Mindspeak- Karim Sadek Citadel Capital

A couple of weeks back, I had the chance to go for Mindspeak , Aly-khan Satchu's business club in Nairobi. The speaker was Karim Sadek, CEO of the Largest private equity fund in Africa, Citadel Capital.

Established in 2004, Citadel has 17  opportunity- specific funds with $9.5 billion under management, with around $800 Million being the partners' assets. It has since returned $2.3 billion in cash to its investors.

What struck me the most about Citadel's approach is its rather common sense approach towards investing in Africa. Karim spoke of Citadel's concentration in investments in 'bottom-of-the-pyramid' sectors. He contends that performance here is more consistent in comparison to higher-end markets. He brought up the example of the Egyptian Real Estate market which had for aeons been controlled by politically correct individuals and depended on a luxury offering. Its fortunes had adversely changed post the 2011 revolution bringing it to virtual collapse. He coyly made comparisons with the current real estate boom in Kenya and clearly stated that Citadel would not invest in Kenya's real estate market. That should be food for thought for anyone trying to invest in the real estate market in Kenya.

He also spoke of their bias towards energy-centric investments in Africa. He believes that the cost of energy will increase over time due to higher extraction cost. He talked of Egypt's over-reliance in energy subsidies where a litre of Diesel  retails at $15 cts. This has structurally messed the economy and its impact once dropped will fundamentally change Egypt's competitive edge. To this end, Citadel brought together a consortium to finance the Egyptian Refinery company (ERC) which will supply a bulk of Diesel in Egypt. It is the single largest FDI post the Egyptian revolution.

He also talked of Citadel not having a pre-determined exit strategy for any investment. He fell short of saying that they would hold an investment for an infinite time period but made it clear their investments are not short term in nature.

He commented on the interest garnered by Africa in the west which he welcomed but was quick to add that it hadn't translated into cheques!

Karim spoke quite plainly about the challenges they had face so far in investing in the region. Especially  with their flagship investment in  Rift Valley Railways ( RVR). He talked about the nature of Publi-Private Patrnerships (which RVR is) and the irrational expectations that governments have on concessionaires. Generally speaking, structuring a concession agreement is tough especially because Government's (justifiably so) on Private equity firms as vulture investors. The only way is to form very close working relations with the government and create a win-win proposition.

He spoke a length about RVR. The key points were;

• RVR will reduce transportation costs in the region by  about 35% by avoiding trucking. East Africa has among the highest transportation cost in the world.It costs more to transport inland than to import from major world port to Mombasa.
• Citadel has raised $300 Million ( from IFC, ADB & KFW) for a 5 year turnaround program. These includes; Surgical intervention to improve rail infrastrucuture, Implementation of automation in operations (MS Excel is the existing level of automation),Rehabilitating the fleet and the add new assets after 2014.
• Restructuring of RVR system wise will definitely lead to labour restructuring. The business' growth will lead to realignments within company, hopefully.
• The key challenges facing RVR are; changing the internal culture from parastatal to private sector and sensitizing the community along the rail regarding the importance of the rail ( Click here ). They are looking into out-sourcing  some services to members of the community.
• Managing expectations on delivery of projects and returns are key aspects ensuring a PPP works out.

The session went to question-time. One question centered on how Citadel was able to weather the revolution in Egypt. Citadel maintained distance with the Mubarak regime and consciously avoided questionable investments. He also talked of demographics as a key factor in the revolution. Mubarak started out as a war hero but couldn't ride through the revolution on the back of his past. The youth could care less. African governments have to deliver basic universal rights to avoid this.

On the question regarding how to manage relations with governments. Karim had free advise for governments;

Governments need to invest in regulators not assets. He thinks the private sector is best suited for managing businesses while the government should work to attract qualified talent to regulate industries.

On the question of  the Lamu Port Southern Sudan Ethiopia Transpoert Corridor -LAPPSET being a competitor to RVR and Citadel intentions in the project, Karim says he does not believe it is a competitor to RVR.  He also thinks that private sector involvement in this is not financially attractive. In as much as China has loads cash  devoted to Africa, its role in financing of LAPPSET is still unclear.  Also, recent t talks between Sudan and South Sudan throw more uncertainity in the future of the project. He was also also asked if a standard gauge railway would be a competitive threat to RVR; RVR has rights to participate in future standard gauge rail. He's therefore not worried if the government decides to build one be it in the LAPPSET project or elsewhere.

On Citadel's biggest investment failure; Karim spoke of a failed investment in oil and gas exploration in Egypt.  There were too many uncertainties and a higher capital requirement for exploration. The only way to fully verify a discovery is to pump it. This should be a red flag for those pegging the hopes of LAPPSET on the oil discoveries in Nothern Kenya.

He also talked Citadel's venture in farming in Southern Sudan and S. Sudan's legendary high cost of food ( ) He feels that the biggest problem in farming in SSA is financial intermediation. Banks not to keen on financing farming and that transportation also a problem.He went on ahead to criticize banks and capital markets not helping in financing the economies of  SSA. Banks are too keen in financing Real estate which is not not a very productive sector and enjoy obscene interest rates spreads are too high.

His advise to foreign investors seeking to invest in Africa-never go in on your own. Go in with locals.

With that , another insightful midspeak session was brought to a close.

The Discount Window:CBK's Gift or Curse?

The debate regarding the fall of the shilling  in 2011 rages on in parliament. What is being exposed by both sides of the divide is a lack appreciation of the other side's view. This is expected of politicians as each has an agenda they are pushing. On one hand, the MPs allied to the CBK Governor,led by the finance minister have chosen to blame the shilling's fall on the Eurozone crisis. On the other hand, MPs pushing for the adoption of the parliamentary select committee  report are blaming it on the banks. The charges include the hoarding of Forex and the abuse of the 'Discount Window' by the CBK.

This 'Discount window' has been the subject of discussion and would be the best place to start to unravel this controversy. Banks need money from time to time meet client cash withdrawals. They can access this in several ways:

• Selling of Assets such bonds 
• Borrowing from another bank (Interbank Market)
• Borrowing from the CBK ( Discount Window)

Banks usually use the Interbank market or sell bonds and reserve the Discount window as a last resort for funding. However, according to the PSC committee report, this appears to have drastically changed in 2011.  According to the report, cumulative borrowing over 2011 through the discount window was around Kshs. 600 Billion. This was driven by the discount window offering lower rates than the inter-bank market, which provided an arbitrage opportunity for banks borrowing from the discount window and lending on the inter-bank market.

This, in the face of a currency crisis in the country, was, and still remains a source of grave concern. How can such an anomaly remain unchecked? It points to loss of touch by the CBK of the market. Which begs the question, why haven't any heads rolled at the CBK?

How Vulnerable is the Kenyan Economy? Interest Rates

Interest Rates


The increase in Interest rates from 5.75% in March 2011 to 18% in December 2011 . This measure came along with increasing the cash reserve ratio from 4.75% to 5.25% over May to November 2011. Both these measures had the effect of squeezing the money supply in the economy in a bid to stem inflation which still remains in the higher teens.

The effects of these measures have been;

• A slowdown in economic growth due to expensive credit in the market. Currently, credit for both corporate entities and individual clients ranges between 20% to 35%
• A shift in investment from listed equities to Fixed income securities due to perceived better returns notwithstanding the fact that election years have traditionally meant poor performance in the stock market.

There has also been hue and cry regarding the egregiousness of spreads between the risk free rate of interest (the CBR rate which is around 18%) and the rate at which banks loan clients currently at around 30%. This has led to a move to curb these rates by parliament the introduction of interest rate caps. This would mean that a bank cannot charge more than a particular percentage over the Central Bank Rate. This has been met with resistance from the Banking fraternity and the treasury who say this is over-regulation and would adversely affect the banking sector.

Both sides of the divide have valid points but the approach has to be balanced. On one hand, capping of interest rates would stifle access to finance due to the fact that only highly creditworthy persons would be able to access loans. The rest would be given a wide berth by the banks. On the other hand, it is unjustifiable that banks continue to make double-digit growth in profit while the economy suffers. There is a sense that they have a disproportionate advantage in comparison with other industries in terms of passing on risk to its clientele. This can only be curbed by increasing competition within the financial services sector to 'force' banks to reduce their margins. This could also be done by encouraging other forms of financing for business via vehicles such as private equity firms, SACCOS and Venture capital funds which would increase choice of financing for entrepreneurs. Also, the CBK can institute regulation capping the portion of capital banks can use for trading securities and currencies so as to skew the capital towards the credit market. 

 

How Vulnerable is the Kenyan Economy? Exchange Rates

Exchange Rates 
The sudden decline of the Kenya Shilling in the second half of 2011 was most alarming. Kenya became the worst performing currency in the world against the US Dollar with 30% loss in value. The question that arises is whether this drop was due to an sudden increase in fundamental demand for currency or was it speculator driven. Recently, the Central Bank Governor has been on the firing line for the perceived slow response to this crisis and the probe by the parliamentary committee on finance has revealed a lot of the behind-the-scenes happenings during that time. Key highlights includes:

• Demand for explanation by the Central Bank Governor from three leading Banks on  their activities in the currency market during this period.
• Parliamentary Task force set to investigate the fall of the shilling. ( Read Parliamentary Report)
• Recommendation by the Parliamentary Select committee that the Central Bank Governor resigns in taking responsibility for the Shilling's fall.

This report provides an insight on the the vulnerability of the shilling against major currencies. The highlights include:

• The Country's ever increasing current account deficit. The CBK Governor indicated this during the testimony by saying between September 2011 to October 2011 this deficit widened by  $116 Million which is about  20% increase. A lot of this is blamed on Kenya's increasing appetite for imports and a lack of focus on exports. However, the increase in the deficit over 2011 was abnormal by any standards  with an almost five fold increase over the second half of the year. ( See Chart) This alludes to the fact that this increase in deficit is not solely based on fundamental changes in import/export patterns. Which brings me to my second point...
• There is also a regulatory gap as attested by the CBK Governor's confession that electronic trading systems are difficult to monitor. He is referring to systems such as Reuters and Bloomberg which financial industry players use to communicate. Due to this, deals that would have once taken months to complete are completed in a matter of minutes. This allows for capital to flow faster in between markets which, on the negative side, exacerbates flight of capital. 
•  Kenya has an open capital account and a floating exchange rate.This means that there are no restrictions to flow of Forex within the Kenyan Market. Whereas it is an important mechanism in making the economy competitive, it makes the country more susceptible to economic shocks locally and internationally. It is no coincidence that as the European debt crisis was coming to the forefront, the shilling began its steep decline. It also opens the door for speculators with access to large chunks of Forex to 'attack' the Shilling by shorting the shilling against the dollar.
•  Kenya's Forex reserves are in urgent need of boosting. This was made clear as the CBK could not adequately defend the shilling by selling dollars as it had meager reserves. Also, at the time of the crisis, the CBK was in the process of building import cover of about 6 months. This could have been among the reasons a supply of dollars from CBK was not forthcoming as the steep decline began.

These highlights above are by no means exhaustive but give an indication as to main the sources of vulnerability. The calls for the Governor's resignation have merit but will not address the issues at the core of the problem. The country's addiction to imports has to be reined but this will take time and should not be at the of expense economic growth. This means that shilling will remain fundamentally weak over the time period it will take to the economy to structurally shift from an import driven one to being export based. The possible solutions for this include; 

• Decreasing our dependency on oil imports buy investing on our own energy infrastructure and importing oil from regional Uganda or Tanzania.
• Encouraging growth of local manufacturing , agriculture and tourism with aim of satisfying local and export demand for goods and services and decreasing need for Forex.
• Smarter regulation of currency markets with impetus placed on regulation that discourages speculative trading. The Central Bank should also build its Forex reserves for sufficient import cover and also aim to diversify its main reserve currencies to reflect our ever increasing need for Chinese imports.   

How Vulnerable is the Kenyan Economy? Inflation

The second half of 2011 was a tumultuous season in the Kenyan financial Sector. We saw the Kenyan Shilling capitulate almost overnight by around 30% against the US Dollar to 107 KES/USD . In a bid to curb this dollar demand, interest rates soared in reaction to the Central Bank setting  the benchmark Central Bank Rate higher. This made the cost of credit for business reach levels last seen in the 90s when the economy was in the doldrums. As this was cooking, inflation rates were soaring hitting over 20% on a month on month basis on the back of higher food and oil prices. These three factors: Inflation, Exchange Rates and Interest Rates, being all significantly negative, formed the ingredients of the perfect economic storm.

So, How vulnerable is the Kenyan Economy? We can try to get to the root of this by dissecting each of these factors.

Inflation 
Inflation is a double edged sword. Too much of it diminishes your purchasing power, too little/ or lack of it indicates low economic growth ( read Japan's Lost Decades)  A common sense approach to define a good inflation rate is one that does not outstrip the rate of GDP growth. Currently (February 2012) , inflation stands at around 18% while projected economic growth for the year is 4-5% depending on who you ask.

Therein lies the problem, our common tab for goods we buy keeps on increasing at a higher rate than our common wealth. The simple solution is to either increase our rate of economic growth to 18+% ( which is means almost quadrupling our productivity....not very plausible) or reducing our rate of inflation to less than 5% ( which can and had been done)

Following this course of action requires that the country at ensure it has food security for at least two years. This requires that agriculture be modernized in terms of production, marketing and storage. Malawi is a great example of how food security can be achieved in a short time with targeted subsidies to smallholder farmers and efforts to use higher yielding and drought resistant seeds.(read Malawi's food security success) There is also need to localize storage for farmers to enable all year long supply of grain. It would also make the farmer less vulnerable to middle-men if farmers can get credit using grain receipts as collateral. Also, there has to be conscious effort to commercialize agriculture.This is the only way food security can be assured in the long run.

Oil is also a major component in the inflation equation with far-reaching effects on the cost of production of most goods and services. Our major handicap is that we have no local production. Nevertheless, we still can institute measures to curb variance in supply and price. In the short term, we can curb our inefficiencies in the oil industry along the supply chain. From outdated infrastructure at the country's sole refinery  to transport issues within the oil pipeline, the supply chain is riddled with shortcomings that are mainly due to poor management over the years. The industry is in need of reform to manage this resource. There also has to be infusion of competition in the industry which is controlled by a few companies. The recent moves to regulate the oil prices is also long overdue. The use of derivatives to manage the variation in pricing while sourcing oil  also needs to be explored. In the long run, Kenya needs to develop its own energy resources: Oil and alternative energy resources. There also has to be an effort to source oil cheaply within the region from either Uganda or Sudan and Natural Gas from Tanzania. There is need for creating strategic reserves to curb interruptions in the importation of oil. Currently, Kenya buys oil with a months lag for downstream distribution. This exposes us to adverse geopolitical events in the Gulf region and attacks on shipping lanes by pirates.

The Biggest Reason why Warren Buffet is a Winner

This morning, I came across an adaptation Warren Buffet's annual Letter to Berkshire Hathaway Shareholders. In case you are Martian, he happens to be the World's most successful Investor with a track record spanning over five decades. I happen to be a big fan for his common sense approach to investing, his down-to-earth lifestyle and lately his political views as President Obama's unofficial economic adviser. This 81-year old is showing no signs of slowing down.

Reading this letter  gives me insights to his way of thinking and is a free education for any aspiring investor. In this letter, Warren Buffet speaks of the folly of Beta. Beta is what Investment Gurus the world over use to quantify the risk involved in investing in a particular asset. Simply put, the higher the Beta, the higher the risk. Beta is part of the Capital Asset Pricing Model created and perfected by revered economists, three of whom received the the Nobel Prize for economics. The problem Warren Buffet has with Beta is the underlying assumption behind it chiefly, that assets with more volatile prices tend to be riskier than assets with less volatile prices. This makes Stocks appear more risky than Bonds. The little problem that no one appear to mention is that currencies to lose purchasing power over time. Thus, if your investment is currency based like Bonds are, you will suffer the inevitable loss of purchasing power due to the simple fact that  money supply increases over time. A stock represents a share of a business, an entity whose primary goal is to increase value for its shareholders. Thus, depending on price you buy the business at and its ability to increase its value( or as Warren Buffet puts it more elegantly,'the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power' ) you are more likely to get better returns over time than a bond investor.

This brings me to what, in my humble opinion, makes Warren Buffet successful: His independence of thought. He questions conventional wisdom, regardless of whom its from. Be it Nobel Laureates or your financial adviser. As long something passes his common sense test, it does not matter what the world thinks. As he puts it, so long as the man in the mirror is ok with it, then he's fine with it. 

You can get more of his letters to shareholders at http://www.berkshirehathaway.com/letters/letters.html . An adaptation of his latest letter by Forbes can be found here

 

The EAC Monetary Integration: The Fiscal and Political Union angle

The East African Community Secretariat  is currently in the process of creating a Monetary Protocol that will guide the member states into Monetary union beginning in 2012. This process, like many other integration processes, would have gone unnoticed . But recent events in the Europe have brought this process to focus  locally. It is important to gain some clarity on what monetary  union  is and what it is not.

 Monetary union is a process not an event. You won't wake up one sunny morning and find the notes in your wallet magically transformed from Kenya Shilling to EAC Shillings. You will not walk down Haile Selassie  Avenue and find 'Benki Kuu ya Kenya' called 'Benki Kuu ya Muungano wa Afrika Mashariki'. These ,among other things, will not happen overnight. In fact, the prospects of a common East African currency and a common East African Central bank being established within the next 10 years should be minimal given the current pace of integration. It  took the EU a decade starting  in 1989 till 1999 to convert into the Euro.

Monetary union is harmonization of monetary systems. It entails analysing how each country's banking system works and coming up with ways to harmonize them. It also requires coordination of monetary policies across the  central banks within the region.  This would mean uniformity in dealing with key macroeconomic factors such as inflation, interest rates and exchange rates. It would mean creation of regional bodies such as a East African Central Bank and inevitable creation of an East African Shilling.

Monetary union is not Fiscal union.  Fiscal policy entails how a country governs its spending and how it gathers revenues. This  has the potential of becoming a major sticking point in the future as it encompasses a wider array of issues. How are governments going to harmonize their spending? How are they going to prioritize their needs? How are they going to raise debt?  How indebted can governments be?

From the ongoing Eurozone debt crisis, a lot of lessons can be derived for our protocol drafters at the EAC. The most important being  that without fiscal union, the monetary union is susceptible to shocks and potential failure. News reports regarding Greece's suspect ability to services its debt began making the rounds in 2010. The  was Greece was busy borrowing from the Financial markets and spending the monies on social programmes and a bloated civil service while on the other hand not increasing its revenue base. There was pressure both in Brussels and Athens albeit of different  and opposite kinds on the Greek government.  On one hand, the Eurozone big economies ( France & Germany) began putting pressure  on the Greeks to institute austerity measures to save their economy while on the other hands ordinary Greeks were protesting and  rioting against their governments for trying  to take away the benefits they have been enjoying so far.  So as political will wavered , the situation kept on getting worse. This was until it became clear  that Greek's defaulting on it debt moved from the realm of Probability to Certainty; It was just a matter of time. A rescue package had to be hastily negotiated with both the EU and the holders of Greek debt taking the heat for the quagmire. The Greek politicians that had been on surviving ended up losing their jobs and ordinary Greeks are set to feel the sting of austerity. This is far from over with Portugal, Spain and Italy beginning to show signs  of wavering and the debt markets demanding higher yields from these countries' debts. 

 A major lesson learnt from the Eurozone is  Political Union  is equally ,if not more, important for both  Monetary or Fiscal union to work. This  brings to question  what standards of  governance are applied within the region. Which broadly translates into the need for some form of Political Union at some point in time. Also, political motivations govern a lot of the factors involved in running an economy. Would a government risk its political survival by not borrowing to pay for a social programme important to the electorate because it is the financially prudent thing  to do? In Kenya, this would be the equivalent of the  halting of the free primary education programme. Can a Kenyan politician risk the backlash? What if we have an errand member in the union like Lesotho where the King's household expenditure is so lavish to the point of borrowing from South Africa to sustain it. And what happens to his subjects?  

We cannot have a government lavishing goodies to its citizens at the expense of economic stability in the region. But neither can we encroach on a country's sovereignty with the pretext of ensuring our economic stability.  The principles of the rule of law and good governance  have to be uniform and acceptable across the region but cannot be forcefully imposed.  With integration, we are throwing our lot with countries that have seen civil wars for decades, with countries with a strong military influence in political life, with governments  formed along ethnic  lines and with countries resistant to integration. 

To say that integration  is an uphill task is an understatement. There needs to be a lot work on the diplomatic front to have some form of governance principles across the board that member states will use to check each other. There also has to be room for constructive criticism  and consequences for not adhering to these standards.