This article was written by Barri Mendelsohn (Managing Associate, King and Wood Mallesons).
The overriding theme of the FT/ EMPEA Private Equity in Africa 2014 Conference was a debate around the role of private equity in the growth story of Africa and an evaluation of the industry’s resilience as the markets mature and new challenges surface. Many are aware of the common quoted macro economic fundamentals in Africa such a fast growing GDP, the rising middle class, a trend to urbanization and improved political stability however, the question remains whether private equity is, and will be part of the African growth story, and how well placed it is to generate enhanced returns in the medium to long term? During the sessions it became evident that the industry has had a strong start with solid performance but there are many challenges.
Creating a conducive environment
In delivering the opening speech of the conference, Nhlanhla Nene, the Minister of Finance for South Africa, noted that since the global financial crisis investors were seeking returns in emerging markets with the appetite for alternative asset classes such as private equity on the rise. He implored private equity funds to partner with government in delivering on the G20 initiatives to deliver over 5% growth in their economies over the coming years, with infrastructure being a focus of investment in South Africa in particular.
Given that private equity is widely acknowledged as a positive catalyst for growth, a creator of jobs and a business innovator when best practiced, the Minister stated that governments must create a conducive environment for private equity to flourish. This includes promoting political stability and legal, governance and compliance structures, together with credible enforcement; all good positive sentiments which many look forward to seeing develop over the coming years across the continent. Private equity must also strike a balance between the use of leverage, aggressive structuring and asset stripping strategies with the need for long term sustainable investments.
A key change in regulation that government could drive is around the limits in place for pension funds to invest in private equity. Creating the statutory authority to invest and/ or raising the thresholds is needed as well as allowing local pension funds to invest in pan-African strategies outside of their own borders where in many cases this is prohibited. It has been reported that there is over US$ 29 billion within African pension funds that could be unlocked to invest in private equity, so resolving this issue will generate more capital for the industry.
What sets African private equity apart?
In exploring Africa’s place in the global economic landscape and whether it is deserving of global capital, the debate commenced with a look at the key features of the industry in Africa that sets it apart from the more developed markets. The first observation was that the strong sectors seen in the public markets do not fully match those targeted in the private sector where there are emerging sectors such as agriculture, logistics and business services leading the way and creating new opportunities for investors.
Another difference in African private equity is the strong reliance on existing founders and management to take investments forward rather than wholly deploying new management that is often the way in the developed markets. Existing management have a deep knowledge of the ecosystem of the investment and so are highly valued by private equity. In order to incentivize them, the view is that industry must show a willingness to take minority positions to allow a meaningful stake to remain with management. Where global private equity investors can add value to the overall investment is by then connecting their African businesses to global supply chains and complementing the existing skills already in the business with new ideas and innovation. A speaker acknowledged that Africa has many “big businesses but small companies” requiring enhanced management capacity, structures and controls. Investors (GPs) must also continue to invest in their own teams and technologies to deploy them in business.
The challenge of a lack of deals
The question remains as to whether there is room for African private equity to grow. With over US$4 billion being raised recently for Africa many see the lack of large deals (to allow for the deployment of capital at the levels being raised) as a major concern. One leading DFI reported that it had conducted research into the topic and found that there are only 3,186 companies in Africa with a revenue of more than US$50 million a year, of which over 1,000 are in South Africa (and a significantly smaller number in Nigeria). Although the research is only as good as the available data, so as the speaker stated, it comes with a health warning, there is clearly a need to develop medium sized companies in Africa. That is the challenge and opportunity for African private equity at its most basic.
A view is that the increased fundraising and attraction of new entrants who are creative in finding deals, will start to solve this issue. A multi-strategy approach to investment is needed too, not just buy-outs, but buy-and builds, taking strategic stakes, partnering and taking positions at various levels in the capital structure are alternatives. There may be a need for more take privates of public companies who could be attractive targets.
Convincing the unconvinced
The discussion then turned to risks that are unforeseen such as the recent human (and economic) tragedy of the Ebola crisis. Looking at it from an economic viewpoint alone, of course the crisis will impact on market perception and willingness to do business on the continent. At a time where African attractiveness is on a high for global investors (LPs), the view is that the way in which the industry reacts to the crisis will demonstrate Africa’s resilience. Many GPs (and their portfolio companies) have been quick off the mark to react to the crisis and safeguard stakeholders, from workers to investors, with decisive and practical measures. The common reaction is that the Ebola crisis, although tragic, should be put in perspective for investors as it will not be a feature forever.
There are those who are long term investors in Africa who understand the core drivers and risks on the continent and will continue to invest. The challenge is to educate those that are willing to consider a strategy for Africa and to ensure that they are not ultimately dissuaded from investing over time. Of course there are those that are “turned off” Africa and will be for a long time to come so more work is needed, particularly with some of the larger US institutions and endowments.
The GPs that are changing these potential investors’ perceptions of Africa are those firms that look like the institutions the investors are used to doing business with in their markets. These tend to be the larger firms, so the challenge is that if one wants to attract new entrants, one must invest and build an institution that is seen to be well placed to deal effectively with issues as they arise, with full risk mitigation strategies and structures in place. The ability to show resilience and to manage the unknown will go a long way to allaying some of the common fears and misconceptions of the yet unconvinced investors.
Identifying and mitigating risks
The approach to structuring deals, carrying out due diligence and developing one’s strategy upfront is acknowledged as a key driver for success. A speaker remarked that “if your diligence is not unearthing issues (whether material or not) then you are probably not doing it right” - and equally not identifying the opportunities to seize upon in implementation to generate upside. This is where investors should rely on their advisers more and allow greater attention to be paid to unearthing the risks and opportunities.
The ability to structure deals and mitigate risk in investment documentation (such as commitments to better compliance and monitoring rights for investors) as well as the use of insurance products (mainly for political risk but increasingly to cover other eventualities) was explored with some GPs of the view that they are being paid to assess and price risk for upside so the cost of a product could not be justified. The value of shifting the risks to a balance sheet that is better suited to holding the risk is evident but the market needs to better understand the offering before it is used more widely (although multilateral credit agencies have made inroads in this area already).
The benefits of supporting demanding environmental, social and governance (ESG) policies in portfolio companies was widely acknowledged, particularly when it comes to exits. Issues that are uncovered during the sale process will cause delays and extra costs and may put off buyers. Good ESG is in essence good business, which will have incremental benefits and costs savings throughout the life of the business.
Views of a strategic investor
In the keynote interview with a strategic investor, aside from the differences in regulatory and tax regimes across the continent, the sometimes poor quality of due diligence information and the inability to obtain accurate portfolio company data was highlighted as a major challenge. Practices that undermine confidence in financial reporting was raised as an example and the involvement of private equity will eventually eradicate these as governance and accounting standards are invariably improved. As a result, creating a far more investable proposition for a strategic.
Focus on the energy sector
The recent shift in focus of certain private equity players to the energy sector in Africa was later discussed. There are high profile examples, such as Carlyle and Blackstone’s recent announcements, but as a sector where private equity by its nature will be stretched to bring about operational enhancements and where there is a reliance on the price of the underlying commodity to drive returns, there are challenges. Early failures of projects in the development phase is also a concern as is the need to reconcile profitability of projects in the sector with ESG. Projects also take time to get the required approvals with regulators wary but the need for energy projects to reach financial close to address the shortages of power in the region remains a priority. Countries to watch are Rwanda and Ethiopia, with investors eyeing up opportunities in the energy sector in these countries.
Focus on Nigeria
Nigeria, with its large population and rapidly growing consumer class, clearly remains a country to watch. The embracing of technology, telecoms and e-commerce is proving a driver for growth. Investors are looking for businesses that can be scaled up to take advantage of these opportunities. However, challenges remain and significant investment is needed in power and infrastructure to enable the growth to continue.
Rise of the Cheetah
In the afternoon Profession Vijay Mahajan, author of “The Rise of Africa” and other works roused attention when discussing what he viewed as the largest risk of all – if the African investment thesis fails, and more specifically, if the middle classes do not develop to drive all the growth that is anticipated. Any growth needs to be inclusive and not create disparities amongst the population. The professor spoke of the “Cheetah generation” who do not remember the failings of the past. It is this generation that is key to the success of the thesis and it is the professor’s view that vastly more resources and effort is needed to be directed at developing this talent. The professor lamented that there are not enough quality African business schools and the African diaspora is not doing enough to promote Africa - so more thought and work to be done to address these.
The enduring challenge (and opportunity)
Working with African pension fund trustees and their fund managers was identified as an area the industry should focus on to unlock capital. The speakers considered why pension trustees (other than the South African institutions) have not in the past invested more. Apart from the regulatory restrictions mentioned previously, there are a number of factors such as the illiquidity of the asset class, a knowledge gap in understanding and pricing, the lack of domestic fund managers with an eye on the industry, general risk aversion, the need for daily valuations and the impact of the “J” curve effect as negative returns are a feature early on before they rise. However, all of this is changing (but more work needs to be done) and the pension funds in attendance warned the GPs to expect more diligence to come.
A cautiously optimistic note with which to end…