The following is an excerpt from a Boston Consulting Group (BCG) report, titled Why Africa Remains Ripe for Private Equity.
To unlock Africa’s potential, funds need to understand the changing dynamics of the continent’s private equity markets. The entry of new kinds of investors is transforming the market. Opportunities to invest in different kinds of target companies are opening. Successful funds are deploying different investment strategies. New intermediaries are opening offices.
While the trends present opportunities, significant challenges remain.
The changing investor profile
A new breed of investors in Africa-focused funds is changing the private equity landscape in fundamental ways. As private equity matures in Africa, the role of development finance institutions is diminishing, while more traditional limited partners, such as pension funds, sovereign wealth funds, and endowments, are accounting for a greater share of private equity capital.
These new investors bring different expectations. The primary mission of development finance institutions such as IFC is to make an impact on an economy and to help develop private capital markets. Africa’s new institutional investors, by contrast, seek high returns – often much higher returns than they can expect in other markets. A recent survey by AVCA found that 52% of limited partners expect that private equity returns in Africa will be higher than in other emerging markets. Indeed, nearly half report that the performance of their African investments already has matched or exceeded their expectations.
New investment targets
Historically, private equity funds have focused on a very specific kind of investment in Africa. They have targeted big, profitable companies that dominate their local markets or are regional leaders. Private equity funds also want companies with proven track records of sound, enlightened management. The supply of such mature targets, however, is well short of demand in Africa. As the competition for these assets intensifies, achieving high returns grows more challenging.
Investors that broaden their horizons will find abundant investment targets. Great opportunities in Africa are with smaller companies that are growing fast – and have the potential to grow much further with infusions of outside capital and management help. For example, Africa has a number of what BCG calls local dynamos, which are rapidly growing companies that are bidding to become national leaders.
The continent also features many established family-owned companies that are led by professional, second-generation managers, many of whom have been educated in the US and Europe. The private equity fund managers we have interviewed say that the new generation of family business leaders is more open than their elders to accepting outside capital and partners to modernise their operations and expand beyond their borders. A recent survey by PwC found that 24% of family businesses in Kenya, for example, prefer to raise capital from private equity, and that 37% plan to sell or float their companies, compared with a global average of 20%. There are also a significant number of family-owned businesses across Africa run by founders who wish to sell their companies, often because they are apprehensive about transferring their businesses to heirs they do not regard as having the skills or business aptitude to succeed.
Yet another rich source of opportunities consists of the holdings of established African companies seeking to shed assets that they no longer regard as core. Many of these opportunities lie in family businesses that used their cash over the years to diversify into businesses that have grown more competitive or that aspire to put their capital to better use in other sectors.
Different investment strategies
An additional distinct characteristic of Africa’s private equity market is that private equity funds prefer to acquire minority positions in a broad portfolio of holdings. When AVCA surveyed investors in 108 African deals, 80% of the respondents said that they invested via minority positions – compared with only 20% in developed economies. Given the high degree of volatility and the complex business environments in many African economies, fund managers maintain that minority stakes help manage risk. General partners who prefer minority stakes say that they feel more comfortable in Africa when they find the right kind of partner – one who knows the field and can manage the business day to day. They also say that it can be tough to find business owners who are willing to cede control unless they are under duress and that the scarcity of experienced executives in Africa makes it difficult to replace incumbent managers.
Some leading private equity funds are taking a different approach, however, and investing in more majority stakes. By exercising control, these managers say, they can better manage risk and create value because they can move more decisively. Controlling stakes also open more options for exiting because funds do not have to align with a majority investor. We found that the majority holdings of several significant private equity funds with both kinds of investments outperformed their minority holdings.
Funds can also explore evergreen investment structures. Currently, most funds are obligated to liquidate holdings and return capital to investors over a certain time frame. Evergreen funds, which have no fixed time frame, 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.
As will be explained below, however, adopting a more active approach to creating value has several important implications. It often means that funds must hold their investments for longer periods of time and invest more resources in building an on-the-ground presence to manage companies in the portfolio. It also means that returns must be higher to justify the greater cost.
Africa’s costly and complex investment ecosystem
The investment ecosystem in Africa is not as well developed as that in the US and in Europe. Access to information is limited, and on-the-ground expertise is in short supply. Investors must navigate a wide variety of business cultures and customs and do business in many languages. This is why transactions in Africa often take 18 to 24 months to complete, far longer than in developed economies.
As a result of this incomplete ecosystem, operating successfully in Africa is costly and requires substantial investment to build local capabilities. Africa-focused private equity funds employ more staff than similarly sized funds elsewhere. The median employment level of international private equity funds is US$112m in assets under management for each staff member. For Africa-focused funds, the median is $45m.
Most global investment banks still cover Africa from offices outside the continent. Only a few have operations in several African nations. Given investors’ scarce local presence, the number of intermediaries and sources of information is growing – leading consulting companies have recently started to open offices across Africa, for example. The number of African financial advisors and both international and African legal advisors with private equity experience is growing as well.
Still, the demand for such expertise outstrips the supply. For the time being, private equity funds must spend more time and money in Africa originating deals and performing due diligence on their own.
This article was originally published on bcg.perspectives by the Boston Consulting Group.