Why Africa’s private equity-bubble worries are misplaced

Cairo, Egypt

Cairo, Egypt

The rapid increase in investment funds has raised concerns that a private equity bubble is emerging – essentially that too much money is chasing too few companies – and pushing the prices of available African assets to high levels.

The crash in global prices for the commodities upon which many African economies heavily depend has heightened this concern. Political events and a terrorist presence in several northern and central African nations have added to fears that the continent’s impressive economic revival over the past decade is in jeopardy.

The commodity downturn clearly has cooled African economies. Revenue from natural resources across the continent plunged from a high of US$460 billion in 2008 to about $250 billion in 2014. Largely as a result, GDP growth in Africa slipped from almost 7% in 2012 to approximately 4% in 2014. The initial terms-of-trade deterioration is estimated at 18.3% for the continent in 2015, and several economies are close to recession in 2016.

Despite these risks, we believe that Africa remains one of the world’s greatest growth opportunities for private equity. The following factors support this bullish outlook.

Private equity penetration is low. Despite rapid growth in recent years, the amount of private equity and principal investment capital mobilised in Africa remains very low relative to world standards. Private equity assets under management are approximately 1% of GDP in western countries. In sub-Saharan Africa, by contrast, private equity assets under management are a mere 0.1% of GDP. What’s more, even though Africa accounts for 3.1% of global GDP, only 0.9% of global private equity funds that are raised focus on the continent.

Africa’s macroeconomic fundamentals remain strong. Healthy economic growth in the decades ahead is likely to greatly expand Africa’s capacity to absorb private equity investment. The continent has enormous needs for physical infrastructure, and there are growing opportunities for large-scale investments in real estate, industry, and services. Although growth in aggregate real GDP in 2016 and 2017 is expected to remain well below the 5% annual average recorded from 2007 through 2014, most economists project that it will soon rebound to historical levels. Average growth of 6% to 9% is projected in economies such as Côte d’Ivoire, the Democratic Republic of Congo, Ethiopia, Ghana, Kenya, Mozambique, Rwanda, and Tanzania.

Africa is one of the world’s fastest-growing destinations for foreign direct investment, particularly in sectors such as energy, transportation, and real estate. The continent’s working-age population is projected to keep climbing for another five decades. Africa’s skilled talent base is also expanding. The portion of college-age Africans enrolling in tertiary schools more than doubled, to 7%, between 1990 and 2010. What’s more, nearly 400,000 African students were studying in nations such as France, the UK, and the US as of 2010. A high percentage of this African diaspora expresses interest in returning home to work upon graduation.

Africa’s rapidly growing consumer class will be a powerful driver of growth. Household expenditure tripled across the continent from 2004 through 2013. The number of middle-class and affluent Africans – those with annual incomes of $1,600 or higher on a purchasing-power-parity basis – is projected to roughly double by 2024, to 166 million, and to reach 270 million by 2034. The continent is projected to add 50 million people with annual incomes of $8,400 to $20,400 over the next two decades and 17 million people with annual incomes exceeding $20,400.

The pool of investment targets is growing. Most funds focus on companies that are considered very large in Africa’s context – those with annual revenues of more than $100 million, assets of more than $200 million, and more than 1,000 employees. There are some 5,000 such companies on the continent, and their number is growing. Indeed, Africa is producing more companies that are competing successfully with multinational corporations and are expanding globally. (See Dueling with Lions: Playing the New Game of Business Success in Africa).

However, there are nearly 11,000 African companies with revenues of $10 million to $100 million, assets of $20 million to $200 million, and staffs of at least 150. This is the fastest-growing segment of African targets, but it remains off the radar of most large private equity funds and principal investors.

The investment environment is improving. Despite the economic challenges and policy missteps in many African economies, the overall investment ecosystem is developing steadily across the region. As more private equity funds, investment banks, and institutional investors establish a local presence in more African economies, they are bringing expertise in a greater variety of deal structures and investment techniques. The pool of local lawyers, auditors, consultants, and bankers with private equity experience is also expanding. By the same token, more African companies are gaining experience in advanced finance.

Governance, too, is improving in many sub-Saharan African nations. Côte d’Ivoire, Benin, Togo, Senegal, and the Democratic Republic of Congo rank among the nations that have improved corporate governance the most, according to the World Bank’s Doing Business 2014 report. The growth of regional and continent-wide professional associations is making the business environment more transparent. While political risk remains high on the continent, it is improving in many economies. A number of governments are becoming more business friendly.

Alternative options for raising capital are scarce. The difficulty that African companies face in raising capital from local equity and debt markets presents a big opportunity for private equity. Only four African economies – Egypt, Morocco, Nigeria, and South Africa – have stock exchanges with a market capitalisation of more than $50 billion. In fact, the 29 stock exchanges on the continent have fewer than 2,000 listings combined.

The small scale of African equity markets makes it difficult for companies to raise the capital they need to grow – or for their founders to exit their business – through initial public offerings. There were only 28 IPOs in Africa in 2015, comprising approximately 2% of the more than 1,200 IPOs done globally. These IPOs raised a combined $12.7 billion (less than 1% of capital raised globally through IPOs) – which does not come close to bridging the financing gap in Africa.

This article was originally published by Boston Consulting Group.