The Mechanics of stock exchange
Tesfaye Hailemichael is the Managing Director of Cornerstone Advisory Services Plc and the former board chairman of East Africa Tiger Brands. A Certified Public Accountant (CPA), Tesfaye served as chairman of the board, chief executive officer, chief financial officer, board member, treasurer and corporate secretary for global companies in the U.S for decades. Among others, Tesfaye was a co-Founder and director of Volution, Inc. a fiber optic and electro optic company in San Diego, California; board member and audit committee chair of partnership with industries, one of the largest Non-Profit Organization in San Diego; and board member of financial executive international, a professional organization. Tesfaye was also a nominee for Chief Financial Officer of The Year from 2007 and 2008 by San Diego Business Journal. In that time, he has acquired extensive experience in taking companies public, merger and acquisitions, joint venture structure, fund raising, security and exchange commission reporting and international operations. Tesfaye was also responsible for identifying targets, performed due diligence activities, negotiating, acquiring and integrating many companies in his career, and accredited for his management and turn- around strategy and creating shareholder value for more than 20X by taking a company public. He also received his M.A. in Accounting from the Catholic University of America, and studied International Finance towards MBA at George Washington University, Washington, DC. Last week, Asrat Seyoum of The Reporter sat down with Tesfaye to tap into his rich experience in publicly traded companies and stock market. Excerpts:
The Reporter: Ethiopia has embarked upon a massive economic and political reform; and among these multifaceted reforms opening up the space for private sector in the traditionally-government-controlled economic activities is gaining a lot of attention. In this, the partial or full liberalization of some of State Owned Enterprises (SoEs) and the PPP framework are expected to alter the way business is conducted in Ethiopia. Yet, although many are in favor of increasing private sector participation, there are concerns that the introduction of private capital in government run service sectors like telecom and power might drive up prices on these critical services, disadvantaging the consumer and other economic sectors relaying on the services. What is your take on that? Are there any mitigating measures?
Tesfaye Hailemichael: Privatization of government enterprises is a good thing; however, expecting successful privatization as intended without deploying adequate infrastructure committed professionals who have the experience and the intellectual honesty successful privatization may not be achieved. Time must be spent on planning before implementation of any project or establishing any institution. Privatization of government entities combined with added competition typically has a positive effect for the consumer by forcing the service providers to provide a better service at cheaper price. The market dynamics allow the consumer to have more options. The Objective is to encourage economic growth by opening up the private sector, thekey point is, allowing for open and fair playing field so that additional competition can emerge, in essence we need clear and transparent governance mechanisms including various checks and balances. If this is not managed properly, you can create oligopolies which may not have positive result for the consumer. Most countries have regulations which prevent companies from raising prices on essential public services such as power without the approval of the government/utility commission. At times, governments give subsidy to ensure that the public receive services at reasonable price. The best example ispalmoil subsidy in the case of Ethiopia.
But, some fear, the involvement of local private sector might encourage the emergence of oligarchic elements as you have mentioned, while other also fear the involvement of foreign capitalists could compromise the nation’s economic sovereignty. Do you buy these concerns? And how is it best to go about the process then?
It is important that we have proper governance mechanisms to help manage the privatizations and the private sector overall once the privatization happens. The privatizations themselves are not the problem.The challenge is how to find the right people who have the capacity to lead and have the fortitude to work on the interest of the shareholders and the country. Integrity, moral compass, understanding fiduciary responsibilities are the cornerstone of managing public or private company. The toneatthetop ongovernance, pride in doing good work, social responsibilities and family value may warrant the success of privatization and any other country objectives.Sovereignty is all dependent on our leadership. Whether sold to local entities or international, the people of Ethiopia give up their sovereignty as soon as laws are not instituted that are in the interests of the people and when those laws are instituted if they are not equally upheld for everyone.Legal framework, strong institutions and education are the insurance for protecting the nation’s economic sovereignty.The best wayis adapting international best practices to the Ethiopian setting/situation. Too many times we try to develop things in a vacuum when there are practices/processesthat work internationally quite well or we copy best practices without understanding and not having the required tools. The tricky part is finding the right team who understand the required tools and adapting it to the Ethiopian social and political situation.We need to demand high standards from ourselves as a yard stick whenever we adopt new processes.
Some also claim the best way to privatize these SoEs is through a structured capital market to a wide base of mixed investors. To that, the GoE seems to have laid out a rather expedited plan to establish a stock exchange platform by 2020. First, do you think this plan is realistic? Regardless, is a stock exchange a good way to go about privatization of SoEs?
Stock market is an investment vehicle for those who are able and have the risk tolerance to invest in stock;it is not for everybody. Stock market by its nature is risky even in developed countries whichhave been tradingstock for hundreds of years. The issue of the stock market is quite tricky. It requires strong institutions before the stock market become effective, we need institutions such as an Ethiopian Security Commission which is responsible to develop the law, Security Enforcement Division at the Attorney General’s Office,accounting oversight board, which oversees the auditors and accountants, professionalassociations such as Association of Stock Brokers which monitors its members, trained lawyers, auditors, accountants, Chief Financial Officer(CFO) etc.Those professionals must be trained and understand the law before they will be involved in such undertaking.In short, 2020 is not a realistic timeframe. I think more time is required to plan and execute the privatization process just as stock market.When and if we start a stock market, assuming all the requirements for initial public offerings are met, I would recommend starting off on a very small scale, maybe allow a small group of companies maybe (5-15) and monitor the behavior of the market over a period of 2-3 years. This would allow the government to understand and improve upon governance/regulatory structures for it. We don’t want it to be a free-for-all that may lead to a dysfunctional market that nobody trusts or believes in.As a general point, since some of these SoEs are quite valuable and have significant upside, allowing for the government and the local citizenry to participate in the upside is a good thing.I think launching the stock market and allowing such valuable SoEs to trade on it right away is too risky. Thinking out loud, one way to do it would be to allow the public to buy restricted shares in the SoE at first with the understanding that they would be able to sell/trade them in the market for a period of 2-3 years, then allow these to trade in the market once we have gotten the regulatory/governance structure to work properly.
This brings us to the question is Ethiopia ready for a stock market today? Or was it ready 20 years ago since the government seemed to claim that a study has confirmed that it was not ready back then? What are the signs to look for to definitively establish that an economy is ripe for an organized share market?
There is certainly local demand and international demand for a stock market in Ethiopia. This does not necessarily mean the country is ready. It also doesn’t mean that it can’t start in the controlled fashion.The key issue is corporate governance and the concept of fiduciary duty. In order to entrust someone with your money, whether through a stock market or even through a widely held share company, there has to be some level of trust on how the money is used. We still see some problems from time to time on these fundamental issues in private companies, locally. There are many examples but one of the most publicized ones is the Access Real Estate. There weren’tmuch regulation on the real estate sector so it became a free-for-all and manypeople got burned. I’d rather us start but in a slow and controlled fashion. I do not think Ethiopia was ready for stock market 20 years ago. I am not sure why a study for a stock market was made 20 years ago I do not think it is ready even today. Obviously, the institutions and the tools for stock market are not in place.
I understand that before the recent renewed drive towards an organized stock market, the GoE was working on a plan to set up a platform to work as a secondary market for bonds and debt securities. Some say the two are structurally similar except the choice of instruments traded, do you agree with that? Which should be the priority?
Both government bonds and stocks are securities and are investment vehicles. There are corporate bonds in developed nations as well. The risk tolerances for all those instruments are different. However, government bondsare less risky than corporate bonds or stocks.I would start with a debt instrument due to its security and guaranteed interest structure. Itis potentially less risky for the investors and the obligations/fiduciary duty are reduced from the investees. It also helps serve the primary need of local investors looking to get yield/interest type of payments rather than trying to understand valuation and trying to figure out whether a stock is under or overpriced.
Are the rules and regulation for trading stocks and bonds (securities) in an organized exchange platform similar? I understand that stock exchanges act both as primary and secondary markets for Shares (stocks), as IPOs and traded stocks. What about for bonds? Can a sovereign entity issue bond or other debt instruments for the first time on a stock exchange platform?
The rules for bonds and stocks are generally similar. Yes, a sovereign entity can issue these instruments on the stock exchange platform assuming that it complies with all the regulation for listing. Generally, in addition to the regulations, there are underwriters who follow the rules and take responsibilities to have a bond or stock got listed.
What about other debt securities. For instance, in 2008 financial meltdown, the role of debt securities like subprime housing mortgages which managed to find their way into the capital market as tradable stocks was highly publicize. So, can any debt instrument be remodeled as tradable stock and join the exchange platform?
Bank loans could be business or personal loan. Banks have their own approval process for loans; in most cases it will be asset based lending. Debt Instruments can be traded on stock market, but I would not recommend such structures for Ethiopia. We need to start small and simple. Complicated instruments do not make sense for us given our level of sophistication both from the borrower and the lender’s perspective. We should only allow simple instruments such as amortizing bonds to start. No abstract instruments such as subprime or others.
Can you talk a little bit more about the Subprime crisis?
With regard to the Subprime mortgage crisis, what had happened was that all the traditional requirements that need to be fulfilled to apply for a mortgage loan were systematically altered leading to a disastrous consequence. Traditionally, to access a mortgage in the US or the UK, first one has to be employed with steady stream of income; then he/she finds a house and approach a bank (usually through brokers) to finance it. Then, they find the buyer a loan at a certain interest rate based on the buyer’s income level. They usually check, the employment, the years of service, the stream of income, any other additional income, size of the family or number of dependents etc. What they usually look for is the amount that the buyer would be able to pay on a monthly basis, since the monthly loan repayments could not exceed 30 percent of buyer’s gross income. However, prior to 2008 crisis, the traditional mortgage requirements were circumvented through loan instruments called subprime mortgages. What they did was that first they bypassed the strict requirements through mortgage instruments which can be resold to other investors, and applied what they called variable interest rates. Unlike previous fixed interest rate requirements, the new variable interest rate can increase and hence carried a risk of increasing the monthly mortgage payments of the buyers. Houses which were affordable to buyers at lower interest rates suddenly faced default when the interest rate went up. It was exacerbated by the fact that banks which offered the loan have an option to resell the mortgage (debt instrument) to third party investors. They resold these mortgage loans as banks were expecting for interest rates to go up. These instruments were attractive for investors since interest rate going up would entail higher gains for whoever holds the mortgages. Nevertheless, the down side was that the interest rates going up also mean risk of default for house buyers; and finally most of them did. These mortgages were also insured in most cases, and the chain of damages went even further. Since then, the requirements have been more stringent; and no variable interest rate. So, from Ethiopia’s perspective, it does not make sense to start with such complicated instruments.
As a CFO of handful of companies in the US you have spearhead projects of ‘going public’. Just humor me, what does “going public really mean”? What is an IPO? What are the critical steps needed to be taken to transition a company into a “publicly traded” one? Perhaps what could be the most difficult step?
An IPO is Initial Public Offering, companies thatcomply with the Security and Exchange required regulations will be on stock market, which means they will be listed stocks and could be bought and sold to public every day.The process of going public in the US where I was involved in, such undertaking is not an easy task. Companies must comply with many regulations from Security Exchange Commission (SEC), Accounting Oversight Board, Stock Exchange Board andstock underwriters/Investment banks as they do their due diligence. So, the requirements go as far as choosing the right CFO. The SEC has requirements to be a CFO of a publicly traded company; they do a back ground check regardingCFO’s professional qualification, integrity and the moral compass to lead the company in this endeavor. They also do the same rigorous checks on the board of companies. The company must have qualified board members and officers in good standing with impeccable track record in professional and personal life. Apart from that, there are financial documentation requirements as well. First, the company has to be at least three years in the business; it should produce a three-year audited financial report with unqualified audit statement. The auditing has to be done by competent and approved financial auditing firm. It needs to have well-organized internal financial reporting system. It also needs to have prudent corporate governance policy. Then the company also needs to have qualified team of lawyers advising it on the security instruments and all the documentation to be submitted to the SEC. So, when a company decides to go public it has to make some hard choices; it has to get its house in order. After preparing all that, the company needs to select fitting underwriter. This process also goes both ways as the underwriter also selectsthe company which plans to go public; since the underwriters/investment banks also want to know who they are getting in business with. Once that is done, the company submitsits documentation to SEC which includes among other things the business plan, the status of your staff and officers and the audited financial statement. Basically, it is a mountain of documentation since it includes everything from biography of officers toall major agreement, products descriptions, patent rights, contracts and many others. Then you respond to inquiries to SEC on the submission. So, the whole process can take 90 days to six month.On other hand, since SEC is a federal agency that regulates securities, the filing is also expected to be made for state corporate offices; this is because there are some state where the requirements are a bit different form SEC. Granted most states accept the federal law or what they call ‘the blue sky law’ but in some instances there could be unique requirement. So, I would say the disclosures process is very testing. As a general note, a company should always make sure that it has the right people for the job beforedeciding to go public since experience matters; also it advisable to never rush to go public before getting you ducks in a raw, as they say; there is also the need to have a trial period before going public; the company needs to keep its preparation totally secret so that there is no speculation on stock before going public.
For years, regulatory capacity was the biggest issue for establishment of a stock market in Ethiopia. What do you think is the most difficult part of a regulating a stock market? Does Ethiopia have the human resources for such a task?
Ethiopia has a lot of very smart, intelligent people spread across the world, all we need are people that have exposure to stock market, sense of fiduciary duty and are motivated to create proper governance structures. We need to recognize that a stock market could be a risky venture without a near full proof monitoring system and trained people to administer and enforce the laws.The government needs to look into the following points before implementing stock market: The government should appoint a temporary commission whose mandate will be to establish the necessary infrastructures, support the Parliament in crafting the law and prepare the blue print for the stock market; although we have smart people in the country, we also need to leverage the knowledge and experience of Ethiopians in the Diaspora to accelerate the process; the team should consist of Certified Public Accountants who have the experience in public offerings Security Lawyers who practiced security law, People with experience in the stock market, experienced Stock brokers, underwriters who worked in banks abroad;the team should be between 7 and 9; the team should be given realistic timetable;
There are also the stock agents or brokers who advise and represent investors in a stock market. But, in developed nation, we also hear about other institutional actors like hedge fund and capital or equity fund manager companies. What is the role of these actors? What is being hedged on a stock market? What about investment banks?
Brokers help buyers and sellers transact. These people are the cogs in the wheels of the stock market.Equity fund managers, on the other hand, are firms that aggregate the money of various institutions or individuals who would like to diversify their holdings. The fund managers manage it on their behalf. I think these are necessary and as many individuals may not have the time or understanding to choose from various investment vehicles. These players are usually long-terminvestors. They invest the fund in accordance with the agreement with investors in the fund. The money managers invest in companies with growth potential and expect high return. The fund life varies. Hedge Funds are alternative investment vehicles using pooled funds with high return expectation for their investors. Hedge fund require a large initial minimum investment and investors must be accredited investors, require less Security and Exchange Commission (“SEC”) regulations. Accredited investors are considered high net-worth individuals and sophisticated investors who have high risk tolerance. There is a minimum lock up period for investors.Hedge funds offer wider investment options than other funds. Can invest in anything where as private equity cannot.Use more aggressive/riskier versions of equity fund managers. They can sometimes borrow from banks to enhance their positions, they may also take short positions (speculate the stock may go down). The fund managers charge an expense ratio and a performance fee structure, 2%asset management fee and 20% of any gain generated.Likes of hedge fund in Ethiopian context is not advisable.