To some skeptics, Africa’s market for private equity investment is starting to resemble a bubble. With more than 200 funds managing upwards of $30 billion—from less than $1 billion two decades ago—they fear that too much money is chasing too few sound investments, pushing up prices of African corporate assets. This capital surge, moreover, has come at a time when low commodity prices have slowed economic growth across the continent.
Despite the region’s economic challenges, Africa remains one of the world’s most promising growth opportunities for funds that have the right strategies and can adapt to the evolving market, say The Boston Consulting Group’s Patrick Dupoux, Marc Becker and Seddik El Fihri, authors of the report “Why Africa Remains Ripe for Private Equity“.
Africa is home to many fast-growing businesses that can absorb immense foreign investment, but have limited opportunities to raise capital in the region’s small stock markets. Take sub-Saharan Africa, which is underserved by private equity and principal investment: capital under management is equal to a mere 0.1 percent of GDP, compared with about 1 percent in the West.
So there’s plenty of scope for private equity investment, particularly as robust GDP growth is expected to resume in the medium term, powered by a swelling middle class, rising foreign investment in infrastructure, and a growing skilled-labor force.
The challenge is that too many private equity investors are pursuing the same kind of target with the same kind of deal structure. Overwhelmingly, funds focus on Africa’s limited pool of profitable companies with more than $100 million in annual revenue, $200 million in assets, and 1,000 employees. Most private equity funds and principal investors also tend to invest only in minority stakes.
Although this strategy has served some private equity funds well over the years, it is getting harder to deliver the high returns that investors in these funds expect. These expectations are rising now that development finance institutions, which have specific development goals to meet, and are therefore not simply focused on returns alone, are being replaced as primary investors in Africa-focused funds by global institutions such as pension funds and insurers, which do seek to maximise returns. Indeed, most investors expect higher returns in Africa than in other emerging markets, according to a recent survey by the Africa Private Equity and Venture Capital Association.
Adopting flexible investment approaches
To fully capture Africa’s opportunities and achieve high returns, funds must consider a wider range of targets that currently are off their radar. The continent has a growing pool of dynamic smaller companies with significant growth potential. Nearly 11,000 African companies have revenue of $10 million to $100 million and assets of $20 million to $200 million—and their ranks are growing fast. There are also family businesses across Africa run by founders who wish to sell their companies, rather than hand them over to heirs, as well as diversified companies seeking to shed assets that they no longer regard as core or because they aspire to put their capital to better use in other sectors.
Funds should also broaden their investment approaches. They should explore majority stakes, strategic partnerships, and evergreen funds, not just funds with timing constraints for divestiture. Most funds take minority stakes in African companies to minimize risk. But some funds are finding that controlling stakes enable them to create value in their holdings, because they can move more decisively, and provide more options for exiting, since funds don't have to align with a majority investor. Evergreen funds, meanwhile, offer the flexibility to hold on to assets until it is the best time to sell, and to roll the proceeds of divestitures into new investments.
Adopting a more active approach to creating value won’t be easy, however. Not all funds have the capabilities in local African markets to identify and address small targets and other new types of opportunities. Although the local pool of experienced lawyers, auditors, and consultants is expanding in many African markets, reliable information and the intermediaries that typically screen and bring deals to funds are still scarce. So, funds must establish strong on-the-ground capabilities to originate deals and perform due diligence, as well as find experienced, locally-based managers with technical and investment expertise who can accelerate the growth of portfolio companies.
Pursuing new investment strategies will be challenging, and building local capabilities will add costs. But funds that can navigate Africa’s complex investment environment and add value to companies are likely to gain a competitive advantage in what promises to be, over time, a significant growth market for private equity.
Patrick Dupoux is a senior partner and managing director based in Casablanca.
Marc Becker is an associate director based in Paris.
Seddik El Fihri is a principal based in Casablanca.
-For more on private equity funds investing in Africa, check out PEI’s Africa Special 2016, available here.