Why African Markets Still Struggle to Attract Private Equity Investors

The Private Equity (PE) industry in Africa is currently enduring the storms of on-going economic challenges, including changes in political regimes in countries such as Kenya, Nigeria and Angola. According to Tanya Lill, Head of Southern Africa Private Venture Capital and Private Equity Association (SAVCA), Africa is a resource-driven economy and therefore, low commodity prices remain a concern for most African countries. Majority of African countries are operating in a closed-form economy such as Ethiopia and this poses a major challenge to Private Equity firms.

A closed-form economy is one that doesn’t allow trading activities from other economies. According to International Monetary Fund (IMF), majority of the emerging markets such as Brazil, India and Poland adopted an open economy which led to a significant increase in capital flows after the globalization era in 2000. This, in turn, changed the internal dynamics of the countries and companies had to look for a better way to build competitive core businesses. Since then opportunities for private equity have expanded in emerging economies since 2000 and the growth has been attributed to several factors such as the increased set up of several companies, which increased liquidity over the years, and an increase in the availability of control positions.

Private Equities & Venture Capital horizon pooled returns in Africa but they remained low year-to-year (y/y) compared to the other emerging economies. Over the last 20 years, private markets in Africa have experienced a slowdown of capital flows compared to other economies in South America and Asia. This can be attributed to a low level of attractiveness for PE firms. Fundraising increased by USD 1.4 bn to USD 14 bns representing a y/y change of 11.6%, further widening the financial scope for the PE funds. They can invest more.  However, emerging countries such as Turkey, Brazil and Poland had a decrease of USD 32.8 billion to USD 77 billion, a downside of 29.8% Even though there has been diminished growth, PE funds in Africa have increased significantly since the financial crisis of 2009. This is a clear signal that investors are bullish on the business prospects of African economies. Positivity. In 2015, PE funds invested USD 8.1 billion in African businesses compared to USD 1.5 bns in 2007.

A summary of horizon pooled returns in Africa and Emerging markets

   1 Year 3 year 5 year 10 year 20 year
PE & VC (Africa) 3.62 5.26 5.23 7.25 6.49
PE & VC (Emerging Markets) 18.07 9.5 12.92 12.83 21.36
MSCI (Emerging Markets) -14.24 9.65 2.03 8.39 8.85
       

Source:  Africa Private Equity & Venture Capital

According to a report from the African Private Equity and Venture Capital Association (AVCA), the total value of fundraising closed by Africa-focused PE firms got to $1.7 billion in the first half of 2019. Even as much as the fundraising amount battled to beat the figures from the last two years, the total value of deals was far from that. 79 PE deals in that first half summed to $700 million in value, almost the lowest in the last half-decade. Trade buyers, accounted for more than half of exits in the first half of 2019, reflecting a lack of options through Initial Public Offers (IPOs) given the small size of local public equity markets.

As the positive outlook for PE in 2016 was reported, the on-going challenges facing African economies such as currency devaluation, the economic slowdown in China and low oil and commodity prices remained a significant concern. According to the head of PE at Trinity International, low commodity prices were a concern in commodity-rich countries, as was currency devaluation. The key challenges remained high price multiples for larger transactions and scarce sizeable assets, political instability, corruption, weak currencies and high regulatory constraints, all of which foster a perception of bad investment jurisdictions.

Without doubt, the global economic slowdown has harmed the continent, particularly with sharply falling commodity prices giving rise to currency devaluations.  A pressing concern, however, is the more inward-looking and increasingly protectionist economic policies that exist in the developed world, which may hurt the long-term development of Africa. Forex fluctuations have been so extreme, especially the US dollar liquidity, while parallel unofficial exchange rates have led to deals being halted.

There is also a raft of regulatory issues that PE firms need to comply with as they put their deal-making plans into action. Additionally, Africa remains an expensive continent in terms of doing business. Due diligence costs are particularly high, especially when the target is based in multiple jurisdictions. There is also a lack of appropriate leveraged finance outside South Africa. The issue of Africa’s tax systems remains a painful debate, particularly in the context of withholding taxes and the flow of currency controls in many of the countries. The ‘reverse VAT’ is a distinctive concept in the tax legislation of African countries, where a VAT charge is levied in specific instances on expenses incurred in respect of services provided by non-residents.

The 1990s were generally not a good period for PE firms in emerging markets like Egypt, Nigeria and South Africa, as evidenced by the Frazer Institutes Economic Freedom of the World Index reflecting that period. The companies were growing, but not willing to sell or share their control with external investors. This ‘evasion’ was the first building block for private equity that derailed growth in the sector, killing most of its opportunities during the ’90s. The opening up of opportunities occurred post-2000. Private Equity in emerging markets uses relatively little debt as its availability is limited.

Banks largely remain focused on lending against assets rather than cash flows and debt capital markets are very under-developed. Before the crisis, companies in which the International Finance Corporation (IFC) had invested had an average debt-to-equity ratio of 0.74, compared to an average ratio a little above 2.0  in developed markets. The availability of leverage has a direct impact on the number of companies which make suitable targets for PE firms. In low leverage economies, only fast-growing companies would be acquired since higher revenue growth is required to meet the target Return on Equity (ROE).

Most African countries have weak legal systems as a result of failure to strengthen the arms of government, which exhibits very slow or difficult contract enforcement for PE funds. Weak legal systems may be linked to too much bureaucracy in the processes which slows down implementation. A legal system that cannot work fast cannot effectively use the rule of law to maintain order or serve its people. As a result, it limits the trust and the people with whom one can do business with are reduced to those with whom a personal relationship exists, probably as limited as family members.

In as much as Africa is considered a growth continent and the growth engine of the world, it is time that we come up with solutions that will propel growth and prosperity in our continent. Governments need to realise that they play a significant role in ensuring this happens in the long run. Strengthening legal systems and carrying out projects that attract investors is a great step in ensuring this happens.

Written by Kennedy Muturi
@kenmuturi5