Economies of scale

In frontier markets plagued by corruption and other issues, there is still investor appetite for first-mover advantage.

For some private equity fund managers, frontier markets in Africa are the last place they’d want to invest. With corruption and political upheaval seemingly rampant, parts of the continent appear overflowing with risk. For others, however, the prospect of operating with essentially no competitors in economies undergoing fundamental growth makes it a land of opportunity.

At London-based Maris Capital, which has offices in Sudan, Mozambique and Kenya, partner Coco Ferguson is quick to point out the benefits of investing in some of Africa’s developing nations.“The countries that we’re looking at are growing much faster than the regional average growth rate, but from a very low base,” she says. “There are opportunities to invest in businesses that are taking tried and true tested ideas that have operated all around the world, whether it’s banking, machinery leasing, telecoms, power construction, maintenance, and yet you can still have first-mover advantage.”

Advertising muscle: Maris Capital portfolio company Afritise operates in South Sudan

One of Maris’ investments is in a Sudanese telecom power maintenance business. “In 2005 there were no mobile phones, no phone infrastructure in South Sudan,” she says. “It has grown from an incredibly low base at one of the fastest rates in the world.”

Maris, which is nearing a close on its $20 million Maris Africa Fund, invests in small and medium-sized companies in fast growing frontier economies in Sudan and Kenya.  The firm has a pipeline of potential investments in Angola, Mozambique, and Zimbabwe, and typically invests between $1 million and $2 million per deal.

Roughly 30 percent of Maris’ fund comes from development finance institutions (DFIs), with the remaining 70 percent from family offices and high net worth individuals, some of which are in Ghana and Kenya. Most of Maris’ investments are in start-ups, but the firm is also considering offering development capital to other businesses.

Simplicity first

Frontier market funds typically focus on small and medium-sized enterprises (SMEs) operating very simple businesses. “They’re not necessarily super-complex or super-innovative deals,” says chief executive officer of the Simon Merchant. “They’re looking at deals in agro-processing, in simple manufacturing businesses, distribution businesses, renewable energy, building materials, things like that.”

The London-based firm invests in new and emerging growth capital investment managers in Sub-Saharan Africa. “They’re basically businesses that need access to capital in order to grow, and that have hit something of a ceiling in banks’ ability to lend to them,” he says. The deals Jacana’s partners invest in range from $200,000 to $3-5 million.

One of the most enticing aspects of investing in SMEs in frontier markets is the fact that in many cases there is already pent up demand for simple businesses. “Bottled water and clean water will to a certain extent be a bumper against any potential downside, because they’re very insensitive to demand and supply,” says founder of Zain Latif. Founded in September 2009, the firm typically invests between $4 million and $6 million per deal, but will make investments as low as $100,000 and as high as $15 million. “We are very much focused on the consumer retail sector,” he says. TLG also invests in healthcare services, and recently completed an investment in a hotel chain in Nigeria.

The trick with simple SMEs is not so much finding customers, but instead finding the right management personnel to meet demand efficiently and keep costs low. “It’s not like you’re investing in Starbucks,” says Ritesh Anand, founder of Invictus Investment Management. “One of the challenges we face as a GP is finding strong management teams.” Invictus is a pan-African focused listed equity fund manager, but has allocations between 10 percent and 20 percent to private equity deals across the continent.

A number of European pension funds are still finding their way around investing in frontier markets.

Ritesh Anand

One major difference between US businesses and frontier market SMEs are company valuations. “In established businesses in the US, you’re paying seven, eight, ten times EBITDA,” says Anand. “In Africa you can buy these businesses at one or two times EBITDA. The valuations are certainly a lot more attractive when adjusted for growth.” 

SME funds have been dominated by DFI investors, but are also finding investors in foundations, NGOs, high net worth individuals and family offices. “A number of European pension funds are still finding their way around investing in frontier markets,” says Anand. “Leading endowments and foundations like Yale and the Wellcome Trust have a long history of investing in frontier markets like Africa and the Middle East.”

Risk factors

In Zimbabwe, management challenges are replaced by capital constraints. “In a country like Zimbabwe you have some of the best management talent in sub-Saharan Africa,” says Ferguson. “The issue there is actually access to capital. You can invest in a company with amazing talent, but none of the banks have any money.” In most frontier markets, a lack of other investors means access to capital is extremely limited.

Political risks in Africa also play a major role in dissuading investors from committing capital to frontier markets. Government regulations can change overnight, introducing new laws that investors must adapt to very quickly. In Zimbabwe, the Indigenisation and Economic Empowerment Bill, enacted in February, forces businesses with revenue over $500,000 to allocate 51 percent of their capital to indigenous partners. The bill alone has scared many investors away from the region.

Corruption is also largely responsible for the hesitation among investors to invest in frontier markets, which is one reason Maris’ Ferguson prefers investing in services businesses rather than businesses that depend on licenses, where corruption is more likely to be an issue. Still, she says, the perception of corruption on the continent is worse than the actual amount to which it affects smaller businesses.  

“I think there has been a real effort across Africa to increase transparency and reduce corruption,” she says. “There is real pressure from small businessmen whose operations are seriously undermined by corruption, and more and more it is possible to operate without it being a major risk.”

Sven Soderblom, a portfolio director at London-based CDC Group, the UK’s development finance institution, says he sees more and more private equity interest in frontier markets despite the common challenges of corruption and regulatory risks. “Zimbabwe has good potential to become an attractive investment destination as in many areas it is relatively developed,” he says. “They have historically a strong banking sector, an established stock market, relatively good infrastructure and a strong skill base, but the current investment framework remains complicated and improvements are needed to attract investors.” He also mentions Rwanda, still in the rebuilding process following the bloody civil conflict of 1994, which saw the massacre of an estimated 800,000 citizens in 100 days. “I think Angola and Ethiopia are other interesting frontier markets, which increasingly are in the focus of investors.”

It may be some time before other investors share Soderblom’s outlook on Africa’s still relatively untested markets, but with frontier investments moving toward the mainstream, more interest is inevitable. 

This feature is part of PEI's annual Africa Handbook, which is published in tandem with the September issue of Private Equity International.