Africa remains one of the world’s most attractive growth opportunities for private equity investors, even though the market has already surged dramatically over the past decade and several economies face serious challenges. To generate the high returns that investors expect, funds should consider more flexible investment strategies and new types of corporate targets. These are among the findings of a new report by The Boston Consulting Group (BCG).
The report, titled Why Africa Remains Ripe for Private Equity, notes that since the early 1990s, the number of private equity funds active in Africa has swelled from about a dozen to more than 200, while funds under management have risen from some US$1bn to upwards of $30bn. This rapid growth, combined with the recent downturn in Africa’s largest economies, has raised concerns among some analysts that a bubble is emerging.
Yet most private equity funds and principal investors tend to invest only in minority stakes, with the goal of better managing their risks by leveraging robust local partners. Also, they overwhelmingly focus on a limited pool of investment targets: profitable companies with annual revenue of more than $100m and proven track records.
Alternative investment approaches are particularly important if funds are to meet the rising expectations of their investors. Increasingly, development finance institutions are being joined by global institutional investors that are far more focused on high returns. As prices for stakes in large African companies rise, it will become more difficult for private equity funds to deliver high returns.
“To fully capture the opportunities in Africa and earn high returns, private equity funds must adapt to the rapidly evolving market and consider more flexible investment strategies,” said Marc Becker, a BCG associate director and a co-author of the report.
The report recommends that private equity investors consider other investment approaches, such as majority stakes, strategic partnerships, and evergreen funds, rather than only funds with timing constraints for divestiture. It also suggests that funds look at a wider range of targets, such as Africa’s growing pool of dynamic smaller companies with significant growth potential.
“Too many private equity investors are pursuing the same kind of target with the same kind of deal structure,” said Patrick Dupoux, a BCG senior partner and a co-author of the report who leads the firm’s activities in North Africa. “But look beyond the narrow cohort of Africa’s corporate elite and you’ll see that the continent is awash in real opportunities. Some of the most promising targets in Africa are companies that are still off the radar of most funds.”
Despite the rapid growth in funds and a crash in global commodity prices that has hit a number of African economies, the following factors support a positive outlook for private equity:
- Penetration is low. The amount of private equity and principal investment capital under management in sub-Saharan Africa remains very low relative to world standards – a mere 0.1% of GDP. That compares with approximately 1% of GDP in western countries.
- Macroeconomic fundamentals should remain strong. Despite recent setbacks, most economists expect that GDP growth in Africa will rebound over the medium term, driven by a swelling middle class, rising foreign investment in infrastructure, and a growing skilled labor force.
- The pool of investment targets is growing. Nearly 11,000 African companies have revenue of $10m to $100m and assets of $20m to $200m – and their ranks are growing fast.
- The investment environment is improving. As more private equity funds, investment banks, and institutional investors establish a local presence, they are bringing greater investment expertise. The local pool of experienced lawyers, auditors, and consultants is also expanding.
- Alternative options for raising capital are scarce. The small scale of African equity markets – only four countries have stock exchanges with a market capitalisation of more than $50bn – makes it difficult for companies to raise capital or for founders to exit their businesses through initial public offerings.
“These trends are likely to expand Africa’s capacity to absorb private equity investment in the decades ahead,” says Tawfik Hammoud, a BCG senior partner and a co-author of the report who leads the firm’s Principal Investors & Private Equity practice. “In fact, they suggest that most African markets are still underserved by private equity.”
Because Africa’s financial markets are still underdeveloped, private equity firms will need to invest in a strong local presence. Access to information is limited. Given the shortage of investment banks and other middlemen that typically screen opportunities and bring them to investors, funds often must be able to originate their own deals and perform their own due diligence. Many private equity firms also need experienced people who can help create value in their holdings by providing management expertise and strategic guidance.
“Africa’s underdeveloped investment environment means that private equity firms need to build significant on-the-ground capabilities that they normally do not require in more developed markets,” said Seddik El Fihri, a BCG expert principal.
Pursuing new investment strategies in Africa will be challenging, and building local capabilities will add to costs. But funds that do so can develop powerful competitive advantages. “Organisations that can navigate Africa’s complex investment environment and add value to companies are likely to gain an inside track on the best deals in what promises to be, over the long term, a significant portion the world’s greatest growth market for private equity,” Dupoux said.