Currency volatility and other ‘macro-economic’ factors affecting the continent have put the brakes on a fair few deals across Africa in recent years. But proprietary dealflow remains strong, despite the more protracted execution timeline in many instances, and those fund managers well plugged into local networks can unearth choice assets. The challenge now, Baker McKenzie partner Scott Nelson explains, is to demonstrate the capability to deliver a full and clean exit for long-held assets – and deliver the returns their LPs are expecting.
What’s the most significant aspect of the Africa private equity landscape occupying your thoughts?
A lot of it still revolves around currency, political stability and confidence in key economies. There’s no doubt those macro-factors are heavily impacting some choices that various sponsors are presently making. I’m not saying there’s a block on activity, there clearly isn’t. But if you compare the situation now to maybe two years ago, there’s no doubt those bigger considerations are affecting transactions, particularly because they affect Nigeria and South Africa. When you talk to the clients and the sponsor community in general, I think you’d find those are the things, together with the associated valuation challenges, that are on their minds more than anything else.
What’s the biggest impact of currency volatility?
It’s investing with dollars and buying assets in local currency. That’s been the problem for a long time now, but it’s very hard to manage. It’s been a recurring theme: how do you manage that level of foreign exchange risk? There are several ways you can deal with it. You can ask the transaction counterparty to take some of that risk, which is generally how we try to deal with it. That is not a popular solution because the economics of the deal change dramatically depending on what happens, but that is your first prize. Second prize is you can try to hedge it operationally, because you have a business that is spread across the continent and has several different operating currencies. You can try to hedge it through the traditional structural methods, but that’s very expensive and doesn’t necessarily provide an effective or workable solution.
On the positive side, it has created opportunities. Assets are now cheaper, which if you’re looking to invest is definitely helpful. Good companies tend to ‘make it through the cycle’, so if you buy a decent business that maybe has a spread of different countries, then it’s not a bad thing. You might be getting a real value opportunity.
Is there a big mismatch between buyer and seller price expectations?
The devaluation of certain of the local currencies has an impact on what people will view their asset to be worth in hard currency terms. It’s definitely been a factor. We’ve seen many deals that have not gone ahead because we couldn’t bridge that gap.
Is it easier to get a particular size of deal done at the moment?
It’s quite random and opportunistic. At some level the larger deals are possibly easier to look at because there’s more scale and more spread across different economies. Some of the smaller ones that are too heavily focused on some of the geographies and economies that are more challenging, might present the greater issue. I think bigger deals right now are probably easier to get away and face possibly less challenges because of scale. It’s all about scale.
How deep is the market for cross-regional assets? How many deals are you seeing a year?
We’re seeing a lot. I don’t think there’s any shortage of opportunity. I think the dynamics of the market are still very interesting. You have several sponsors who are now long-in-the-market players, very experienced; you have some new entrants, big bulge-brackets who are trying to enter the market, possibly in conjunction with the people who have been there for a long time. It’s not a situation where there’s necessarily too much capital in the market: Africa is not generally a continent where you are struck by the over-supply of capital – it’s all about the right deal dynamics and structure.
You also have the dynamic of the tremendous importance of proprietary dealflow. You’re not going to come into this market as a large player and just wait for a deal to fall on your desk. It’s totally relationship-driven, and that is apparent. Those that have those relationships are doing well and those who don’t have those relationships are looking to work more closely with those who do.
Execution and diligence are taking longer just now because everyone’s a little bit wary about the macro factors, but there’s certainly no lack of transaction opportunity if you have visibility.
Are international players finding the deals they want to find?
I think they’ve always struggled a bit to find deals of the right size. The challenge is access to dealflow. If you’re not seeing a lot of deals you want to do, and if they’re not of an equity cheque that is efficient for you, I think the larger funds will always struggle. The critical importance of avoiding a protracted auction process – ‘auction allergy’ – given execution lead times and the ‘opportunity cost of capital’ is also clearly a factor.
Some of the larger market participants fall more squarely within the concept of ‘diversified asset managers’, although most sponsors operating on the continent are now looking at broader capital solutions for the right assets. So if a deal team here finds a hydro dam project in Ethiopia which is not a ‘pure play’ private equity deal, it’s still a financeable deal for the ‘broadly based’ asset manager. I think they’re struggling, in certain instances, to find ‘pure play’ private equity deals of a scale which meet their more traditional aspirations and requirements.
Are managers able to deliver the returns LPs are expecting?
The A-list Africa funds, yes, I think they are. However, a lot of these funds are going to have to really focus in the next 12-24 months on showing their LPs that they have properly got out of these deals. A lot of funds rely on the recycling of internally-generated operating capital to return money to investors.
Exits will become more important as the bigger funds go back into the market again. They’ll need to demonstrate some strategies on the exit side. There are some sizeable ‘sponsor-held’ assets which I think we will see ‘in play’ in the relatively near term. The extent to which certain of these may now be of a scale to be attractive to the international capital markets, and thus perhaps begin to dilute the predominance of the trade sale as an exit route on the continent, also presents an interesting dynamic.
The trade sale is still the predominant form of exit on the continent, largely because of the relatively shallow nature of the capital markets on the continent and relative asset sizes and valuations at the time of exit. A significant trend we’re seeing of late is co-investment as between ‘strategics and sponsors’. It’s a real opportunity, not least because it marries access to dealflow and proprietary dealflow experience on the continent with deep sector/industry expertise and management skills, and also potentially delivers a compelling structural ‘pre-baked’ exit opportunity in a three- to-five-year period.
But yes, the returns are good and I don’t think any of the big funds, in particular the A-list Africa funds, would be as bullish as they are about comfortably raising the same if not more again if they weren’t.
The importance of the right team composition, from both a fundraising and transaction execution perspective, cannot be overstated.
Are currency issues making selling assets a challenge?
I don’t think that’s the issue. I think it’s very much about managing exposure, and this issue in particular, at the point of investment and entry into the asset, with reference to some of the potential approaches mentioned above. Trading some cover on forex exposure in general, for a slight uplift in valuation, is also something that can ‘raise its head’, but should also be very carefully considered – entry valuation is clearly absolutely key.
This article is sponsored by Baker McKenzie and appeared in The Africa Special 2017 published in Private Equity International in September 2017.