Africa remains a continent in growth mode, with The World Bank predicting that 32 of its 48 countries will officially reach middle-income status by 2025.
While international investment in Africa has traditionally been focused on natural resources, the burgeoning middle classes of the emerging economies of sub-Saharan Africa are driving demand for consumer goods and services (especially telecoms), financial services and more effective infrastructure and reliable energy supplies. These industries are experiencing extraordinary growth and companies are looking to overseas sources of capital to keep pace with their competitors.
Although Africa has not been immune to the economic downturn, with some overseas investors taking flight to safer assets, the outlook is positive. Private equity (PE) has relatively few competitors and those that can adapt their investment strategies and structures to address the nuances and risks of the local markets stand to capitalise on the attractive returns that can be generated in the region.
The Funding Gap
With local banks offering funding at high rates of interest, and public markets remaining relatively small scale and illiquid, company owners are turning increasingly to institutional investors to plug the funding gap.
PE has now arrived in abundance, with big international players raising sub-Saharan- focused funds, committing significant resources to the region and battling for ground with Africa stalwarts such as Actis, Aureos and Helios. All have limited partners keen to tap into the Africa story, but unable to gain satisfactory access through illiquid stock markets.
Institutional equity and debt capital tend, however, to be concentrated on a small pool of large, established companies in the continent’s more stable economies, while smaller, often family-owned, businesses still struggle to find funding. The opportunities, particularly in the lower mid-market, are plentiful, but for the savvy investor, it is vital to address the unique risks and challenges that affect deal-making in Africa.
Africa’s reputation has long been blighted by perceptions of political instability, corruption and social unrest. In recent years, concerns have receded, but fresh occurrences of violence and social unrest in Nigeria and Kenya, and labour revolt in South Africa, demonstrate how quickly the situation can change. In addition to creating a diversified portfolio designed to spread risk across a range of geographies and industries, it is important for investors to have an operational team on the ground with a thorough knowledge of the local market and an extensive book of local contacts to be able to react quickly and effectively to political and social change.
Rightly so, one of the biggest concerns for overseas investors remains corporate governance. The far-reaching effects of the UK Bribery Act and US Foreign Corrupt Practices Act mean that overseas investors can simply not afford to associate themselves with businesses that may be involved in corrupt practices. Carrying out effective diligence in this area is tricky, and efforts are often better concentrated on taking steps with the incumbent management team to improve levels of governance, transparency and accountability. Helpfully, business leaders across the region are increasingly aware that improper practices create a barrier to accessing overseas capital and that good corporate governance is an absolute prerequisite of doing business with European and US investors.
Investors must be prepared to take a longterm view. Companies tend to be looking for a medium- to long-term capital solution to allow expansion, rather than a quick turnaround to maximise return. In familyowned and -managed businesses there can be mismatched expectations in terms of control and exit strategy. The investor should lay down the conditions of its investments clearly at the beginning of the process and be prepared to accommodate the family’s reluctance to allow control to be fettered. Further, achieving a successful exit may take time, with exit routes currently restricted to sales, mainly to trade. Illiquidity in local stock markets means initial public offerings have not been a viable option, though larger companies may decide to list in London or Paris.
A Flexible Model
Investing in Africa does not, in the majority of cases, take the form of the traditional leveraged buy-out model and an investor needs to be creative in its approach to finding a solution that provides sufficient protection to be able to navigate the obstacles it faces in the market, but remains attractive to the company. While taking a minority position is common, there is also an increasing trend for investors to offer senior and mezzanine debt financing.
Convertible bonds also work well. A convertible bond is a secured debt instrument with a call option or warrant instrument, allowing the investor to purchase shares in the company at a fixed price immediately prior to an exit. It’s an instrument that has been tried and tested in other emerging markets, where access to finance through more traditional means is restricted. By virtue of their hybrid nature, convertible bonds are considered to be a “safe haven” for investors wary of taking an equity stake in an unproven business, an unstable market or unstable economic conditions.
By placing a conversion option or equity kicker on the debt, which enhances the investors’ return in the event of a positive liquidity event, the company is able to offer a lower coupon rate than if it attempted to issue a straight bond or access local bank debt. By paying out lower levels of interest, the convertible bond creates less drag on a company’s cash flow and is a relatively cheap way for a business to generate capital. Again, investments tend to be a long-term game, with the investor essentially being paid to wait, easing pressure on the company to generate a quick return.
As well as being able to take advantage of upside in the event of an exit, there is also significant downside protection for the investor. The investor is in a better position in the event the investment is unsuccessful, as the investor ranks ahead of unsecured creditors and shareholders. There also may be an opportunity to syndicate the debt, reducing the risk of the investment further. For shareholder-managed businesses, convertible bonds represent an opportunity to access institutional cash without relinquishing control and giving up less upside equity than they might otherwise in a pure PE play.
There is no doubt that Africa offers great opportunities. However, despite the potential for returns, the pitfalls associated with doing business in Africa remain, and the perceived lack of credible competition will change over the coming years with more PE players entering the market Where some of the large international funds have stumbled, unable to deploy funds effectively, niche Africa-focused specialists may prosper. Investors should remember that a much broader approach to PE is needed in Africa, and funds should be structured to offer flexibility in the form of equity, debt and hybrid solutions.
Investors should be mindful of the risks, but not be deterred. Having an experienced operational presence on the ground, with good local connections, is the best way to secure and structure deals, and also enables investors to respond quickly to unexpected problems.