Co-Investments in Africa – Platform. Disruption. Innovation

Private capital markets in Africa are maturing. It is imperative for international financiers to drastically revisit their co-investment strategies.

Co-investing efforts in the private capital markets of Africa have been around for some time, but in recent years both the increased interest levels, style of investment and execution demonstrate the critical need for different approaches. Co-investments historically have taken place between private equity (PE) managers and their target investors. Typically, institutional investors referred to as Limited Partners (LPs) tend to not only invest in PE funds but also in side transactions alongside these funds’ external asset managers , commonly known as General Partners (GPs)). These GPs create Special Purpose Vehicles established for a top up into a particular company in the fund’s portfolio or as a side deal. By doing so, LPs tend to also negotiate preferred terms for those specific transactions.

However, currently, many LPs and their GPs face a few challenges, either with regards to fee remuneration levels, or, the rationale behind these arrangements as some LPs involved in the actual funds managed by GPs question why they are excluded from co-investments structures, and, whether these do not take away time and resources from the day-to-day mandate. Inroads are increasingly being made towards various straight forward co-investment vehicles un-encumbered by associated PE fund structures. These can be investment holding or platform companies. We believe that investors with either developmental mandates or strategies that are less liquid or which require more upfront capital and longer holding periods can play a disruptive role in the expansion of the co-investment space, and ultimately, in the development of a larger and more active secondary market in the continent.

What is the issue?

Joseph Pacini of Blackrock puts it nicely «”private equity co-investors typically take controlling equity positions in companies. After taking actions to improve the operational efficiency of the portfolio company which can include restructurings, management changes and asset dispositions, co-investors will ideally exit through an IPO or sale of the target company to a strategic buyer. The holding period for private equity co-investments can vary widely and may last 10 years or longer”.

This holding period extension can often be the cause of dissatisfaction from investors and also dis-incentives for managers, as the perceived fees are halved after the first 5 years. This is at times a perfect recipe for disasters and an eventual basis for a full fledged ‘divorce’ if tensions persist.

About two decades ago, Africa inherited the traditional PE model from highly liquid and developed western markets. The west supplied a disruptive framework whereby DFIs (Development Finance Institutions) provided catalyst financing to a new breed of private equity managers operating across the continent. DFIs contributed large capital pools to managers who roughly charged annually 2% of the size of the pool and earned 20% of the capital gains over a ten year period.

Many of us at the time were privileged participants in the economic creation of an entirely new industry on the continent– the cellular telephony market. We also helped develop some related sectors and re-invigorate many other existing markets like banking and other service industries. The capital we then helped introduce to the continent principally helped scale up successful business models. There was a clear void to fill, since the local banks either did not fully understand the models at that time, or could not finance an entrepreneur or corporate client across multiple countries in Africa.

In many cases, excellent returns were achieved whenever we were able to rigorously select an innovative business model driven by stellar management teams operating in fast growing industries under fantastic economic conditions. This continues to be the case and we can only expect PE funds to have a phenomenal impact and to deliver spectacular stories across Africa. But when one or more of the selection criteria were absent, the results were less enchanting. This sometimes translated into write offs, delayed returns, or often into stretched holding periods within a «”limited life company “ or vehicle – called the fund. After all, there is only so much stretching one can do to a rigid and inflexible structure.

The tenor of the standard PE funds, the economics, and the liquidity or il-liquidity of the capital markets in Africa when taken together, can lead to (a) non conducive environment for restructuring of the asset or portfolio company and (b) ill-adapted structures for the needs of the continental, entrepreneur or sponsor (who often faces local growth cycles and complex realities). Thankfully, drastic changes have been occurring over the last two decades across the continent, whether at the entrepreneur, manager, or investor level. More and more, with the arrival of broader sources of capital (over and beyond DFIs), these three distinct parties have found ways to stay connected outside the rigid box of traditional PE fund structures.

Is there an opportunity here to innovate, solve and profit?

Compelling co-investment opportunities exist for investors; by exploiting capital supply imbalances brought about by financial system repositioning.

Across the continent, with the confluence of market challenges occasioned by commodity price collapse and local currency volatilities, banks are in crisis management mode, actively reducing their market participation in response to tightened markets. There is another vacuum to fill. Skilled managers have been able to move into this space and recognize the profit making opportunities. They have re-engineered themselves to provide urgent capital directly to sectors in need, purchase heavily-discounted, illiquid and impaired assets from companies needing to dispose of them and supply capital to industries where demand has outpaced available funds. In the growth capital segment of the private equity industry, UK based player DUET have teamed up with AMCON, a sovereign owned distressed asset manager based in Nigeria, to participate in the consumer space, while local player KAIZEN in Nigeria has joined forces with US and South Africa listed NET ONE to tackle the short term lending space in their One Credit platform company.

Similarly, Norwegian development body NORFUND, Dutch bank RABOBANK and private sector development bank FMO have formed the company — named Arise — by combining investments in financial service providers across more than 20 countries, including Kenya, Tanzania and Zambia. A new age of co-investment is upon us. The new macroeconomic paradigms will require more nimble and flexible solutions. This is true across industries and in sectors outside the consumer and services space.

In the infrastructure space for instance, AFC (Africa Finance Corporation) under the leadership of Andrew Alli has made great inroads in this direction. AFC collaborated, earlier this year with HARITH towards the creation of a pan african power vehicle, providing more than 1500kW of power projects across more than 5 countries impacting the livers of over 30 million people, is a strong testament of the rise of a new form of co-investment where a DFI like AFC and a PE manager like HARITH combine their assets and expertise to facilitate greater impact in a specific sector – energy – by establishing a platform company.

Another example is the collaboration of AFC, PIC, OLD MUTUAL and LIBERTY GROUP and their co-investment few weeks ago in three toll roads amounting to more than 1,364 km in the Southern part of Africa. Such co-investment allows a set of local long term investors of different nature (DFI, Pension Fund, and Insurers) to avoid the constraints of traditional PE funds but still put their resources behind a platform to resolve another critical bottleneck on the continent –road infrastructure.

Such co-investment efforts can be conducted alongside other asset managers but sometimes directly with industrial leaders. As such, AFC teamed up also this year with the OLAM group in a joint-venture platform company they co-own with the Government of Gabon to erect a model Special Economic Zone (SEZ). The SEZ includes several capital intensive assets such as a mineral port, cargo port, power plants, and other transformational projects collectively aiming to accelerate the Industrialization process in Africa.

Key Take-Aways

Evolution occurs with individuals, revolution occurs within markets. Just as interactions change during individuals’ evolution, some of the participants in the private capital market in Africa need to change how they interact with each other. For instance, long-term institutional investors such as DFIs need to increasingly play a leading role in the formation of co-investment partnerships; aggregating a mix of local and international pension funds, insurers and strategic investors. Their common objective should be specifically to deploy capital collaboratively into not only attractive investment opportunities but does that provide developmental impact on civil society.

As more institutional capital is now actively chasing PE managers across the continent and will continue to do well within the 2/20% 10-year fund structure, the DFIs should embrace a new catalyst role, There are proven and tested methods to access assets on more favorable terms, either through an option tied to an existing external fund manager, or through an investor-led platform that collates peer investors together.   DFIs should take a leading role in applying them.

In the case of infrastructure investments, partnering with the public sector or development agency can help improve the confidence of investors for investing in this asset class. Involving an industrial or engineering company in some cases can provide the strategic advantage when investing in an emerging market. More DFIs can espouse this view and join in engineering more opportunities for flexible co-investment.This will in the long run trigger the arrival of larger pools of longterm capital and benefit the development of a more robust secondary market for African PE.

 

Ibrahim Sagna

Please follow Ibrahim on twitter at @ibrahimsagna