Investing in African private funds
By Mayank Gupta, Partner, and Solomon Olukoya, Trainee Solicitor, K&L Gates
Published: 27 January 2017
Introduction
Investors have been looking at the emerging markets, including those in Africa in particular, as an important piece to their investment strategy in a time where the established Western markets have not been producing expected returns.
The Private Equity (“PE”) industry has been expanding rapidly in places such as Asia, Latin America, and Sub-Saharan Africa. PE deals in Africa used to be in large infrastructure projects that attempted to solve the needs of everyday people in sectors such as electricity and clean
water. Subsequently, there has been a diversification in the sectors that PE deals target.
The obvious benefits of investing in Africa — an increasing middle class and an abundance of natural materials — are very well known and have been for many years.[1] The risks that have been a barrier to investment in Africa for many years — political instability and conflict — are reducing with each passing year. There is now less conflict in Africa than in any time since the “decolonization” of the continent. However, as the old risks subside, African PE faces new challenges — some unique to the continent and some mirrored by other emerging markets.
This note looks at the appeal for funds investing in Africa, the risks associated with such investment, regional differences in PE, and the outlook for the medium- and long-term future.
Appeal
PE in Africa plays attracts a diverse investor base: the industry was pioneered by development finance institutions that looked into large infrastructure projects to help develop specific industries in Africa.[2] Now, the local and international investor base includes pension funds, sovereign wealth funds, foundations, and endowments.
Africa’s appeal to private funds is multi-faceted: Infrastructure needs investment across the continent, and the growing middle class means there is an increase in the demand for consumer goods. Fund managers have cited the increasingly mature role that Africa now plays in the global economy coupled with the ease of doing business with other fund managers across multiple countries as factors that make Africa attractive.[3]
Energy, infrastructure and telecommunications are the sectors that most funds have targeted recently.[4] These sectors are vital in the development of modern economies. Statistics on the access to electricity in Sub-Saharan Africa show that there is dramatic underdevelopment in this sector. The 48 countries in Sub-Saharan Africa generate approximately the same amount of power as Spain.[5] PE firms filled in this demand for capital. For example, Blackstone Group completed a hydroelectric dam project in Uganda in 2015.[6]
Risks
The risks for private funds investing in Africa can be split into two groups: (1) risks for investing in Africa generally; and (2) specific risks within the African PE industry. Conflict and corruption remain risks that may affect any business operating in Africa. Although conflict is now at its lowest level in 50 years, it still exists and disturbs nations, governments, and service provisions, thus making it harder to operate in African countries. Corruption has long been highlighted as one of the key problems hindering development in Africa, and poses special risks for PE investors that may be subject to the Bribery Act or the Foreign Corrupt Practices Act.
The PE industry faces specific issues dealing with the size of business that PE firms want to take over and the typical methods of improving the business. Although large PE firms typically prefer to purchase businesses that are valued at over US$100 million, targets of that size are generally scarce in Africa.[7] The statistics show that most deals in the PE industry in 2015 were for less than US$10 million. These smaller types of deals that are available dim the appeal of Africa, to some extent, for some of the larger funds. Nonetheless, despite that challenge , the PE industry closed on a record US$4.3 billion of fundraising for African investments in 2015.
The standard PE model of buying a company, loading it with debt, and selling the company after five years of expanding the business and improving its profits is not always successful in Africa. First, the local owners may not recognize the need for private equity and be unwilling to relinquish control of their companies. Furthermore, international funds need local knowledge from fund managers in order to identify the key improvements that can be made to make the companies more profitable.[8]
For fund managers, investing in Africa requires a much more hands-on approach than typical Western PE, as it can be difficult to exit via a listing due to immature stock markets. In 2014, 31 PE firms in Africa reported exits, and this figure dropped slightly to a total of 28 in 2015.
Regional disparities
PE in Africa has been growing, but Africa is an extremely diverse continent and there are marked differences between regions. Thirteen of the AVCA Index funds are focused primarily on South Africa, which evidences South Africa’s continued preeminence in African PE, despite Nigeria’s economic growth in recent years and the fact that Nigeria is the largest economy in Africa.
Since the oil price drop in mid-2014, Nigeria’s economy has been struggling. It is currently in recession, with third-quarter 2016 results showing that the economy shrank 2.24% as compared to the same three months in 2015.[9] It is too early to predict the effect that this will have on private funds that focus on Nigeria. Considering that Nigeria is the biggest economy in Africa, and that 25% of the PE deals between 2010 and 2015[10] were in Nigeria, the recession is a concern for the future of PE investment in that country and for western Africa more generally.
Although Nigeria and South Africa dominate the headline figures for African PE, East Africa posted the strongest returns in comparison to the public markets in those countries between 2007 and 2015.[11]
Looking forward
PE firms active in Africa are looking to diversify from infrastructure, increasingly in competition with development financial institutions seeking new industries and asset classes in which to invest in the future growth of the continent. The new sectors that are interesting PE fund managers in Africa include financial services, education, and healthcare. These areas will continue to be targeted by PE investment in the foreseeable future.
Only 7% of the working population in Africa currently invests in a pension, and with the growing middle class, this figure will only increase. As more African countries develop more sophisticated pension programs, more African pension providers will have capital to invest. This extra capital coupled with continued interest from overseas will help grow PE in Africa.
Fund managers are aware that valuations have tended to be inflated in recent years. As a result of the fall in commodity prices, the growth projections across Africa have been dialed back, which will bring down the prices of overvalued businesses and keep less serious investors away from the African market.[12]
Conclusion
Despite downward trends in emerging markets, Africa’s long-term growth outlook provides attractive investment opportunities for emerging markets PE firms. PE in Africa has diversified from its traditional development infrastructure starting point to more consumer-focused sectors in order to cater to the growing middle-class population. The risks associated with PE in Africa — smaller deals and nontraditional methods of growing the business — means that PE firms must be nimble and equipped with local knowledge to tap into the continent’s potential. Africa is not a homogenous place, and there are regional differences in the successes of PE. Looking ahead to future African pension funds will be vital to the continued growth of PE in Africa in the financial services, education, and healthcare sectors.
Footnotes
[1] EY, Private equity opportunities in emerging markets, accessed on 1 December 2016 http://www.ey.com/gl/en/industries/private-equity/pe-opportunities-in-emerging-markets--private-equity-in-africa
[2] AVCA Annual Limited Partner Survey, Institutional investor views and expectations about private equity in Africa, 2016 page 2
[3] Into Africa: the rise of private equity, Freshfields Bruckhaus Deringer, 2014 page 1
[4] AVCA Annual African Private Equity Data Tracker, 2015
[5] CNN, Why are 600 million Africans still without power, 2016 edition.cnn.com/2016/04/01/africa/africa-state-of-electricity-feat/
[6] CNBC, Private investors pile into Africa, accessed on 1 December 2016 http://www.cnbc.com/2015/03/17/private-equity-investors-pile-into-africa.html
[7] The Economist, A sub-Saharan scramble, accessed on 1 December 2016, http://www.economist.com/news/business/21640327-private-equity-investors-are-getting-hot-africa-businesses-there-need-all-capital
[8] Ibid.,
[9] Financial Times, Nigerian economy remains firmly in recession, accessed on 1 December 2016 https://www.ft.com/content/b860c57e-1b2f-3da1-b14b-240000001748
[10] AVCA Annual African Private Equity Data Tracker, 2015
[11] EY and AVCA, How private equity investors create value , 2015
[12] The Economist, A sub-Saharan scramble, accessed on 1 December 2016, http://www.economist.com/news/business/21640327-private-equity-investors-are-getting-hot-africa-businesses-there-need-all-capital
To contact the authors:
Mayank Gupta, Partner at K&L Gates: [email protected]
Solomon Olukoya, Trainee Solicitor at K&L Gates: [email protected]
