African PE firms raised less than $20bn in the decade to 2018, equivalent to just 2.5 per cent of the capital raised by the world’s emerging markets, according to a Prequin report. Moreover, most of that African capital was invested into the relatively advanced economies of South Africa and North Africa, with very little flowing into the rest of the continent.
Investors explain this limited investment into Sub-Saharan Africa (SSA) in PE funds as a result of the low returns from such investments. The PE firms, themselves, acknowledge the limited gains but claim these markets are still nascent and that returns will rise as these economies evolve.
Yet the reality is that it may be the approach being taken by SubSaharan Africa’s PE investors that is causing them such poor returns.
As it is, nearly two-thirds of the region’s private capital investment is made by larger PE firms who inject more than $50m per investment. However, the scale of such sums can make for reduced risk appetite. As a result, such funds seek out traditional business models with limited operational risks, established profits, and the potential for an exit within the fund’s lifetime. Typical have been banks, insurance companies, manufacturing, and consumption-led businesses targeting the top 5 per cent of African consumers.
But the limited number of such businesses in SSA has created stiff competition for any eligible transaction, pushing investors to enter at high valuations into businesses serving a customer segment that is barely growing – compared with the 95 per cent of underserved Africans.
Moreover, many of these transactions are sales by existing shareholders rather than investments into the company, further limiting the new growth they generate.
Such dynamics limit returns.
In recent years, however, smaller investment firms have begun backing young, entrepreneurial businesses with investments as low as $500,000. But with smaller capital pools and limited scope to support capacity building, these investors have struggled to make these investments to their full potential.
Moreover, these businesses are also suffering some inherent issues that are driving low returns. For, while they are targeting significant local problems, they are often relying on developed markets’ business models, which are not supported by the fragile infrastructure and under-developed fundraising ecosystems of our region.
A case in point is the proliferation of digital credit for the unbanked in East Africa. Digital data, which worked well as an underwriting tool in developed markets, has proven woefully inaccurate in Kenya. As a result, large numbers of loans have been made that have led to defaults, with Bloomberg recently reporting that 1 in 10 adults in Kenya has defaulted on digital credit. This has damaged both the new loan businesses and the borrowers too.
However, the lesson in such cases is to pursue and support the development of local solutions.
At Aavishkaar Capital, we faced such a situation after the India Microfinance Crisis of 2010-11, when the local government stepped in to curtail the industry’s recovery practices, which had led some borrowers to suicide. Rather than demonising microfinance and shutting down the sector, regulators put in place checks and balances to protect consumers and investors. Industry leaders revised the sector’s underwriting and strengthened self-regulation. As a result, microfinance bounced back as a $28bn industry serving more than 60m customers.
If regulators, industry and investors can come together to achieve successful digital credit for the informal sector through microfinance, there is no reason such success cannot be emulated elsewhere.
Indeed, impact investors in emerging markets, such as India, have repeatedly demonstrated that backing indigenous businesses and local entrepreneurs in finding solutions to significant social and economic problems create successful businesses. We believe Africa offers similar opportunities, based on its structural parallels, including young aspiring demography, deepening technology footprint, rapid urbanisation – with its unwarranted side-effects – underdeveloped public infrastructure, and a mostly agrarian and unorganised workforce.
Business solutions such as dry waste management through recycling and upcycling; enabling access to quality inputs, knowledge and markets for small-holder farmers; and providing working capital financing to informal sectors through physical and digital underwriting offer huge potential.
In this, businesses in Africa operate in smaller markets and are handicapped by a dysfunctional banking system and small capital markets. But we believe that where investment funds can source exceptional local entrepreneurs with on-the-ground experience and back them with enough capital and capacity building, they can execute a successful investment strategy.
However, even as Africa offers the potential to be the growth engine of the world, private investors must wake up and recognise that what hasn’t worked in the last two decades is unlikely to work going forwards and make amends or risk becoming irrelevant forever.