Broadening the Private Equity Solution Set for Africa

In transparent and efficient markets, the function of large private equity (PE) managers is to largely find, turnaround and sell undervalued assets at a premium as well as to inject growth capital into high potential businesses and support management in realizing that potential. To raise finance for investments and ongoing management fees, private equity fund managers promise above market rate returns for their investors.

In practice, there has been considerable debate over whether private equity has historically outperformed public equity in developed markets. According to the Boston Consulting Group and State Street, the private equity asset class in the United States has averaged net returns of 13.1%, compared to an 8.1% public market equivalent benchmark return over the last 30 years. Several scholars dispute these findings however, noting that private equity returns have not exceeded those of public equities since 2006. 

Either way, the PE sub-asset class (of equities) has proved resilient in developed markets over the last decade— in 2019 US private equity funds raised $300 billion from institutional investors, almost 5 times the fundraising value about a decade ago.   

How has African PE fared so far?

For Africa focused funds, the story has been markedly different. Start with the origins of the asset class in the continent. Unlike their developed-economy counterparts, private firms in Africa have historically had few options—due to underdeveloped or non-existent public stock exchanges and expensive bank financing options­­— for raising finance.  

Initially spearheaded and financed by development finance institutions (DFIs) such as the CDC group and the IFC in the early 1990s, private equity has helped fill this gap over the last few decades. In the process, this sub-asset class has contributed significantly to the growth of key sectors such as telecommunications, which represented 25% of the $34.5 billion in Africa private equity transactions that took place between 2007 and 2014. 

But even as African private equity has grown, persistent issues continue to challenge its financial performance for investors. For one, markets in the region are still small— for context, California’s GDP in 2018 was about 36 times that of Kenya, which had a GDP of $87 billion in the same year. This means funds must often adopt a regional focus to see sufficient deal flow, leading to increased costs and time required to find and close deals. Navigating the regulatory, political and cultural domains of a range of countries further compounds the problem.

City view of Nairobi, Kenya. Private and equity and venture capital are becoming increasingly instrumental in funding development gaps in Africa. Photo credit: Nina Stock

The sales side is equally, if not, more challenging. A dearth of exit options often requires fund managers to force sales at a discount in order to conform to overall stringent (in the African context) fund life terms, thus hampering returns.

What is more, unlike their PE counterparts in the USA or Europe, African PE investors have access to a much more limited supply of low cost debt, which hinders their ability to enhance returns through financial engineering, a practice that is prevalent among investors in developed markets.  

These challenges, combined with macro-risks such as currency devaluations and political instability, have contributed to meagre investor returns and mostly deterred a broader cross-section of investors from entering the fray. According to data from the African Private Equity and Venture Capital Association(ACVA), limited partners have on average received a pooled return of about 5.5% net of management fees, expenses and carried interest over a ten-year investment period for funds that were formed between 1995 and 2014. 

For development-focused investors whose primary goal is to catalyze economic growth across the Africa region, such returns may be palatable. As posited by Paul Brest, a particular investment has impact if it increases the quantity and quality of an enterprise’s social outcomes by more than would have otherwise occurred. In the case of Africa, private equity is doing just this by mobilizing capital for firms that have few good options for fundraising. 

Regardless of past performance, many of the existing limited partners are confident that African PE can deliver superior financial returns. A survey conducted by the AVCA in 2020 found that 67% of limited partners believed African PE returns would exceed 2.0x over the next ten years, with 82% of LPs also stating that they plan to maintain or increase their African PE allocation over the next three years.  

Former International Development Secretary Alok Sharma MP at the UK - Africa Investment Summit 2020. Photo credit: DFID

But this data belies the fact that DFIs still make up the majority of the institutional investors in African PE. Attracting a more diverse group of investors will likely require a marked improvement in financial performance among Africa focused funds, and over time the adoption of a broader set of PE investment models as observed in more mature markets.  

Expanding the private equity solution set for Africa

There is no silver bullet for addressing the limitations that face funds operating in Africa. But there are ways to expand the African PE solution set to help alleviate the major constraints on both the buy side (limited deal flow, small markets) and sell side (lack of exit options), and to mitigate the risks for institutional investors.     

One such strategy would be to increase the allocation among institutional investors towards Search Funds, which are funds designed specifically to ‘seek out’ promising, high-growth businesses in a key sector or regions. The primary benefit to this strategy is that it allows institutional investors to de-risk their investments in African PE by making various small bets at the origination stage, instead of tying up capital in untested funds with 5-10 year timeline horizons. Following asset discovery institutional investors then have first right of refusal on the opportunity to invest in the specific asset or move on.  

Figure 1: Search Fund graphical depiction. Source: TWA Analysis

Figure 2: Sweep Fund graphical depiction. Source: TWA Analysis

On the sell side, institutional investors can also coinvest in a type of “sweep fund” to prevent the fire sale of assets at the end of the fund lifecycle. Such a fund would essentially act as a reinvestment vehicle in assets where institutional investors see long term value. These sweep funds can also be designed to combine similar assets in new joint vehicle, thus reducing the overheads associated with managing each individual asset.  A recent example of this in developed markets is Permira’s and Coller Capital’s partnership in a GP-led secondary transaction where the remaining 4 assets of the Permira IV fund will be transferred to a new fund, giving existing LPs the opportunity to roll-over their LP stake or exit as well as further invest in the new fund. Given the cohesive DFI LP base in Africa, collaborating through platforms like EDFI, such a construct should indeed be possible for Africa.

These solutions are not meant to be comprehensive. They represent a starting point to thinking more critically on how the private equity model can be expanded and evolved to create long term value for businesses and investors on the continent, with the ultimate end goal of catalyzing increased private sector growth in Africa. 

At ThirdWay Africa we have witnessed first-hand the power of private equity in bringing instrumental change to industries across Africa. And we also believe that much more can be done. As such, we are excited to collaborate with DFIs, institutional investors and fund managers to expand and improve the African PE solution set over the coming years. 

DFIs paved the way for private equity in Africa. It is up to all of Africa’s stakeholders to help scale its impact.