Emerging markets: Big continent with small enterprises

Even in a good year, private equity fundraising for sub-Saharan Africa hovers below the $2 billion mark. And it’s not as if there isn’t a growth story, or there aren’t businesses to buy. But while large business attract equity investment, small and medium enterprises are often trapped between banks who don’t want to lend and firms whose bitesize is too big.

A nascent alternative may be mezzanine debt – halfway between debt and equity. Johannesburg-based private equity firm Ethos Private Equity recently moved into the space as part of its attempt to transform itself into the leading alternative asset management platform in sub-Saharan Africa.

The firm bought Mezzanine Partners, with its founding partner and chief executive Philip Myburgh continuing to lead the new Ethos Mezzanine Partners. The subsidiary is now in market with its third fund, which is targeting $150 million and has a $200 million hard-cap.

Myburgh’s team – which is looking to invest in several countries in eastern and southern Africa – is able to lever off Ethos’s broader origination pipeline, potentially taking up opportunities that would otherwise be turned away as unsuitable for private equity investment.

“There’s a universe – it’s perhaps not as big as the traditional private equity universe, but it’s a substantial universe nonetheless – of investment opportunities that have some or all of the following features: the business owners don’t want to dilute or want to defer any dilution (until say, after some expansion initiative); or where the stakeholders want to eliminate the risks associated with traditional private equity exit challenges in developing markets; or where the business simply wants to reduce its weighted average cost of capital. Those investment opportunities aren’t available to traditional private equity investors,” Myburgh says.

Meanwhile Syntaxis Capital, the mid-market mezzanine debt fund manager specialising in Central Europe, recently expanded its remit to sub-Saharan Africa.

Syntaxis’s three-strong Africa team will initially invest on a deal-by-deal basis in four core geographies: South Africa, Nigeria, Ghana and Ivory Coast. It will then add Kenya, Uganda and Tanzania to the list.

Adesuwa Okunbo, who co-heads the Syntaxis Africa team, says the firm is seeing annual demand of around $800 million for the funding it is offering: an investment of $5 million-$15 million in companies with EBITDA of $1 million-$5 million.

This demand is being driven by a combination of factors, including the unwillingness of local banks to engage with businesses of this size.

“The local banking system in a lot of the countries we target is not supportive of SMEs and mid-market businesses. They’re much more willing to lend to larger corporates and regional champions after the financial crisis,” Okunbo says.

“On the other hand you have some of these countries still growing at 5 percent annually. There’s obviously a significant gap in the market where local banks are not servicing SMEs and mid-market businesses. We don’t see that changing in the foreseeable future.”
Myburgh adds that term debt funding is quite difficult to arrange in much of sub-Saharan Africa.

“To raise multi-year term debt funding (even for established businesses) in some emerging markets is difficult, simply because the banking and debt capital markets aren’t that developed,” he says.

“Mezzanine finance offers a funding alternative on terms that extend beyond those which a traditional senior secured lender would provide; and mezzanine instruments are considerably more flexible and capable of adaptation to suit a borrower’s specific needs. Banks often can’t be that flexible because it would increase the risks and associated cost constraints imposed upon them by banking regulation.”

Okunbo also thinks the private equity capital available for investing in Africa is unsuitable for the bulk of opportunities on offer. more than $3.6 billion was raised by funds focusing on the continent in 2015, according to PEI data; more than 85 percent of it in just four funds.

“They have to deploy at least $50 million to $70 million cheques to make the economics work for such a large fund,” Okunbo says. “When you compare that to the opportunity in Africa and how many deals are being completed in that segment, there are very, very few.”

The owners of SMEs with strong growth prospects are often not ready to relinquish a significant minority or control interest to a private equity buyer.

Scott Nelson, a private equity and corporate funds partner at Baker & McKenzie who focuses on Africa, says control issues can present “a real challenge” to deal execution.

“Many assets, vendors, owners and entrepreneurs can be relatively allergic to ceding control of an enterprise.”

Syntaxis’s aggregate pipeline is currently around $250 million, including potential transactions in Nigeria, South Africa, Kenya and Zambia. The firm is expecting to close its first deal – an investment in a poultry business in Nigeria – early in the first quarter 2017. “We’re quite active, and I think that’s reflective of the demand we see,” Okunbo says.

“A lot of these companies really have no other option that allows them to grow whilst retaining control of their business. They don’t want to take on local bank debt [when] for their five-year business plan the local bank has given them a two-year amortising facility that’s priced at 30 percent in local currency. They also don’t want to have to dilute their business by more than 40 percent when they actually haven’t taken out any dividends themselves.”

Okunbo is confident Syntaxis will be able to close several deals it is working on and be in a position to begin raising an Africa fund next year. The vehicle is likely to target between $125 million and $150 million, in keeping with Syntaxis’s funds in Central and Eastern Europe.

Although the argument for mezzanine investment in Africa makes sense on paper, Baker & McKenzie’s Nelson warns it is not without challenges. “You need to have fairly robust ‘in country’ creditor rights for the mezzanine tranche of finance to make sense and to properly work, in the context of the overall transaction risk/return assessment,” he says, adding that there are certain countries in which this kind of investment is unlikely to happen, despite an otherwise compelling business case for it.

“While you should be looking at a huge number of deals, given the otherwise compelling dynamics of mezz in an African context, you probably have to rule some of those out reasonably quickly because you’re just not going to get comfortable with the legal and structural exposure.”

Mezzanine can also pose a challenge for LPs, as it fits neatly neither in the private equity nor the private credit bucket.

However, for those willing to make room for it, the strategy offers investors which are comfortable with the continent a way to gain exposure with less risk than taking part in a private equity fund. “Investors probably look at us as a safer way to capture the African opportunity,” Okunbo says. “We’re not aiming to hit 4x or 5x on a deal, but at least if something goes wrong you definitely have a seat at the table and because of the way we structure our security, you’re in a stronger position than a private equity fund.”