwick Board of Graduate Studies, my doctoral colleagues at the Law
School, Dr. Ambreena Manji and Dr. Upadhya Radha both of the British Institute for Eastern
Africa, and Prof. Yash Pal Ghai of Katiba Institute, Steve Sitienei and Dr. Billingsley
Kaambwa (my friends), as well as Mrs. Joy Warmington, CEO Brap Ltd, Mrs. Siobhan
Harper-Nunes, Ghiyas Somra, Amy Wilkins, Emma Wright, Safia Lul, Dr. L Sitienei - for the
various parts they each played to support me through.
xvi
DECLARATION
I, the undersigned, hereby confirm that this thesis is my own original work and does not
include any material already submitted for another degree at the University of Warwick, or
material I have previously had published. I also confirm that the thesis has not been submitted
for a degree at another university.
TUIMISING, Nathan Ronoh
xvii
Abstract
In Kenya, like in many other countries around the world, private equity’s
emergence as a creative method for financing companies, is attracting
attention as the government seeks new ways of financing its private sector –
which it now recognises as the engine for Kenya’s economic development.
This policy outlook is undermined by the reality of a yet extensively under-
capitalised private sector, and the lack of a coherent body of knowledge and
experience on Kenyan private equity. This study, for the first time, brings
together that dispersed body of knowledge to facilitate coherent analysis of
the emerging legal and institutional issues that private equity introduces.
Using case law and statutory analysis, documentary reviews, interviews and
surveys to construct the complete picture of Kenyan private equity, this
empirical legal inquiry finds that the law on private equity in Kenya is
incomplete: it is patchy and dispersed, and is not uniformly applied among
and across all private equity market intermediaries. Secondly, the institutions
charged with supervising the implementation of the law are under-
capacitated, with the result that regulatory supervision within the private
equity industry remains weak and largely unfelt. Thirdly, the legal
institutions supporting private equity practice in Kenya (security of property
rights, security of financial contracts and integrity in financial reporting) are
in a nascent state of development. Fourthly, there is no clear policy on
alternative investments generally, and private equity particularly, in Kenya,
undermining precision in regulatory objectives. These realities combine to
blunt the impact of private equity in driving creative entrepreneurship. These
realities support the need for structured national capacity enhancement
across all spheres of private equity practice, such as would strengthen
regulatory supervision, the emergence of a ‘home brand’ to private equity,
the increased visibility of structured government engagement in channelling
private equity into economically productive sectors linked to the nation’s
development strategy. These findings mirror earlier research investigating
the under-performance of private equity in emerging markets, with the
upshot that a Law and Institutional Growth Model for Private Equity in
Kenya is the necessary catalyst that will trigger the rapid expansion of the
Kenyan private equity industry in aid of national development.
xviii
ABBREVIATIONS
ARDC American Research and Development Corporation
AVCA Africa Venture Capital Association
CBK Central Bank of Kenya
CMA Capital Markets Authority of Kenya
EMPEA Emerging Markets Private Equity Association
ERS Economic Recovery Strategy for Employment and Wealth Creation
EVCA European Venture Capital Association
GP General Partners
ICAP Investment Action Master Plan
ICAP Investment Climate Action Plan
LLP Limited Liability Partnership
LP Limited Partners
MAPSKID Master Plan Study for Kenyan Industrial Development
MFI Microfinance Institution
MoTI Ministry of Trade and Industry
MSME Micro Small and Medium Enterprises
NSE Nairobi Stock Exchange
NVCA National Venture Capital Association
PE Private Equity
PSDS Private Sector Development Strategy
SACCO Savings and Credit Cooperatives
SASRA SACCO Societies Regulatory Authority
SBIC Small Business Investment Companies
SBIR Small Business Investment Research
SME Small and Medium Enterprise
SMEx Small and Medium Enterprise Exchange
VC Venture Capital
1
1
SETTING OUT THE PROBLEM AND SCOPE OF STUDY
1.1 Introduction
Private equity - a financial and investment intermediary between holders and
providers of capital on the one hand, and specific types of private companies, on the other
1
-
can be catalytic in transforming the way in which a country’s most productive economic
sectors develop.
2
This is particularly true in a developing country context like Kenya, a sub-
Saharan African country whose private sector is still under-capitalised and under-developed.
3
Development research indicates that the private sector is the main driver of economic
growth,
4
a position adopted in development literature
5
as well as in Kenya’s ambitious
economic development plans which seek to transform Kenya into a middle-income economy
by the year 2030.
6
Yet to be an effective partner in development, the private sector needs to
be adequately and appropriately capitalised.
1
Douglas J. Cumming and Sofia A. Johan, Venture Capital and Private Equity Contracting: An International
Perspective (Elsevier, USA, 2009) 3, 4
2
Richard Kitchen, ‘Venture Capital: Is It Appropriate for Developing Countries?’ In Business Finance in Less
Developed Capital Markets (1992) Klaus Fischer and George Papaioannou (eds), Hofstra University– private
equity is (a) a type of investor, (b) a financial contracting strategy through which equity capital is made
available to private companies, and (c) an investment management service.
3
Mukhisa Kituyi, Improving the Investment Climate and Participation of the Private Sector in the Economy
(Ministry of Trade and Industry, Policy Briefing Paper, Nairobi, 11-12 April 2005) 2,3
accessed 29 December
2011; also: IMF Financial Access Survey (2009) - accessed 5 February 2012 – key
indicators are that out of 1000 adults, less than 74 have access to a bank loan, and less than 370 own a savings
account. There are 2 bank branches in every 1000 square kilometres (or 7 ATMs to every 100,000 adults), and
lending to private sector stood at 32.6% of GDP, while deposits were 46% of GDP.
4
Yochanan Shachmurove, ‘An Introduction to the Special Issues on Financial Markets of the Middle East’
(2004) 9(3) International Journal of Business 213
5
DfID, ‘The Engine of Development: The Private Sector and Prosperity for Poor People’ (DfID, 2011)
accessed 5
October 2011. Also: Asian Development Bank, ‘Overview’ (ADB, 2011) accessed 20 October 2011 – ‘private sector has been, remains and will be the engine of
growth’.
6
Government of Kenya, ‘Vision 2030’ accessed August
2007.
2
There is extensive evidence from multilateral development institutions that financial
infrastructure in emerging markets remain under-developed.
7
‘Financial infrastructure’
includes all the institutions, technologies, standards and rules that support financial mediation
in a country.
8
Bossone, Mahajan and Zahir find that weak financial infrastructure tends to
drive selection bias, that is, providers of enterprise capital tending to withhold financing from
borrowers deemed to carry too much risk.
9
Rajan and Zingales had earlier lead evidence
suggesting that efficient financial infrastructure improved quality and quantity of business
finance.
10
A World Bank and IFC study in 2010 suggested that laws and regulations support
the efficient operation of a country’s financial infrastructure and financial system, thereby
indirectly the direction in which a country’s private sector develops.
11
This study argues that private equity can be a useful partner in expanding sources and
types of business finance, enabling private companies to more efficiently access the types of
enterprise capital in the right amounts.
Why is private equity uniquely well-suited to resolve these challenges?
7
Margaret Miller, Nataliya Mylenko and Shalini Sankaranayanan, ‘Financial Infrastructure – Building Access
Through Transparent and Stable Financial Systems’ (2009) International Bank for Reconstruction and
Development and International Finance Corporation,
accessed 23 January
2012 – “access to finance is the result of a complex interplay of different financial intermediaries, the right kind
of financial infrastructure, and a sound legal and regulatory framework”, 1
8
Penelope J Brook, ‘Foreword’ in Margaret Miller, Nataliya Mylenko and Shalini Sankaranayanan, ‘Financial
Infrastructure – Building Access Through Transparent and Stable Financial Systems’ (2009) International Bank
for Reconstruction and Development and International Finance Corporation,
accessed 23 January 2012
-‘Institutions’ in this context include payment remittance and securities settlement systems, collateral registries
and credit reference bureaux.
9
Biagio Bossone, Sandeep Mahajan and Farah Zahir, ‘Financial Infrastructure, Group Interests and Capital
Accumulation: Theory Evidence and Policy’ (2003) IMF Working Paper 03/24
10
Rajan Raghuram and Luigi Zingales, ‘Financial Dependence and Economic Growth’ (1998) 88 (3) American
Economic Review 559-86
11
Miller, et al., ‘Financial Infrastructure’ (2009) (n 7), 1 “access to finance is the result of a complex interplay
of different financial intermediaries, the right kind of financial infrastructure, and a sound legal and regulatory
framework”
3
Industry studies
12
on the one hand, and development literature,
13
on the other, have
urged the argument firstly that private equity drives economic development because it
promotes innovation. European studies, however, suggest a less optimistic impact, finding
mixed results in Italy
14
and UK.
15
The general weight of opinion nonetheless suggests a
positive relationship between the introduction of private equity into a company and its rapid
growth.
16
The argument is that this type of finance improves corporate performance by
increasing productivity
17
and disciplining management efficiency.
18
These studies ascribe
these outcomes to the private equity contracting model, which introduces close monitoring of
management action – and the overall impact, it is argued, is stronger business entities in the
economy.
Private equity, unlike collateral-based business credit, does not operate on a lending
basis – it becomes a shareholder in a business, strengthening balance sheets, providing
financing for a company’s most risky ventures, and enabling a company to unlock matching
traditional credit where needed, aiding promising new businesses to blossom. Research
12
Samuel Kortum and Josh Lerner, ‘Assessing the Contribution of Venture Capital to Innovation’ (2002) 31(4)
RAND Journal of Economics 674-692
13
Josh Lerner, Morten Sorensen and Per Stromberg, ‘Private Equity and Long-Run Investment: The Case for
Innovation’, The Global Economic Impact of Private Equity Report (2008) World Economic Forum, January
2008.
14
Stefano Caselli, Francesco Corielli, Stefano Gatti and Francesca Querci, ‘Corporate Governance and
Independent Directors, Much Ado About Nothing? The Evidence Behind Private Equity Investment
Performance’ (2008) CAREFIN-Universita Bocconi (unpublished); cf: Francesco Perrini, Ginevra Rossi, and
Barbara Rovetta, ‘Does Ownership Structure Affect Performance? Evidence from the Italian Market’ (2008) 16
(4) Corporate Governance: An Intenational Review 312-325 - explores the cause-effect relationship between
private equity and innovation; inconclusive whether innovation follows private equity, or vice versa.
15
Robert Cressy, Federico Munari, Alessandro Malipiero, ‘Creative Destruction? Evidence that Buyouts Shed
Jobs to Raise Returns’ (2011) 13(1) Venture Capital: Journal of Entrepreneurial Finance, 1-22
16
Johan Per Stromberg, ‘Private Equity, Industry Performance and Cyclicality’ (2010) The Global Economic
Impact of Private Equity Report, World Economic Forum, 19 part 2
17
Kevin Ames, ‘Management Buyouts and Firm-Level Productivity: evidence from a panel of UK
manufacturing firms’ (2002) 49(3) Scottish Journal of Political Economy, 304-317 – studies 78 UK buyouts
between 1986-1997; Richard Harris, Donald Siegel and Mike Wright, ‘Assessing the Impact of Management
Buyouts on Economic Efficiency: Plant-Level Evidence from the UK’ (2005) unpublished working paper –
studying 979 UK buyouts between 1994-1998.
18
Oliver Hart and John Moore, ‘Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining
Management’ (1995) (85) 3The American Economic Review 567-585; Cf: Matthias Dewatripont and Jean
Tirole, ‘A Theory of Debt and Equity: Diversity of Securities and Manager-Shareholder Congruence’ (1994) 19
(4) The Quarterly Journal of Economics 1027-1054
4
suggests that private equity is effective in introducing new technologies and new ideas into
the marketplace and dispersing them across an economy.
19
Such investments, it is said,
encourage and spur innovation,
20
generate good returns to investors thereby aiding in the
mobilisation of capital,
21
encourage robust corporate growth and expansion.
22
It is also
argued that it improves corporate governance
23
and promotes research and development as
lucrative commercial undertakings.
24
With all this promise, private equity does warrant serious academic investigation, a
pursuit that would model options for its growth within a developing country context. This is
all the more pertinent given its origins in North America and Western Europe, countries with
highly developed legal systems and institutions, compared to the relative under-development
of legal systems in developing countries.
25
This chapter does five things. Firstly, it sets out, in section 1.2, the main research
question underpinning this thesis and motivates it through a reflection on how various
governments around the world have employed legal instruments in public policy targeted at
private equity, and an exploration of private equity as a problem in law. Section 1.2 ends with
a statement of supporting questions that help in focusing the scope of the study. Secondly, In
19
Richard Kitchen, Venture Capital in Developing Countries (n 2) 1
20
Marcos A. Mollica and Luigi Zingales, ‘The Impact of Venture Capital on Innovation and the Creation of
New Business’ (2007) Working Paper Chicago University; cf: Josh Lerner, Morten Sorensen and Johan Per
Stromberg, ‘Private Equity and Long-Run Investment: The Case for Innovation’ (2008) The Global Economic
Impact of Private Equity, World Economic Forum Alternative Investment Working Paper Series
accessed January 2011.
21
European Private Equity and Venture Capital Association, ‘Survey of the Economic and Social Impact of
Venture Capital in Europe’ (2002)
accessed 20 October 2011
22
Shai Bernstein, Josh Lerner, Morten Sorensen and Johan per Stromberg, ‘Private Equity, Industry
Performance and Cyclicality’ (2010) The Global Economic Impact of Private Equity Report, World Economic
Forum, 19 accessed January 2011
23
George P Baker and Karen H Wruck, ‘Organisational Changes and Value Creation in Leveraged Buyouts:
The Case of OM Scott & Sons Company’ (1989) 25 Journal of Financial Economics 163, 190
24
European Private Equity and Venture Capital Association, Special Paper on Technology Success Stories
(2002) accessed 4 June 2011 - research and
development is especially important to growing economies that need innovative solutions to long-standing
economic challenges.
25
ch 3, 65, for a succinct history of private equity.
5
section 1.3, a number of justifications are offered why a study of private equity is important
to a developing economy like Kenya. Thirdly, in section 1.4, the study is delimited through
ascribing meaning and context to the two central themes of the inquiry, that is to say, ‘laws’
and ‘institutions’. This section also sets out the claims to originality, and justifies the choice
of Kenya as a case study in this investigation. Fourthly, in section 1.5, some of the key
concepts underpinning the study are defined, notably the richly nuanced and contextual
meaning of the term private equity, and the meaning of emerging markets. Lastly, in section
1.6, the chapter concludes with an outline of the way in which the remainder of the thesis has
been organised.
1.2 The Questions
1.2.1 Main Question
The general reflections in the preceding section suggest the existence of a dependency
between the state of a country’s economic , financial and private sector development. If
private equity offers a viable part solution to the unlocking of a nation’s private sector
potential in driving economic growth, a fundamental policy question becomes how can a
country grow private equity? In other words, what factors must a country secure for a robust
and economically significant private equity industry to grow – that is deepen its financial
infrastructure and its financial system?
26
What would those factors mean for a country’s law
and institutional development process?
26
Miller et al., ‘Financial Infrastructure’ (2009) ( n 7) 1
6
Opinion is generally united among private equity practitioners,
27
investors
28
and
academics
29
that the following four broad country characteristics influence the emergence of
private equity markets:
(i) economic growth rate and size of the economy;
(ii) size of stock markets and or depth of debt markets;
(iii) levels of entrepreneurship; and
(iv) quality of the legal system and regulatory practices.
The first three determinants are macro-economic in character, while the fourth is
socio-legal in nature. There is much less agreement, unfortunately, on which, if any, of the
four factors wields the greater influence – the deterministic effect, so to say – in catalysing a
sure start to the industry’s emergence and robust growth. This mix of factors, it is clear,
transcend any single academic discipline, but the fourth set of factors (legal system and
regulatory practices) to varying degrees appear to influence the manner in which the first
three conditions develop. In light of the foregoing, this study asks the following main
question -
Are laws and legal institutions really relevant to the growth of private equity
in an emerging market like Kenya? If so, what are the key emerging legal
and institutional issues?
This thesis argues that in an emerging market context, the law, and its legal
institutions, are likely to be more influential than macro-economic factors in nurturing
fortuitous environments for a robust private equity industry to emerge and expand. In
27
Heino Meerkatt and Heinrich Liechtenstein, ‘New Markets, New Rules: will emerging markets reshape
private equity?’ (IFC, November 2010)
accessed 11 October 2011.
28
International Finance Corporation, ‘The Case for Emerging Markets Private Equity’ (IFC, February 2011)
accessed 16 October 2011
29
Marina Balboa and Jose Marti, ‘Conceptual Model for Private Equity Markets: Proposal and Empirical Test
on Fundraising’ (EFMA London Meetings 2002)
accessed 16 November 2011.
7
adopting this proposition, this study views the first three elements as the ‘external factors’
that create the economic opportunity, while the fourth element is viewed as the ‘internal
factor’ that qualitatively unlocks both demand and supply of private equity through creating
crucial platforms for efficient financial contracting. In effect, the law is viewed as an
‘enabler’, hence the question what can a country do to enable the emergence of conditions
that support the growth of private equity.
30
As chapter 5 discusses in detail,
31
Kenya has a nascent private equity industry,
suggesting it is still a new form of financial contracting and intermediation in Kenya. The
second part of the main question, hence, seeks to explore the legal and institutional issues that
private equity raises and how the practice of private equity is anchored in the law. To what
extent are the issues raised by private equity efficiently resolved within the Kenyan legal and
institutional system? These are the central themes holding this investigation together.
This study thus unpicks the fourth element from among the four broad country
characteristics for private equity set out above – from the perspective of its likely
disproportionate influence on how the other three factors develop.
32
A discernible theme
arising from the literature, as far as emerging markets private equity is concerned, is the
notion that socio-economic environments, with particular emphasis on legal and regulatory
conditions, are especially crucial to private investment. This line of thinking argues that “the
most attractive markets for investors are determined (…) by the relative sophistication of (…)
their regulatory and legal systems.”
33
Without prejudice to the thesis statement set out above, the macro-economic factors
(economic growth rate, size of the stock market, depth of local debt markets, levels of
entrepreneurship and infrastructure), which are styled ‘the external factors’ in this chapter,
30
Miller et al., ‘Financial Infrastructure’ (2009) (n 7) 1 – laws and regulations support financial infrastructure
components to perform optimally
31
ch5, 158
32
Miller et al., ‘Financial Infrastructure,’ (2009) (n 7), 1-2
33
Meerkatt and Liechtenstein 2010 ( n 27) 1
8
are not unimportant in the wider scheme of private equity growth.
34
The argument in this
thesis, however, is that for these external factors to be highly effective, a supporting legal and
regulatory framework is necessary.
35
Evidence by Armour and Cumming
36
that stock markets do play a role in the growth
of private equity, also places heavier weight on the impact of laws that support
entrepreneurship, tolerates business failure, and protects shareholders, in addition to
supporting a low-tax environment. These, they find, play a potentially larger role in
determining whether private equity markets deepen in an economy. Their finding on taxation
resonates with earlier work by Porteba,
37
while their findings on the legal determinants
(including pension fund regulations and tax policy) extend similar findings by Jeng and
Wells.
38
These notions have certainly found currency in public policy, as the next section
illustrates. Studies by the private equity industry itself lend support to the core argument in
this study: the Latin America Venture Capital Association,
39
the British Venture Capital
Association (BVCA),
40
as well as the European Venture Capital Association (EVCA)
41
all
agree on the importance of law and legal institutions in culturing conducive environments for
private equity to emerge and grow.
34
Maria Ahmed, ‘Strong Prospects for African Private Equity’ (Emerging Markets, 24 April 2006)
accessed
16 October 2011
35
Wei Xiao, ‘The New Economy and Venture Capital in China’ OYCF (2002) 3 (6) Perspectives
36
John Armour and Douglas Cumming, ‘The Legislative Road to Silicon Valley’ (2006) 58 Oxford Economic
596-635
37
James M. Porteba, ‘Venture Capital and Capital Gains Taxation’ in LH Summers (ed), Tax Policy and the
Economy, (Cambridge, MA, MIT Press, 1989) ch 347-67
38
L.A. Jeng and P.C. Wells,’ Determinants of Venture Capital Fundraising: Evidence Across Countries’ (2002)
6 Journal of Corporate Finance 241-89
39
Jenna Gottlieb, ‘Evolving Regulation’ (LAVCA, 8 March 2011) accessed 23 January 2012
40
British Venture Capital Association, ‘A Guide to Private Equity’ (2010)
accessed 23 January 2012
41
EVCA Benchmarking Tax and Legal Environments (2008)
accessed 23 January 2012
9
1.2.2 Legal Instruments in Public Policy for Private Equity
Governments across North America and Western Europe, as well as others around the
world (see table 1, below), have adopted varied public policy measures targeted at crafting
more conducive national environments for private equity. A strong tenet of these public
policy responses has been the employment of legal instruments.
The first column in the table shows the year when governmental responses to private
equity was undertaken. The second column shows the country implementing the measure,
and in the third column, the policy measure is depicted. Column four summarises the impact
each policy measure helped deliver.
Table 1 Cross-Country Evidence of Policy Interventions in Private Equity/Venture Capital
Year Country Policy Intervention Impact
1958 USA Small Business Investment Companies Act
42
Larger fund pools, PE/VC
Professionalization
1974 USA Employee Retirement Investment Scheme Act
43
Chocked off pension
Investments in PE/VC
1978 USA “Prudent Man” ERISA clarification
44
Triggered rapid investments in
PE/VC
1980 USA Small Business Innovation Research Programme
45
Channelled billions into
PE/VC
1992 Israel Yozma Programme – USD100m Govt VCF
46
Rapid co-investing by private
Sector
2000 UK Numerous specialist government funds
47
Targeted small firms
42
U.S. Small Business Administration, ‘Small Business Investment Act of 1958’ accessed 24 October 2011
43
ERISA, Pub. L. 93-406 - USCS s1002 of 2 September 1974
44
Title 29-18 1B-4 USCS s1104 – ‘Fiduciary Duties’, s1104(a)(1) ‘The Prudent Man Standard of Care’.
45
Joshua Gans, and Stern Scott, ‘When does funding Research from Smaller Firms Bring Fruit? Evidence from
the SBIR Programme’ (2003) 12 (4) Economics of Innovation and New Technology 361-384
46
Gil Avimelech and Morris Teubal, ‘Israel’s Venture Capital Industry: Emergence, Operation and Impact’ in
David Citendamar (ed.), The Growth of Venture Capital: A Cross-Cultural Analysis (Westport Praeger 2002)
47
British Venture Capital Association, ‘A Guide to Private Equity’ (2010)
8-13
10
2001 Denmark Danish Growth venture Fund
48
Market Stimulated
2001 EC European Investment Fund
49
Euros 2 billion fresh capital
2003 France Plan Innovation
50
Targeted at innovative firms;
2006 Netherlands Regulatory Harmonisation
51
More investments into PE/VC
2002 Singapore
52
Tax Incentives (Silicon Valley Model) Rapid growth of local PE
2002 Taiwan
53
Tax Incentives/Business Regulation Explosive growth in VC
2003 India
54
Venture Capital Regulations / Capital Markets Rise of Technology Valley
2003 China
55
Changes to PE Laws – 2003; 2006; 2007 Increased fundraising for China
2003 Japan
56
1998 Brazil Various regulatory improvements since 2003
57
Brazil more attractive to global
Private equity firms
The role and influence of public policy in the emergence and growth of markets for
risk finance is thus well documented. It is telling that a substantial number of the foregoing
public policy responses employed legal instruments, and were targeted at shoring up the
supply, or quantity, of private equity/venture capital in an economy.
48
Vækstfonden’s (Danish Growth Fund), ‘The Best Market for Innovation Finance in Europe’ (2001)
accessed 25 October 2011
49
Europa, ‘European Investment Fund’ (1994) accessed 8 December 2007
50
Marco Da Rin, Giovanna Nicodano and Alessandro Sembenelli, ‘Public policy and the creation of active
venture capital markets’ (2006) 90 (8-9) Journal of Public Economics 1699-1723
51
Douglas Cumming and Sofia Johan, ‘Regulatory Harmonization and the Development of Private Equity
Markets’ (2007) 31 Journal of Banking and Finance 3218-3250 – see chapter 3, section 3.2.2c for detailed
discussion.
52
Winston T.H. Koh and Francis Koh, ‘Venture Capital and Economic Growth: An Industry Overview and
Singapore’s Experience’ (2002) Singapore Management University, school of Economics and Social Sciences
Workong Paper 21 /2002
53
L Songtao, ‘The Stage and the Character of Venture Capital Development in Taiwan, Asia and Pacific
Economies’ (2000)
54
Mike Wright, Andy Lockett and Serika Pruthi, ‘Internationalization of Western Venture Capitalists into
Emerging Markets: Risk Assessment and Information in India’ (2002) 19 (1) Journal of Small Business
Economics 1 – 62 Springer Netherlands
55
Lutz-Christian Wolff, Mergers and Acquisitions in China: Law and Practice 2008 (2
nd
edn, CCH Hong Kong
Limited 2008), ch 5, 6, 7, 8 and 15 - These include the Regulations on the Administration of Foreign-Invested
Venture Capital Enterprises, 2003 (which sets out express prohibitions on the types of investment activities
foreign-invested enterprises cannot undertake), the Interim Measures for the Administration of Venture Capital
Funds, 2006, which apply to non-foreign invested venture capital undertakings, and revisions to the Chinese
partnership law in 2007, which had revisions impacting foreign-invested partnerships. Chinese law distinguishes
between onshore and offshore funds, and subjects offshore funds and special purpose investment vehicles to
specific restrictions.
56
Masaki Kuroki, Mark P. Rice and Pier A Abetti, ‘Emerging Trends in the Japanese venture Capital Industry’
(2000) Journal of Private Equity 39 -49
57
Generally,[Editor], Latin America Venture Capital Association, ‘Evolving Regulation’ (8 March 2011),
accessed 23 January 2012
11
Korosteleva et al
58
suggest that regulation is an important catalyst of start-up capital
into the economy, but find that ‘over-regulation’ has a stifling effect. However, ‘over-
regulation’ within that study is not precisely defined, and it is doubtful whether the term
means the same thing in different economic contexts, casting some doubt over the ‘stifling
effect’ argument. From a public policy perspective, nonetheless, the effectiveness of a
country’s financial system’s regulatory model would seem to have a strong impact on how
financial markets develop.
Bose, Panini and Chitralekha find that while there is broad consensus that enforcing
property rights accounts for the emergence of financial markets, causation could run in the
opposite direction as well: so that financial development can trigger or catalyse property
rights reforms.
59
Other factors include, on the one hand, taxation policies and how the capital
gains system is organised,
60
and, on the other, the assurance of an exit framework from
investments.
61
These issues have been categorised by other commentators among the
qualitative elements of public policy.
62
The main line of inquiry in this work is motivated by the notion that at the heart of the
private equity investment decision in emerging markets lie perhaps two fundamental worries:
firstly, the extent to which property rights in financial investments are secure, and secondly,
58
Julia Korosteleva, and Tomasz Mickiewicz, ‘Property Rights, Supply of Formal Informed Finance and
Business Start-up Financing’ (2008)
accessed 25 October 2011
59 Niloy Bose, Antu Panini Murshid, Chitralekha Rath, ‘Finance and Property Rights: Exploring Other
Directions’ accessed 25 October 2011
60
James Porteba, ‘Capital Gains Tax Policy Toward Entrepreneurship’ (1989) 42 (3) National Tax Journal 375,
90; Christian Keuschnigg and Soren Bo Nielsen, ‘Public Policy for Venture Capital’ (2001) 8 (4) International
Tax and Public Finance 557, 72; Christian Keuschnigg and Soren Bo Nielsen, ‘Start Ups, Venture Capitalists
and Capital Gains Tax’ (2004) 88 (5) Journal of Public Economics 1011,1042
61
Claudio Michelacci and Javier Suarez, ‘Business Creation and the Stock Market’ (2004) 71(2) Review of
Economic Studies 459, 81
62
Colin Mason, ‘Public Policy Support for the Informal Venture Capital Market in Europe: a critical review’
Working Paper 08-07/2008
Accessed 25 October 2011
12
the extent to which acceptable investment returns can be earned, from such markets. Both
worries have been mainstreamed by a literature strand backing a role for law and legal
institutions in financial market development,
63
and secondly, links contract and divestment
efficiency to earnings or realized returns.
64
The main question is also motivated by the experience of private equity in emerging
markets.
65
Once an exotic and limited investment and financial contracting activity, it has
rapidly globalised,
66
having first appeared in North America and Western Europe, where it is
also highly sophisticated and well developed.
67
According to Preqin,
68
the industry raised
over USD1.8 trillion
69
globally between 2006 and 2008 – the highest in history, and a period
that came to be known as the ‘golden age of private equity’.
70
During the same period, the
number of private equity fund managers doubled – from 918 fund managers in January 2007
to 1,673 in March 2009.
71
Statistics collated by the Emerging Markets Private Equity Association (‘EMPEA’)
on fundraising, the number of active funds and fund managers, and the geographic spread of
63
For example, Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails
Everywhere Else (Black Swan, Bantam Press, Great Britain, 2000).
64
Douglas Cumming and Grant Flemming, ‘A Law and Finance Analysis of Venture Capital Exits in Emerging
Markets’ (2003) Australian National University Working Paper Series in Finance.
65
Emerging Markets Private Equity Association Accessed 16 September, 2010 –
these markets, for private equity, are Latin America, India, China & Asia, Eastern Europe, Middle East and
North Africa, and sub-Saharan Africa - South, East, Central and West Africa
66
Mike Wright, Sarika Pruthi and Andy Lockett, International Venture Capital Research: From Cross-Country
Comparisons to Crossing Borders (2005), Nottingham University Business School Centre for Management Buy-
Out. See also: W. Megginson, Toward A Global Model of Venture Capital? The University of Oklahoma
( 2002) 2, 5, 23-28 accessed 2 April 2008.
67
Steven M Davidoff, ‘The Failure of Private Equity’ (2009) 82(3) Southern California Law Review 481-546 -
for history of private equity, go to chapter 3, 65.
68
Preqin, ‘Global Quarterly Private Equity Fundraising 2004-2009’ (USA, 1 July 2009) 1
accessed 15
September 2010
69
ibid
70
Richman Lou and Elaine Cummings, ‘Global Private Equity Report’ (Bain & Company Inc. , 2010) 2
accessed 30 September, 2010
71
ibid.
13
private equity, indicate phenomenal growth in emerging market private equity activity.
72
Indeed, by 2008, the OECD observed that ‘private equity is the African investment story to
watch’.
73
Private equity has thus become a global phenomenon.
It is unsurprising, hence, that Kenya has in the last decade witnessed an increasing
number of private equity companies setting up office in the country.
74
The quality of financial
transparency – ultimately a question of business and securities regulation – is already
recognised as one of the areas relevant to private equity that calls for development to promote
access to enterprise finance.
75
Other barriers stem from firm characteristics such as family
ownership of business, especially the impact of relinquishing control of family businesses.
76
Amidst this fast-changing space, Kenyan investment managers are setting up funds of their
own, riding on their stellar investment records.
77
Private equity’s arrival on the world stage has not induced similar economic impact
across countries, however, with industry statistics demonstrating its early underperformance
in emerging markets.
78
Research continues to vex the question why it has not always
‘transplanted’ successfully in emerging markets.
79
The general question that arises is whether
72
EMPEA, ‘Emerging Market Private Equity Industry Statistics: Fundraising and Investment’ (Q4 2009) accessed 6 April 2010
73
Thomas Dickson, OECD, Policy Insight No.60, Private Equity: An Eye for Investment under African Skies?
(OECD African Economic Outlook, 2008) accessed 6 April 2009
74
Wanjiru Waithaka, ‘Kenya Becomes a Magnet for Private Equity’ (BiD Network, 7 March 2008)
accessed 5 April 2008. See chapter 5 for a full discussion of the
Kenyan private equity industry.
75
George Omondi, ‘Lack of Disclosure Blocking SMEs from Funds’ (All Africa, 22 April 2010)
accessed 22 April 2010.
76
George Omondi, ‘Small Firms Shy Away from Private Equity Lenders’ (All Africa, 4 May 2010)
accessed 4 May 2010.
77
Emanuel Were, ‘Kenya’s New Capitalists Go Big on Private Equity’ (Business Daily, 5 June 2009)
accessed 5 June 2009.
78
Emerging Markets Private Equity Association, ‘Emerging Markets Private Equity Fundraising and Investment
Review 2008’ (2009) 22
Accessed 27 July
2010
79
Josh Lerner and Antoinette Schoar, ‘Private equity in the developing world: the determinants of transaction
structures’ (2003) Harvard Business School/Massachusetts Institute of Technology Working paper, cf: Douglas
Cumming and Grant Fleming, ‘The impact of legality on private equity markets: evidence from the Asia-Pacific
(2004), EFMA Conference, Glasgow, unpublished)
14
the experience of emerging markets private equity is a case of an investment model that has
proven unsuitable to emerging market conditions, or of incomplete market institutions in such
markets that cannot effectively support the asset class, or primarily a problem in law – legal
frameworks with structures that cannot support the needs of the specialised financial
contracts that underwrite private equity?
80
These issues underpin the main themes of this
study.
1.2.3 Private Equity: A Problem in Law
To amplify the preceding issues, it is observed that in practice, private equity occurs as a
set or series of financial contracts that define ‘the private equity cycle’.
81
The ‘cycle’ has
three main phases of occurrence –
(i) the fundraising phase when investors make funds available for private equity
ventures;
(ii) the investment stage when specialist fund managers identify, select and invest in
private companies;
82
and
(iii) the divestment stage when fund managers unlock the value in their investments
through a range of liquidation strategies.
83
Each stage is underwritten by a specific type of financial contract, hence there are three
main sets of contracts: contracts governing the relationship between capital holders and fund
managers, contracts between fund managers and investee (venture) companies, and contracts
80
Daniel Berkowitz, Katharina Pistor and Jean-Francois Richard, ‘Economic Development, Legality and the
Transplant Effect’ (2003) 47 European Economic Review 165-95
81
Paul Gompers and Josh Lerner, The Venture Capital Cycle, (MIT Press, Cambridge, Massachusetts 2004) ch
2 (An Overview of Venture Capital Fundraising) 23; ch 3 (What Drives Venture Capital Fundraising?) 33
82
ibid 157
83
ibid 345 ch 3 s 3.3 for an exposition of the nature of private equity.
15
between fund managers and third-party acquirers of fund manager-held securities at the time
of divestment. At the level of the venture company (stage II of the cycle, above), three
specific sale and purchase agreements underpin the private equity ‘event’.
84
They are –
(i) a share acquisition transaction;
(ii) an equity finance transaction; and
(iii) a debt finance transaction.
The research question asks in effect: at each of the key stages of the private equity
cycle, what role do (or can) laws and legal institutions play in expanding fundraising, or
driving demand for private equity, or creating efficient conditions for the conclusion and
execution of financial contracts?
85
At first glance – and as economists readily argue - the very design and nature of
private equity as a monitoring-based financial contracting strategy would seem to discount a
central role for the law and by extension its legal institutions in the emergence and expansion
of the industry.
86
This argument rides on the much-flaunted ability of private equity to
effectively assess investment risks through thorough pre-investment screening processes,
overcome informational asymmetries, and align ownership and management interests thereby
ruling out or sufficiently internalising agency risks through negotiated compensation
structures embedded in the investment agreement.
87
It is upon this basis that arguments have
been advanced that macroeconomic factors that drive the external environment for private
84
Jack S Levin, Structuring Private Equity, Venture Capital and Entrepreneurial Transactions (Aspen, 2011),
5-12, and for background: 1-3, 1-8, 1-10, 2-10, 4-4 and 4-68
85
Ronald J Gilson, ‘Engineering a Venture Capital Market: Lessons from the American Experience’ (2003) 55
Stanford Law Review 1067-1103
86
Michael Gorman and William Sahlman, ‘What Do Venture Capitalists Do?’ (1989) 4 Journal of Business
Venturing 231-248
87
From the framework of an economic conception of property rights – for instance: starting with Coase 1937
(contract theory of the firm); Alchian and Demsetz 1972 & Jensen and Meckling 1976 (incentives theory and
residual claims); Klein, Crawford & Alchian 1978; Williamson 1979 (limitation of post-contract alienations);
Grossman and Hart 1986, and Hart and Moore 1990 (detangling of hold-ups); Aghion and Bolton 1992
(incomplete contracts).
16
equity (availability of investment opportunities and exit avenues), rather than internal factors
(legal factors such as systems for contractual integrity) play a deterministic role in the
occurrence and growth of private equity markets.
This thesis takes the view that an exclusivist approach to the subject’s study, either
economic and fiscal, or legal, would yield misguided results in an emerging market context
for at least five primary reasons.
Firstly, private equity is structured as a set of financial contracts, and as such, raises
issues in contract law.
88
The mere fact that lots of resources are devoted to a pre-investment
discovery process that leads to the adoption of financing agreements that in some cases run
into hundreds of pages suggests not only the critical importance of pre-investment covenants,
but also the importance of clarifying a logical basis for the allocation of rights and obligations.
It would be folly otherwise.
89
As much, therefore, as other environmental factors such as
macro-economic determinants may be important variables in a country’s attractiveness to
investment, the foregoing argument asserts that legal determinants could be the decisive
variable, in the investment decision.
Secondly, as a monitoring-based contracting and investment strategy, the private
equity financial contract is a relational contractual coalition that relies on external agencies
for the resolution of contract-based disagreements – which introduces a role for dispute-
88
To illustrate the intensely law-based private equity process, model private equity contract templates can be
found at the American National Venture Capital Association website at
(current as of
February 2011) accessed 17 February 2012 – These include a term sheet, a stock purchase agreement, a
certificate of incorporation, investor rights agreement, voting agreement, rights of first refusal and co-sale
agreement, management rights letter, indemnification agreement and legal opinions.
89
id – the USA private equity industry is estimated to spend over USD200 million annually in pre-investment
contract negotiations.
17
resolving institutions. These institutions include courts, but also norms of behaviour
supporting positive reputations.
90
Thirdly, by virtue of its methodology - share capital and acquisition-type
investments – private equity raises issues under both corporate and securities laws.
91
Fourthly, in an emerging context where legal and market institutions are still nascent
or absent, and macroeconomic instability common, an important role arises for the law in
organising market structure and behaviour.
92
Fifthly, macroeconomic factors depend on legal instruments. Thus to achieve deep
debt markets in a country, that country will rely on bank sector regulation and capital markets
regulations in organising market activity, establishing trading and other rules of exchange,
punishing errant behaviour – in effect, employing the law to deliver the macroeconomic
effect of ‘confidence’ in a financial system.
93
It can be observed that in an inter-disciplinary industry such as private equity, no one
academic discipline in isolation is able to deliver a definitive model for growth. Nonetheless,
this thesis argues that legal and institutional factors are likely to wield a stronger influence
than the other competing explanations to the emergence and growth of private equity in
developing countries like Kenya.
90
Eric A. Posner, ‘A Theory of Contract Law under Conditions of Radical Judicial Error’ (August 1999)
University of Chicago Law School, John M. Olin Law & Economics Working Paper 80
accessed 23 October 2007.
91
Luc Renneboog, and Tomas Simons (2005), ‘Public-to-private transactions: LBOs, MBOs, MBIs, and IBOs,’
Finance Working Paper 94/2005 European Corporate Governance Institute.
92
Douglass C North, ‘Institutions’ (1991) 5(1) Journal of Economic Perspectives 97-112
93
Joseph J Norton, Taking Stock of the First Generation of Financial Sector Legal Reform, (2007) SMU
Dedman School of Law Legal Studies Research Paper 9, 32 accessed 28
October 2011; cf: JJ Norton, ‘Financial Sector Reform and International Financial Crises: The Legal Challenges’
(1998) 16 Essays in International Financial Economic Law; Davide Lombardo and Marco Pagano, Law and
Equity Markets: A Simple Convergence and Diversity of Corporate Governance Regimes and Capital Markets, J.
McCahery, P. Moerland, T. Raaijmakers, L. Renneboog (eds.) (Oxford University Press, 2002)
18
The foregoing themes are central to this inquiry for two reasons. Firstly, economic,
94
financial economists
95
and legal
96
scholars have and continue to clash over attempts to
answer the main question in this study, with the former two pointing to macroeconomic
factors as the deterministic elements, while the latter holds up the defining role of the law and
legal institutions in facilitating private transactions. All disciplines lend forceful and
persuasive arguments in support of the divergent views. Secondly, for Kenya, which is
seeking to unlock channels for financing its private sector in an effort to catalyse economic
development, and given private equity’s promising emergence in Kenya, modelling
approaches could not be more confusing and uncertain.
97
This is thus an important question
from both academic and practical perspectives.
1.2.4 The Secondary Questions
To fully explore the variables to the research themes outlined above, the following
secondary questions appear pertinent to the totality of this inquiry:
? Firstly, if the law is relevant, whether it plays a deterministic or supporting
role.
? Secondly, if relevant, in what ways it is so.
94
Alexander I. J. Dyck and Luigi Zingales, Private Benefits of Control: An International Comparison (2002)
CEPR Discussion Paper 3177