In today's feature, first year WIIP Investment Associates Tala and Steve share what they learned about private equity and impact investing in Africa from their trek to Johannesburg and London with the Wharton PE/VC Club last semester. The trek visited a wide range of highly influential players, each with their own approaches to investing in Africa, including The Abraaj Group, Emerging Capital Partners, Helios, Black Rhino, Phatisa, Actis, CDC Group, DPI, 8 Miles, Ethos, Rockwood Capital, Vantage Capital, The Carlyle Group, and Sango Capital.
Here are the lessons and trends that we believe every investor needs to know.
Private Equity in Africa
Private equity in Africa receives comparatively little attention from investors. According to Preqin, Africa accounted for less than 1% of private equity funds raised in 2015 – far less than both the continent’s GDP share and the amounts raised for other emerging markets. This has been partially driven by the presence of many widely-held and longstanding negative views that continue to influence investors. Nonetheless, many of these views are only partially true or are misconceptions. Exposure to African investments helps diversify a portfolio and can deliver strong risk-adjusted returns. The growth story seen in many countries, driven by increased urbanization, higher consumer spending, and large capital projects, continues despite short-term macroeconomic headwinds.
Perhaps most importantly, from an impact standpoint, there is an unprecedented opportunity in Africa to effect tangible social impact while generating highly attractive financial returns. As will be explained, dedicated double bottom line investing is prevalent in Africa and even traditional funds put a great deal of focus on positive impact. In most markets, “impact investing” is a small subset of the private equity asset class; in Africa, impact is of critical importance to all private equity investors.
Impact is Everywhere
The positive social impact effected by African private equity is substantial. From job creation to ESG (environmental, social, and governance) standards, private equity fund managers are leading the way on both financial return long-run social impact.
A great number of development- and impact-focused fund managers with explicit double bottom line mandates are investing in Africa, from development finance institutions (DFIs) to early-stage impact investors. These fund managers invest in businesses and projects that create jobs, increase incomes, supply energy, help the environment, and build substantial local value chains. DFIs also play a key role as limited partner investors in private funds. As LPs of first time fund managers, they are working to increase the number of private equity funds in Africa, acting as a force multiplier. Finally, DFIs have the added effect of requiring more stringent social, environmental, and governance compliance from their investees’ portfolio companies, leading to a focus on such issues unseen perhaps anywhere else in the world.
Fund managers in Africa, even those without an explicit impact focus, spend far more time and money on ESG matters than do their peers in the West. Partially driven by the presence of DFIs and other impact-oriented players (either as LPs or as potential future acquirers of portfolio companies), they strive to ensure that their portfolio companies are limiting negative externalities and are creating positive impact wherever they can. In a similar vein, one of the value creation tools that African private equity fund managers excel at is their ability to bring their portfolio companies (often younger and/or previously family-owned) up to above-market standards of compliance and transparency – since this tangibly increases their value at exit, whether to a strategic acquirer, to a larger financial buyer, or via IPO. Investors can even help influence the political climate by investing in countries with strong rights and governance standards and not investing in those that lack such rights and standards. This was well put by Joseph Bergin, Senior Partner and Investment Director at Phatisa, a Johannesburg-based private equity fund manager focusing on agriculture and housing. Bergin said that Phatisa “simply won’t invest in countries that are going in the wrong direction politically – it’s bad for our development impact goals and it’s risky financially.” This sentiment was echoed widely by other fund managers.
In Africa, private sector investment tangibly improves standards of living and development outcomes even when a traditional double bottom line approach is not used. Since, as detailed in Part II, private equity investments almost always act as growth enablers for portfolio companies, this investment helps trigger a virtuous cycle of higher employment, higher incomes, and greater profits for the companies. The marginal societal and macroeconomic value of private equity investment is thus substantially greater in Africa than in the West.
Growth is Everything
Traditionally, private equity fund managers have created value through a combination of earnings growth, multiple expansion, and financial leverage. In Africa, earnings growth is of paramount importance in any investment.
Financial leverage is available in smaller increments and at a higher cost than in other markets. Often, it is not available at all. Thus, fund managers must and do focus on portfolio company growth above all else to create value. Many have dedicated operations teams that are fully dedicated to growing portfolio companies and improving their profitability.
Leveraged buyouts, the preferred form of investment in Western private equity, are rare in Africa. This is driven by debt availability and pricing, as noted above, and by the preference of many company owners (particularly family-owned businesses) to have private equity funds take a minority share rather than do a full buyout. This lack of full control is not viewed negatively, as it would be in the West. As minority shareholders, fund managers maintain influence through negotiated rights that often equate to effective majority control on key issues and, more importantly, a strong focus on cultivating deep and collaborative relationships with majority owners and management teams. “Control comes from building good partnerships,” said Sev Vettivetpillai, Managing Partner at The Abraaj Group, a pan-emerging markets fund manager. “It's not about 51% or 49%.”
Given all this, private equity in Africa looks more like growth equity in the West than it does like “private equity” in the West (i.e., leveraged buyouts). Fund managers live and die by their ability to pick strong companies and help them grow.
Relationships are Essential
Western private equity is often transactional. A deal will be sourced through an investment bank, the highest bidder will buy the company, and the prior owner will cash out. Deep relationships are less important than a willingness to pay.
In Africa, this is far from the case. Most private equity deals, except in South Africa, never come through an intermediary like an investment bank; they come to the fund manager through a network or are actively sought out by the fund manager. As noted in Part II, most transactions are not buyouts, so existing owners will hesitate to do a deal with an unfamiliar player they see as a capital provider rather than a partner. With imperfect information, the business operations of portfolio companies are facilitated by having a strong local network – particularly, in certain countries, where government is active in the private sector.
Finding the right management team is a major challenge for African fund managers; most of those we visited cited portfolio company management talent and depth as the single largest inhibitor to growth. Finding and assessing teams is therefore vital.
Without a deep local network of intermediaries, businesses, and government officials, a fund manager will struggle to source deals, expand portfolio companies, hire quality management teams, and exit deals.
Heterogeneity is the Reality
More people live in China than in Africa, yet Africa has 54 countries and covers a vast land area three times that of China. It should not be surprising, therefore, that talking in simplistic terms about the African market as a whole is misguided. Countries, industries, and companies vary immensely in their nature and in their level of attractiveness for private equity investors. It is a far different reality than trite stereotypes would assert.
Many in the West talk of investing in or expanding into South Africa and Nigeria, Sub-Saharan Africa’s two largest economies, in one breath. Yet the economy and infrastructure of South Africa are highly developed while those of Nigeria are not. Likewise, they may assume investors should shun the consumer sector in resource-rich Angola, a country where most citizens have very low purchasing power and 99% of goods are currently imported, in favor of the oil & gas sector. However, many investors on the ground are increasingly looking to Angola’s consumer sector, with its strong macro trends and growth opportunities, and avoiding oil & gas, due to the government involvement and corruption surrounding it.
This heterogeneity is not limited to countries and sectors; the private equity fund managers investing in Africa take many different approaches. As noted in Part I, some (such as IFC) pursue investment with an explicit double bottom line mandate, while others have a more traditional profit focus. Some (such as DPI and 8 Miles) have one central office, combining the whole team in one city and limiting cost. Others (such as ECP and Actis) have numerous offices across the continent, facilitating the building of local relationships. South African fund managers like Ethos and Rockwood generally prefer to invest in South African companies and gain exposure to the rest of the continent through these companies’ operations. Pan-African players, often based in London, invest in the whole continent – and avoid South Africa due to its well-developed local private equity market.
Given all this, it is clear that there is no one answer to how to be successful in private equity in Africa – no one country to focus on, no one sector to target, and no one investment strategy to employ. What it also makes clear is that a fund manager’s focus is imperative; its investment strategy must seamlessly fit with its target sectors, focus countries, and firm structure.
Risk is Unavoidable – But is Manageable
Many companies and investors stay out of Africa altogether because they obsess over the risks – political risk, currency risk, commodity price risk, and capital access risk are four of the favorite bugbears. But this binary view is overly simplistic. As discussed previously, potential investments in different countries and sectors have far different risk profiles. It is fair to say that the average private equity investment in Africa is riskier than that in the West. Some level of risk is unavoidable – as it is, perhaps to a smaller degree, in the West. This risk is, though, accompanied by the potential for higher returns.
The perception of major political risk in Africa is the one of the most widely-held, and damaging, views of the continent. Certainly, major areas of political risk exist. However, this fear is overstated. First, overall political risk has been declining since the immediate postcolonial era. Second, there are many countries with highly stable political environments (such as Zambia, Botswana, and Ghana) – and many of these welcome and encourage private equity investment.
Currency risk is real in Africa. The South African rand has fluctuated significantly, and in the past two years the Nigerian naira has declined by ~50% against the dollar. Hedging on a large scale is prohibitively expensive. Nonetheless, there are strategies to mitigate currency fluctuation risk – such as taking out local currency-denominated debt and having local companies pass through depreciation via price adjustments to end customers. Ultimately, though, fund managers (and, more importantly, their LPs) must recognize that any foreign investment in any region does have currency risk attached to it. It is on the top of minds right now because African currencies have depreciated recently; in the long run, they are just as likely to appreciate.
Commodity price variance (which, more often than not, drives currency fluctuations) has played a major role in some of the macroeconomic headwinds the continent has faced over the past two years. However, most fund managers we spoke with were not overly concerned by this risk. Crucially, most private equity capital is not flowing into extractive industries directly – so commodity price risk, while a factor in that it affects spending power in the overall economy, is not a binary risk in the way that it would be for an investor in, say, a mine or an upstream oil & gas play.
Finally, risk to the return of capital is a factor. Certain countries, such as Ethiopia, make it easy to invest money but hard to pull money out of the country. This risk must be evaluated in every deal – and considered in potential deal and company structures that might mitigate its effect. A wider concern in this area is exits. Exits can be difficult in the continent; there is not a universe of ready, well-capitalized buyers to sell one’s portfolio companies to as there is in the West. IPOs are rare – exchanges are not well-developed and are illiquid, except in South Africa, and public capitalization is highly concentrated in companies focus on mining, energy, telecom, and banking (while many fund managers are focused on the emerging consumer class in Africa). Given all this, fund managers must be more proactive in sourcing exits. All this said, exits have become materially more achievable in the past two decades as private equity has become more commonplace. South African and North African corporations are increasingly acquisitive as they pursue regional expansion through M&A. The field of potential multinational acquirers has expanded beyond the traditional players to include Asian and Latin American corporations and family offices seeking growth. Finally, mid-sized private equity fund managers can look to larger fund managers, who are raising ever-larger amounts of capital to deploy. These larger fund managers look favorably on African businesses who have experience with institutional capital (it mitigates risk), creating an opportunity for mid-sized fund managers to serve a crucial role in the growth trajectory of a company – while facilitating an exit.
Fund managers in Africa, however, are quick to point out that the factors underlying risk in Africa are different from those experienced in other regions, giving LPs the opportunity to diversify the risk of their portfolios. For example, when Western markets struggled in 2008, growth in Sub-Saharan Africa neared 6%. Additionally, portfolio construction is ever more critical to private equity success in Africa. As Richard Okello, Co-Founding Partner at Sango Capital, pointed out, “a well-considered portfolio construction approach that combines top-down risk mitigation with a disciplined bottoms-up focus on driving returns from sustainable growth is well-positioned to outperform a developed market private equity portfolio handsomely.”
Overall, there are significant risk factors to private equity investment in Africa – but they are generally overstated, are unevenly felt in different situations, and are compensated for by potential returns higher than those seen in other geographies.
About the Authors
Tala Al Jabri is an investment Associate with WIIP focused on investments in food and nutrition. From Saudi Arabia, she is currently using her MBA studies at the Wharton School and MPA at the Harvard Kennedy School to explore the many intersections between gender-lens impact investing, emerging market private equity and Islamic Finance. Previously, Tala was a strategy consultant specializing in economic development interventions in the Middle East and East Africa.Tala will be interning for an emerging market growth PE fund this summer based out of New York.
Steve Rizoli is an Investment Associate with WIIP focused on investments in the energy, environment, and agriculture sectors, primarily in Sub-Saharan Africa. Before Wharton, he worked in private equity and consulting in North America, Southeast Asia, and Europe. In addition to pursuing his MBA at Wharton, he is a dual degree candidate pursuing an MPA at Harvard's John F. Kennedy School of Government. This summer, he will be working in private equity in Johannesburg, South Africa.