The following appeared in June’s Business Diary Botswana:
Private equity (PE) has long been considered a viable way to achieve risk-adjusted returns that exceed those possible in the public equity markets (though per University of Chicago scholar Steven Kaplan, during the three decades ending in 2005, the average private equity firm’s annual return was no better than that of Standard & Poor’s 500 stock index). Accordingly, institutional investors include private equity (or even funds of funds) in order to concurrently achieve optimal diversification and risk premia. And while such “limited partnership interests” demand that investors lock-in their contributions for an appreciable time period, such that general partners can commit to any number of strategies, in recent years the once highly illiquid asset class has given way to a vibrant secondary market available for sellers of private equity assets, which in turn has spread risk and further fueled the entrance of fresh capital.
The industry, however, is not without detractors. When debt was cheap, they point out, the skillfully orchestrated turnarounds of distressed companies gave way to what one writer described as “’financial engineering,’ a then-admiring euphemism for a simple conceit: loading up fine companies with massive amounts of debt in the hopes of flipping them to new owners at some point down the road.” Moreover, instead of relying on industry-specific expertise, some funds were accused of relying less on their acumen or wit, and more on simply racking up fees in order to pad returns. “Management fees, deal completion fees, consulting fees, performance fees, special events fees, fees of every kind and stripe. Chalk it up to yet another racket of the bubble years,” steamed one critic. Yet it would be unjust to condemn the entire industry based solely on a portion of credit-induced mishaps. In a working paper published in February out of the IESE Business School-University of Navarra in Spain, Alexander Peter Groh writes studies have shown that “PE-backed companies are more efficient innovators,” and have proven that such firms “create more employment and growth than their peers.”
For example, he notes, a paper by Ross Levine, now a Professor of Economics at Brown University, “documents well the role of PE funds in foster innovative and competitive firms, and indeed, there now exists a broad consensus that a strong PE market is a cornerstone for commercialization and innovation in modern economies.” Furthermore, the performance of those funds in the top quartile is extraordinary enough that most if not all observers expect the industry not only to weather the economic crisis, but like those hedge funds that suddenly find themselves conveniently devoid of bulge-bracket proprietary competition, to emerge more robust than ever (current exodus aside; Financial Times reports the secondary market is so strong currently that funds are having trouble raising new money). Funds will learn to adapt to changing market and constraints. The extreme debt financing once used for acquisitions and buyouts, for instance, will likely give way in the short-term to more debt restructuring, recapitalizations and advisory work, while the lending world takes time to reinvent itself. Additionally, The Wall Street Journal (WSJ) pointed out in April that “private equity investors are increasingly focused on emerging markets as the global downturn has put the brakes on activity in developed economies.” To that extent, frontier markets, and those in both the Maghreb and Sub-Saharan regions of Africa particularly, are experiencing the greatest investment surge.
According to Moin Siddiqi of Africa Business Intelligence (ABI), for example, “the growth of private equity funds in Africa is now on a par with Latin America and Russia and is expected to triple in size over the medium term, making it the fastest-growing asset class.” One driving factor behind the trend is the perception that domestic demand in these economies has not been as tarnished by the credit crunch, as well as the fact that expansion capital, rather than risk-spiraling leverage, is the pillar underlying dealmaking. “With a rise in consumer demand, there is a much broader selection of deals, especially among companies in the food, industrial and manufacturing sectors,” said Erwin Roex of Coller Capital. Henricus J. Stander III, Managing Director and Partner of Henshaw Capital Partners, a London and Johannesburg-based fund of funds, talks about the growing “formalizing of the informal economy,” and the “bankerizing” of countries where in the past, low declared net worths due to punitive taxes and questionable land rights effectively kept large amounts of capital static. The result now, he says, is that consumers’ “unmet needs” are triggering a rapid response from companies across sectors, all looking to react to what one banker labels “pent-up middle-class aspirations.” As Stander told Global Investor Magazine in April, “Africa in general, and sub-Saharan countries in particular, are ideally positioned to benefit from this historically unprecedented demand arising from half a billion people moving into the lower middle class on a purchasing power parity basis, with their concomitant changes in consumption preferences and patterns.” In fact, The World Bank estimates the sub-Saharan middle class will reach 43 million by 2030, nearly four-times what it was only a decade ago. Much of the foundation supporting increased consumption rests on economic and political liberalization and deregulation, in concert with the decade’s hitherto rising commodity prices and foreign investment as well as a growth in exports and a newfound demand for credit. During this time, many African countries underwent long overdue macroeconomic reforms, strengthened fiscal balances and reduced inflation to single-digit levels. Many also benefited from substantial debt relief, such that debt service/export ratios are now relatively low in most countries. Moreover, cross-border trade among regional economic blocks gradually has reduced barriers to movement and commerce.
That said, there is room for improvement. A new book co-authored by Vijaya Ramachandran, a Georgetown professor formerly of the World Bank, concludes that Sub-Saharan Africa in particular is still hampered by inadequate infrastructure (especially unreliable electricity and crumbling roads) and burdensome regulations. That means that “the real opportunities [in Africa] are in the consumer sector and in domestic infrastructure,” Peter Schmid of the Johannesburg-based buyout group Actis Management, told the WSJ last August. And Actis CEO for West Africa, Simon Harford, alluded last month to the fact that “the private sector [in Africa] has gained a critical mass and momentum, which makes it harder for the government to get in the way.” Dr. Ayo Salami, manager of the Duet Victoire Africa Index Fund, added “Africa has not seen demand destruction like in the developed world. For this reason, I like companies like brewers, cement, food companies.” As further evidence of Africa’s potential, he points out that while his Duet Victoire Africa Index fell 40% in 2008, the collective earnings per share (EPS) of the index’s constituents rose 32% in that same period, a value investor’s dream, since these same firms exhibiting strong double-digit growth can often be acquired at single-digit multiples of EBITDA. In an interview with the Financial Times in early May, Dr. Salami further admitted that he was “enthusiastic about the idea of a private equity fund.” That said, he surmised that the market environment was not currently conducive to such a project. “The problem is the lock-up. Few investors are prepared to tie up capital [in African companies] for any length of time at the moment.” Yet Dr. Salami may be overlooking the current reality of what Siddiqi describes as a growing appetite for the very high-risk potential growth that Africa offers. He cites a spokesman for Afrinvest bank in London, for instance, who recently said “in the past 18 months, we are receiving record amounts of calls from Africa-specific funds.” Actis, a leading private equity investor in emerging markets with $1.5bn invested in 15 African countries who in February bought a 19% stake in Nigeria’s Diamond Bank for $134m, the country’s largest private equity deal to date, agrees. “Over the past few years, Africa has been delivering some fantastic returns. Global investors are realizing that risk comes in lots of different forms. They’ve got risk in developed markets that they had not appreciated fully, and they’ve got less risk in places such as Africa than they thought,” said a spokesman.
The capital influx couldn’t come at a more opportune time, for investors and private firms alike, asserts Rashad Kaldany, vice president for the International Finance Corporation’s (IFC) Middle East and North Africa (MENA) division. “Private equity funds can play an important role in providing capital emerging markets companies need to survive and grow,” he said. In April, the IFC, a member of the World Bank Group, announced that along with the European Investment Bank (EIB) it would act as an anchor investor in Citadel Capital’s (a Geneva-based investment fund for Emerging Markets) Sphinx Turnaround Fund. Marianne Ghali, managing director of the Fund, applauded the deal. “With a fund that mainly targets distressed assets and turnaround situations, we are providing timely access to finance and managerial expertise during one of the worst credit crunches in recent history.” One of the veterans of the African PE movement is Aureos Capital, which was established in July 2001 and has since extended its reach to over 50 emerging markets covering Asia, Africa and Latin America via 15 regional private equity funds. Sivendran Vettivetpillai, its CEO, notes that the firm targets companies that are considered mid-sized from the African perspective–typically with an annual turnover of between $10-20m–and that it considers itself an “active” investor, meaning “we want to work with management to help build their company; that means that we do not usually invest in the very largest companies. Very few companies start off with the perfect management team or with all the right senior executive skills they need to grow profitably. Therefore, we are frequently involved in helping to source and recruit extra talent for investee companies through our network.” Citing the company’s “deep local knowledge”, Aureos looks to add value to the operational and management side of the company. “A lot of private equity is just about financial engineering,” says Vettivetpillai. “We do some interesting things for our investee companies like help them set up state-of-the-art IT systems or make and integrate strategic acquisitions. But in the end, it’s about value addition, which means either bottom line growth or an increase in multiples. Being on the ground we tend to know how to achieve what they need.”