Private Equity

The Capital Markets Act, Chapter 495A, Laws of Kenya provides for the Capital Markets Authority (CMA) to register qualifying venture capital firms. To this end, the Capital Markets (Registered Venture Capital Companies) Regulations, 2007 were enacted to facilitate the operations of venture capital firms in Kenya. Registration under these regulations is not compulsory and was intended to be mirrored with attractive taxation benefits. However, we are not aware of any registered venture capital firms to date.

Additionally, as of 30 June 2020, the Capital Markets Act was amended to enable the CMA to license, approve and regulate private equity and venture capital companies that have access to public funds. During parliamentary consideration of this legal provision, the reason provided for this amendment was the need to safeguard funds accessed by private entities from public entities such as public pension schemes. However, no further legal amendments have been made or regulations enacted to clarify this regulatory approach. As such, the regulatory landscape in Kenya has, from a practical view, remained unchanged.

There is also a diverse range of statutes and regulations that apply to or have a direct impact on private equity transactions in Kenya. These are discussed where relevant throughout this Q&A.

In 2016, there was an amendment to the investment restrictions applicable to pension schemes in Kenya. The trustees of pension schemes are now permitted to invest a maximum of 10% of their assets under management in private equity or venture capital investments. Licensed retirement schemes have a significant source of capital for private equity funds in Kenya as private equity would enable them to diversify their investment portfolios/strategies from the ordinary property, bonds and stocks approach.

On the transaction front, Kenya has consistently received high investment inflows in the East Africa region and continent at large. This is due to the technical capabilities of the local population and Kenya’s economic and political stability, which create a ready environment for investment in key sectors. Popular sectors for private equity investments include fintech, agribusiness, logistics, healthcare and education.

The following regulators are relevant to private equity transactions in Kenya:

• The Capital Markets Authority (CMA) is mandated to license, approve and regulate private equity and venture capital companies that have access to public funds. The CMA also regulates all offers of securities to the public, including the listing of equity or bonds on securities exchanges, which is relevant if such an exit option is pursued.
• The Competition Authority of Kenya (CAK) regulates the merger notification and approval process, which is often triggered by private equity transactions. The Common Market for Eastern and Southern Africa (COMESA) Competition Commission also has relevance for cross-border transactions involving more than one COMESA member.
• The Registrar of Companies oversees the incorporation of companies, partnerships and maintenance of records in relation to their operations, including shareholding changes and financial encumbrances. This is relevant for private equity/venture capital firms wishing to set up in Kenya, but also for the entities they invest in.
• The Retirement Benefits Authority regulates the operations and investment activities of licensed pension schemes, including restricting the percentage of assets under management (AUM) that pension funds can invest in private equity/venture capital funds.
• Other relevant regulators will depend on the sector the private equity/venture capital firm invests in.

The Law of Contracts, the Companies Act and the Competition Act are the most relevant laws for mergers and acquisitions in Kenya. Other legislation may apply depending on whether investments are in regulated targets in Kenya.

The CAK requires merger notification of transactions that result in a change of control of an undertaking. The need to notify or obtain approval is assessed based on the combined value of assets or turnover (whichever is higher) of the target and the acquiring firm.

If the combined value of assets or turnover is below $5 million, the transaction is exempt from notification. If the combined value is between $5 million and $10 million, the transaction will be excluded from full merger review, but is notifiable to the CAK. All mergers where the parties’ combine value of assets or turnover is above $10 million qualify for notification to the CAK and should not be implemented prior to approval by the CAK. They may also be subject to cross-notification rules of the COMESA Competition Commission, which shares concurrent jurisdiction with the CAK, in cross-border transactions.

Local shareholding requirements are also applicable in certain strategic industries. These include the following:

• Information communications and technology: Each prospective licensee must be owned 30% by Kenyan citizens. The previous threshold was 20%. Licensees have three years from July 2020 to comply with this requirement.
• Mining: A local equity participation of at least 35% is a condition for the issuance of a mining licence.
• Insurance: At least one-third of the shareholding of an insurer must be held by citizens of the East Africa Community partner states and 60% of the shareholding of an insurance broker must be held by Kenyan citizens or an entity wholly owned by Kenyan citizens.
• Private security: Corporate private security providers must be at least 25% owned by Kenyans to be licensed.

In the banking sector, a single person is not permitted to own more than 25% of a licensed bank, except as:

• an authorised non-operating holding company;
• a Kenyan licensed bank;
• a foreign bank licensed in its own jurisdiction;
• a Kenyan parastatal; or
• the Kenyan government itself.

Private equity investments in Kenya are usually structured as:

• share subscriptions or purchases;
• straight debt or convertible debt transactions; or
• asset and/or business acquisitions/carve-outs.

It is more common for private equity firms to make equity investments into an offshore holding company of the target rather than directly into the operating entity in Kenya. Such offshore holding companies are usually situated in countries that offer greater tax efficiency to the fund on exit. The restructuring of targets to create offshore holding companies is therefore a common condition to equity investments. In terms of the interests acquired, these vary, from minority interests with minority protection/veto rights to controlling stakes. Debt transactions, however, tend to be direct into Kenyan targets.

Depending on the circumstances of a particular transaction, investing into offshore holding structures may be beneficial for tax or strategic reasons. Most funds in Kenya have other investments regionally; hence their preference to disburse funds through an entity in one jurisdiction where all their portfolio holding companies are domiciled. It may also be strategically beneficial for targets with regional operations to have their holding companies domiciled offshore. The main disadvantage is that it is often costly, from an advisory and tax perspective, for targets to restructure their shareholding to an offshore entity, particularly for early-stage targets. Restructuring can also be a lengthy exercise, thus delaying quick equity investment, as extensive legal and tax advice is required.

Equity investments provide more control and/or visibility over the business and operations of a target. These typically entitle investors to board seats, veto rights and dividends which can be pre-negotiated in the case of preference shares. The disadvantages are primarily the tax consequences on dividends and exit, which are discussed below.

Debt transactions are generally more straightforward than equity transactions from a structuring and timing perspective. They can be securitised for added protection. Investors can have their repayments grossed up so that they receive their repayments net of withholding tax. Additionally, loans offer an investor less exposure to the liabilities that a target may accrue in the course of its operations. The disadvantages include:

• lack of control over the target and potentially a risk of non-payment;
• stringent security enforcement mechanisms and difficulty in enforcing unsecured debt;
• potentially, interest rates and events of default that may not be favourable to targets; and
• general unattractiveness, as debt tends to be more short term than equity

Asset or business sales allow an investor to cherry-pick the assets that are of particular interest. However, there may be significant taxation concerns, such as in relation to value added tax and capital gains tax (on the part of the target), which require specialist advice. Investors should also seek legal and tax advice on exposure to transfer of liabilities of the target from such sales with a view to mitigating the risks.

Funding of targets will usually be through:

• capital calls/new share issues for either ordinary or preference shares; and
• shareholder loans or third-party loans where dilution is a concern.

Where the target has a holding company, funds then filter through to it as shareholder loans. As a holding company loan is a related-party transaction, advice should be sought on the appropriate interest rate to charge. Interest-free loans will be subject to deemed interest rates applicable from time to time in Kenya. Targets that are foreign controlled should also be mindful of thin capitalisation rules.

In equity transactions, where a fund elects to subscribe for preference shares, the rate of dividend and the exit price can be prescribed, which is advantageous to the fund. Dividends will be subject to withholding tax, which may be significant depending on the resident or non-resident status of the recipient and its shareholding interest. This will vary from 0% to between 5% and 15% to be withheld and remitted in Kenya. The rate may be less depending on the applicability of double tax treaties with Kenya. On a sale of shares held directly in a Kenyan target, capital gains tax calculated at the rate of 5% of the net gain from sale of shares will be due. This is a final tax and cannot be offset against other taxes. Equity transactions also generally trigger regulatory consent at entry and exit, which can be a lengthy process, may affect transaction structuring and/or may be conditional.

Shareholder or third-party loans will avoid dilution of existing shareholders and rank higher than the claims of holders of ordinary shares in the event of liquidation. Keeping track of thin capitalisation rules may be difficult and breach will have dire consequences for the target.

The requirement to obtain merger approval from regional authorities or national competition authorities should be considered. This may affect:

• the timeline for completion of the transaction;
• the transaction costs, due to filing fees; and
• the transaction structure.

Kenya recently amended its laws to allow for merger notification and approval by the Common Market for Eastern and Southern Africa Competition Commission in cases of concurrent jurisdiction with Kenya’s Competition Authority of Kenya. This should eliminate the need for dual filings and reduce filing fees payable (if applicable).

Investors should also consider the foreign investment restrictions mentioned in question 2.2, which require a minimum shareholding by Kenyan citizens in specific sectors.

Alignment of co-investors, particularly in equity transactions, is very important. Investors should agree on their rights (eg, voting rights) and obligations based on their respective investments and percentage shareholding in the target. Returns expected and route to exit should also be agreed, as well as deadlock provisions where no one party has a controlling vote. All these factors should be captured appropriately in shareholder agreements. In debt transactions, particularly those taking securities, inter-creditor agreements are crucial in coordinating lenders’ rights and actions in the event of default.

The investment process in most transactions will unfold as follows:

• drafting and negotiation of the term sheet, with non-binding terms relating to the transaction;
• due diligence on the target and other necessary entities – this usually covers legal, technical/operational, financial and tax due diligence. Environmental due diligence is also becoming increasingly important;
• drafting, negotiation and execution of the transaction documents between the parties;
• obtainment of regulatory approval, where necessary;
• oversight of the closing formalities as negotiated in the transaction and satisfaction of agreed conditions precedent; and
• completion of the transaction and satisfaction of agreed conditions subsequent

This will vary depending on the circumstances of each transaction. Prior engagement or transactions between the investor and target may significantly reduce the level of scrutiny during the due diligence phase.

For first-time investments, factors that may influence the extent of due diligence include:

• the investor’s preference;
• the duration of existence or operations of the target; and
• the industry/sector of the target.

For 100% share or business acquisitions, in-depth or full legal due diligence covering a period of seven years or more plus historical corporate records from incorporation is recommended. For minority stakes with or without controlling rights or for convertible debt transactions, it is common to carry out red flag or issues-only due diligence.

For the purposes of legal due diligence, the target will usually be required to disclose the following:

• corporate structure or ownership details;
• existing commercial agreements (as per an agreed materiality threshold);
• regulatory records and correspondence with relevant regulators;
• details of property (eg, land and assets owned);
• financial arrangements (eg, facilities, loans, securities issued to third parties);
• employee details and records (including any union agreements);
• litigation history, if any;
• other corporate records, such as IP registrations and insurance; and
• environmental compliance, if necessary

The investing private equity firm will usually have less disclosures to make to the target in the ordinary course of a transaction, including but not limited to:

• evidence of financial capability/source of funds;
• ownership and board structure of the firm; and
• if the transaction involves certain regulated sectors, key personnel or beneficial owners. This is the case with the banking, insurance and pension industries.

From a regulatory perspective, however – in particular, where a competition application is required – the financial statements of both parties will need to be disclosed to the Competition Authority of Kenya, together with details of entities controlling and/or controlled by either party.

Other advisers and stakeholders in the investment process include the following:

• Tax advisers: To conduct due diligence on tax compliance and structure advice for tax optimisation.
• Auditors/accounting firms: To assess the financial statements and provide background on any financial aspects flagged during the due diligence phase.
• Specialist consultants: These may include environmental specialists, surveyors and similar industry specialists, depending on the nature of operations conducted by the target.
• Regulators: If the target is in a regulated sector such as banking, insurance, agriculture or healthcare, regulatory liaison is critical.

Common closing mechanisms include closing accounts, the locked-box approach and the earn-out mechanism. The choice of which mechanism to adopt is largely determined through negotiation.

Closing accounts may be preferred where there are occasional fluctuations in the financial performance of the target, whether due to industry cyclicality or unusual events affecting its financial performance. This has become more likely due to the impact of COVID-19 on businesses.

Earn-out mechanisms will be preferred by investors that are seeking to incentivise the long-term cooperation and contribution of key managerial personnel and shareholders in the performance and growth of the target.

The locked-box mechanism provides predictability on the consideration payable while avoiding the hassle associated with verification of closing accounts. Provisions on permitted and restricted leakages are key in this option

Break fees are common in Kenyan private equity transactions and are usually negotiated into term sheets and initial transactional documents. Break fees are usually due if the transaction does not end in binding agreements, since term sheets are usually non-binding. The costs incurred by the firm in conducting due diligence on the target and drafting costs will usually be included in the break fee. Such clauses must be carefully worded to avoid being deemed as penalty clauses. The general rule is to ensure that such clauses require the payment of a genuine estimate of the loss suffered by the firm.

The allocation of risk is subject to the negotiation of the parties to the transaction. The founders will usually be required to issue full warranties and representations and indemnities on identified or potential risks. The target may wish to mitigate the risks arising from issuing warranties by issuing a disclosure letter. Firms will usually carefully weigh the disclosures and determine whether they are acceptable, as disclosures limit their ability to make a claim against the founders. Disclosures in relation to capacity and ownership of shares are typically not acceptable. Firms should carry out extensive due diligence before accepting disclosures, so as to be able to understand whether the risk disclosed against will materialise and what its potential impact will be on their investment. Broad and uncapped indemnities and unlimited warranties are the best outcome for firms. However, founders are likely to require that indemnities be restricted to specific identified risks and capped to a quantifiable exposure, and that warranty claims be restricted to a claim time and maximum amount.

In addition to those that are specific to the circumstances of a transaction, it is usual for warranties and representations as to the following issues to be included:

• legal capacity to enter into the transaction and related agreements;
• good title, which is free from encumbrances or third-party claims;
• that all licences, permits and authorisations required under law have been obtained;
• that all known claims and risks applicable to the transaction have been disclosed;
• that all material contracts/transactions and material litigation have been disclosed (with the term material being defined); and/or
• that taxes, levies and penalties payable to governmental or related authorities have been paid in full.

In the event of breach by the founders or target, a claim for damages is available to the private equity firm. Such claims may be restricted by the terms of the binding documents or unrestricted and subject to proof of damage or loss suffered by the firm.

Warranty and indemnity insurance is not a common insurance product from Kenyan providers.

The management of the target will be incentivised based on the terms negotiated into transactional documents, especially in the case of manager shareholders. Some of the key mechanisms utilised include share options plans and bonuses.

Share option plans offer a more long-term-oriented incentive and can be structured to incorporate specific performance metrics. They also offer a predictable incentive to qualifying personnel and assist in maintaining talent for the long term.

Bonuses will typically be dependent on the performance of the target and may take the form of cash bonuses or phantom share option schemes which are tied to the share value of the target.

These incentives are critically informed by the taxation treatment that may apply to either the target or the recipient.

Persons participating in profits of the target will be required to account for such profits as additional income in addition to their employment income. This will be taxed according to the income scales prescribed under Kenyan tax laws from time. Responsibility for remitting applicable taxes lies with the target/employer.

Tax implications will vary depending on the structure of the share option plan. Regular employee share option schemes will not amount to income or a taxable distribution when the option is granted; once the option vests, the benefit accruing from the difference in share price between the date of the grant to the vesting date will attract fringe benefit tax. The remittance of this tax is the responsibility of the target, which must ensure that it has adequate cash flow to meet the obligation. Post vesting, any distributions made on income from the portfolio company’s shares will be subject to withholding tax (if applicable) and capital gains tax on disposal of those shares.

Firms and founders may elect to set up a phantom share option scheme, a hybrid structure that entitles the qualifying employee to a cash payment equivalent to the gain in the share price from the grant date to the exercise date. Phantom options do not lead to an actual issue of shares in the portfolio company; thus, issues such as dilution do not arise. Phantom options are still subject to income tax, but as the benefit is paid in cash, the target can deduct the applicable tax before remitting the cash payment to the employee.

Pre-emption rights are a usual provision in private equity transactions, whereby existing shareholders will have the right to first be offered any shares being sold or allotted to a third party prior to such allotment or share transfer being conducted. Exemptions to this may include transfers to wholly owned entities of manager shareholders or transfers to family members.

Tag-along rights are also common for manager shareholders. These enable managers to exit at the same time as their investors if the criteria for such exit are met.

Investors may wish to restrict the exit of manager shareholders or other key personnel in the portfolio company through lock-in periods. During these periods, such manager shareholders may not transfer or change the ultimate beneficial ownership of their shareholding. This may also be a restriction on the manager shareholding resigning from employment in the portfolio company, without the consent of the investor. Such restrictions are imposed to ensure the predictability of operational control and the retention of institutional knowledge, especially where the personal capabilities of such a manager shareholder are instrumental to the success of the portfolio company.

The determination of leaver provisions will usually be negotiated into the transactional documents and is thus subject to the interests and bargaining power of the involved parties.

Good leavers are usually those who cease their relationship due to:

• death;
• incapacity;
• ill health; or
• retirement.

Bad leavers are typically defined as persons who:

• breach the terms of existing shareholder agreements or related binding documents;
• are summarily dismissed under their employment contracts due to, for example:
• • conviction of a serious crime;
  • statutory disqualification from directorship;
  • embezzlement of funds of the portfolio company; or
  • participation in similar fraudulent activity; or
• take any action or omission that will bring the portfolio company or investors into serious disrepute.

Private equity investors will usually aim to have some degree of influence or control over voting rights in board meetings and shareholder general meetings. This can be achieved through:

• veto rights over certain influential decisions;
• specific quorum prescriptions and the specification of various reserved matters that must achieve a requisite level of approval by shareholders or directors; and/or
• negotiation on the composition of the board of directors, with control over the appointment of key executive managerial positions.

This decision is largely at the discretion of the private equity firm. Nonetheless, it is critical to monitor and address conflicts of interest as and when they arise, as this is a statutory requirement under the Companies Act, 2015. It would also be appropriate to appoint such nominees based on their industry expertise and familiarity with potential aspects of the business of the portfolio company.

Yes, the investing private equity firm or its nominated agrees can veto specified decisions. These must already have been negotiated into a shareholder agreement or even the constitutive documents of the portfolio company.

Examples of decisions to which such veto may be applied include:

• significant changes to the approved budget of the portfolio company;
• entry into or exit from key business streams;
• appointment of key executive management personnel; and
• mergers with other entities, fundraising or similar actions that could result in changes of control in the portfolio company.

The private equity firm can require mandatory inspection of the books of accounts of the portfolio company on a periodic basis, including the management accounts.

It will also be useful to have regular managerial performance reports submitted to either the board of directors or shareholders, in addition to those prepared for regular meetings.

The typical exit options for private equity firms are:

• trade sale to other investors, especially subsequent strategic investors;
• management buy-outs; or
• portfolio sales to other funds, when private equity firms may be exiting from a specific market for strategic reasons.

Despite the Nairobi Securities Exchange (NSE) being one of the most vibrant bourses in Africa, exits via initial public offerings on the NSE are rare.

Various industries may have statutory minimums on local ownership by Kenyan citizens, which may be affected by the choice of exit strategy. These include the insurance, telecommunications and mining sectors. In some cases, it may be possible to apply for a temporary waiver from the respective regulators, but specialised legal advice is necessary in this respect.

Tax implications will arise from the chosen exit strategy. Key taxes that may influence this decision include capital gains tax and value added tax, which would be applicable depending on the exit choice.

Certain exit strategies may constitute a ‘merger’ for purposes of notification to the Competition Authority of Kenya and/or to the Common Market for Eastern and Southern Africa Competition Commission. This is the case where a change of control occurs.

This will largely depend on the structure of the transaction. It is therefore advisable for specialist tax advice to be obtained prior to and during the transaction.

The key taxes to be considered in private equity transactions include:

• capital gains tax for share sales;
• value added tax for business and/or asset sales; and
• withholding tax on dividends.

The parties to a transaction must be aware of the possibility for historical tax non-compliance concerns being raised by the Kenya Revenue Authority (KRA). This is has become more common due to the recent digitisation of KRA’s systems and reconciliation of this with historical filings by taxpayers. Thus, despite a party holding a tax compliance certificate, it would be prudent to carry out thorough tax due diligence and seek a wide array of warranties and indemnities to cover unforeseen tax liabilities.

The most common strategy is to invest in an offshore holding company domiciled in a jurisdiction that is tax efficient for the fund. Indirect equity investments are more common than direct equity investments; most targets tend to restructure their ownership by incorporating suitable offshore holding companies that ease investments from private equity funds.

Given the impact of the COVID-19 pandemic, there is a need for recapitalisations of existing portfolio companies, as the need to stabilise working capital persists. It is still too early to tell whether investor appetite in new investments will wane due to the negative economic impact of COVID-19. However, Kenya has historically dominated private equity performance in the East Africa region and this is expected to remain the case.

Nonetheless, the situation may result in amended valuations of potential targets in key investment sectors that offer ideal entry points for funds.

All companies incorporated in Kenya must now file details of their ultimate beneficial owners. An initial filing deadline of 31 January 2021 has been extended to 31 July 2021. Despite issues being raised about ambiguities in the filing system, affected parties must be aware of the implications that their disclosures may have on various structuring approaches or the confidentiality requirements of limited partners in private equity funds. Private equity funds may therefore need to disclose limited partners with controlling stakes that filter down to Kenyan entities. Funds should seek legal advice on appropriate filings before the 31 July 2021 deadline.

Kenya has also been in the process of implementing its new data protection framework since the enactment of the Data Protection Act in late 2019. With the recent appointment of the data protection commissioner, we anticipate that data protection concerns and regulatory actions will gain more prominence. It will be essential for investors and targets to be cognisant of new regulations and guidance from the data protection commissioner, and the implications of these, especially in data-heavy industries.

While some tax cuts were implemented when COVID-19 broke out in early 2020, these were reversed in January 2021 despite fresh lockdowns following a third wave in Kenya, one year after COVID-19 was first detected. The government has also introduced a minimum tax of 1% of the gross turnover and a digital services tax at the rate of 1.5% of the transaction value with a view to increasing revenue collection, which fell drastically in 2020. The minimum tax has been challenged in the Kenyan courts, given its detrimental effects on businesses, and the digital tax is currently facing filing challenges. We anticipate clarity on these and possible other austerity measures in the Finance Bill 2021.

Understanding the Kenyan market and extrinsic factors (eg, election cycles) that affect entry and exit requires patience and determination. Local partners and advisers are a fund’s best bet in tackling the Kenyan market, which is full of opportunities and consistently ranked first and/or high up both in the East Africa region and in the continent at large. Although the current economic climate has left the business operations of potential targets in turmoil, this provides a unique price entry level – especially for companies that have suffered a disproportionate impact from the COVID-19 pandemic or whose business valuations may be significantly altered by the current pandemic. Managing expectations from targets in the current climate while aligning the same with exit timelines is key. Co-investments may enable investors to share the risk and increase the liquidity needed to carry potential targets through this phase.