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* Airtel aims to buy partly state-owned Telkom Kenya
* Merger agreement was first announced in February
* Combined entity will compete with leader Safaricom (Adds regulator, Telkom Kenya comment)
NAIROBI, Aug 28 (Reuters) - Kenya's anti-corruption commission said on Wednesday it had suspended a planned merger of Airtel Kenya with partly state-owned Telkom Kenya pending a probe into allegations about the misappropriation of public funds at Telkom.
India's Bharti Airtel had said in February its Airtel Networks Kenya unit had agreed to buy Telkom Kenya, the East African nation's smallest operator in which the state still holds 40% after a majority stake was sold in 2007.
The combined entity would create a stronger challenger to Safaricom, which now controls almost two thirds of the market in terms of subscribers.
The merger was suspended because the Ethics and Anti-Corruption Commission (EACC) was "conducting investigations into allegations of misappropriation of public funds in the process of privatization, recapitalisation and restructuring of balance sheets of Telkom Kenya Ltd," EACC spokesman Yassin Amaro said.
Amaro did not say how long the investigation would take.
Telkom Kenya Chief Executive Mugo Kibati told KTN News television his company would cooperate with the investigation and said the probe was not linked to the merger deal.
Airtel declined to comment.
Francis Wangusi, the outgoing director-general of the Communications Authority of Kenya, told Reuters the authority had received a letter about the suspension from the EACC.
"They want to investigate the recapitalisation of Telkom Kenya," he said, adding that he expected the two companies would "make sure the investigation is concluded very fast."
Bharti shares dropped as much as 4.4% on Tuesday on reports that the deal had been suspended.
Amaro said the EACC was examining how partly state-owned Telkom was combining with Airtel Kenya and "how it is safeguarding the interest of taxpayers," adding that the investigation was restricted to Telkom Kenya.
France's Orange bought a majority stake in Telkom Kenya when it was privatized in 2007 but then sold its stake to London-based Helios Investment in 2015.
Airtel Kenya has previously said the deal would not involve Telkom Kenya's extensive real estate holdings and some government contracts for unspecified services.
The companies have not previously said when they expected to complete the merger. Both firms have been continuing to operate normally as independent operators in the meantime. (Reporting by George Obulutsa; Additional reporting by Omar Mohammed in Nairobi and Chandini Monnappa in Bangalore; Editing by Louise Heavens and Edmund Blair)