In Sept 2012, we wrote an article called “Patterns, Predictions and Profits: the Powerful Case for African Private Equity” - White Lake Group's macro investment thesis at that time for Africa. The title speaks for itself - investment professionals always have a view – and we were pounding the table in support of African PE, albeit with some risk caveats.
Let’s assume at that time we “bought” African PE as a long-term investment. Would it have been a good deal? When I was a stock market equity analyst or even as a PE investor, the process was first of all in the form of an investment thesis, which is essentially a set of assumptions based on which triggers are pulled.Then as time unfolded, we monitor (in the case of listed equities) to see if they come true (in the case of PE you try and control what you can, to make the assumptions come true). In this article however, I will re-analyze the assumptions we made then, to see if they have proved true and restate how I feel on African PE now as well as its opportunities and challenges.
Am I up or down and will I Buy, Sell or Hold my African PE position assumed bought in Sept 2012?
Of course there was not and still isn't a PE index for Africa that I could buy over the counter. A full study would need to be done on every PE fund of that vintage in Africa to ascertain returns to date. Perhaps Cambridge Associates or Harbourvest can help out here. My belief from looking at 4 funds I know reasonably well, is cash on cash it would be still down or neutral at best (mainly due to the stage in the cycle (just at the end of investment period) - only a couple of exits and on the flip side also some write-offs, with unrealized returns looking better than that. However I always take unrealized returns with a pinch of salt. Adjusting this to the currency weakness effects of a dollar denominated fund and I would say I am down or barely breaking even. So let’s say we are neutral to 10% up – which based on an expected risk-adjusted IRR expectation for African PE of 30-40% is not where we need to be. The cash generative side of the PE cycle should be just ahead though.
However now what to do - Buy, Sell or Hold? (Theoretically of course, as PE is so illiquid and the secondary market always heavily discounted).
Let’s examine our original macro investment thesis to see if it has come true and continues to be true.
The Macro Opportunities as of 2012:
1. Commodity boom – Continued high prices of oil and precious minerals sourced in Africa bringing continued revenue to these countries.
Were we right or wrong?
WRONG – On two fronts actually. First, oil has crashed from over $90 a barrel in 2012 to $49 as of today and this is after a current two-month rally from $35. This has put the economies and currencies of oil exporters like Nigeria (fifth largest exporter in the world), Algeria and Angola under serious pressure. Palladium and platinum which are mined almost exclusively in Africa have dropped an average of 32% over the four-year period. So Government revenues from commodity sales taxation which could have been used for badly needed infrastructure projects in Africa are falling away, not to mention the associated jobs from the marginal cost producers.
On the second front – even before the price drop –, Nigeria, that being the country population as a whole, was not benefiting from the oil funds glut. Yes the richest few and the corrupt were, however taking Norway as an example where oil funds are collected by the Government and invested for the good of the country as a whole – Nigeria is a long way from this ideal.
In short the earnings gap in emerging markets, due to lower priced soft and hard commodities, has not been offset by an increase in spending from the western world, even as they experience more spending power due to this same price drop.
2. Economic growth will keep ahead of the rest of the world.
Were we right or wrong?
NEUTRAL – It turns out that the target set for Africa to beat by the rest of the world over the past 4 years (which they duly did) was quite modest, outside of China (which has now also started slowing). However over the past 12 months there have been alarm bells on African growth. Declining commodity prices and economic difficulties in China, Africa's key trading partner, are driving down African economic growth. The International Monetary Fund (IMF) was forced to revise downwards its growth forecasts for Africa twice in 2015.
Add to that now - some other new macro speed-bumps:
- Weakening currencies all over Africa – the cause? Various reasons for this from lack of export value (commodities' value drop in general as mentioned, agricultural failure in Kenya in 2015), to a fall in tourism due to terrorism/Ebola across the continent. A weakening currency makes a country’s imports expensive, and import-led inflation leaves less money for internally produced goods. Yet Africa is still at a stage where it still needs to import specific materials to build up its own manufacturing industry.
- (Very!) High interest rates – in part due to the emergency funding often needed by African governments, who go to the bond market with crazy yields to fill the book quickly. However the feeling is, these rates do not affect consumer spending as people do not borrow much personally in Africa – after all, at these rates and with a lack of banking credit history, who can?
- High unemployment – mainly among the youths aged 18-34. This is heartbreaking and a serious social and economic headwind. This counteracts the advantage of Africa having the youngest fastest growing populations of all continents.
However, with that said, African growth outlook (IMF set 2016 prediction at 3.5%) is still brighter than for most of the developed world (1.5-2%).
3. A continued and improving stable environment for business and growth in Africa.
Were we right or wrong?
RIGHT – With some caveats. Since 2012 some elections have thankfully passed with minimal violence, most recently Uganda where Museveni prevailed, albeit with grave doubts as to the absolute fairness of the election. To say that Governments in Africa are approaching the transparency level of the western world is still a stretch. Every day here in Kenya the man in the street bemoans the corruption of the Government of the day. We had violent protests on election reform with deaths only last week. So the improvement has stabilized and consolidated but is not continuing at the pace set at the beginning of the decade from what I can see. Old habits die hard. Though we have always maintained that this risk can largely be managed.
4. A growing middle class in Africa will be a consumer product companies dream.
Were we right or wrong?
NEUTRAL to WRONG – it’s all relative as it turns out. So is the growing middle class thesis proving true?
In 2011 a paper from the African Development Bank Group (AfDB) found that the number of middle-class Africans had tripled over the space of three decades to 313m. This study defined the group as those with a daily of consumption $2-$20. However reading the study more closely revealed that 60% of the so-called middle class went into a category of individuals with a consumption level of $2-$4 per day. Hardly a group that has much discretionary spending power.
Then last September, Standard Bank examined the middle class of 11 countries that make up >50% of sub-Saharan GDP finding that the middle class in these countries was just 15m people. Adding to this information nuggets such Barclays pulling out of Africa and Nestle shedding 15% of its African workforce in June 2015.
My own ‘on the ground’ evidence here in Kenya would at first glance give credence to the theory that the middle class growth is true. I shop in a local store where milk or cheese cost more than a store in London. There are western style malls popping up all over Nairobi and the roads are jammed full of expensive SUVs. However I have to balance that against the fact that I run a team of 14 well educated accountants who earn per month at the lowest level a fraction of what their European counterparts earn. These workers are in the middle class as defined by AfDB however I know they do not shop regularly in these malls or buy these products. These malls are supported mainly by the elite of Kenyan society and expats.
So yes discretionary spending is rising in Africa however we are still a long way from what would be considered a western world middle class discretionary spending power.
5. Shift towards urbanization driving consumerism and thus economic growth
Were we right or wrong?
RIGHT – However this is not necessarily a good thing. Cities in Africa continue to expand, slums expand, consumerism rises and traffic continues to worsen. From the Asian experience urbanization means people live longer, have fewer children and consume more discretionary goods – pushing economic growth. In a decade the population of Nairobi has gone from 2 million to 4 million people. If the Government can manage the social issues of urbanization (youth unemployment, slum proliferation, increased crime), the scene will be set for increased economic growth. The jury is still out on whether urbanization will be a good thing for Africa.
6. Communication improvement – proliferation of the mobile phone will lead to increased economic activity
Were we right or wrong?
RIGHT – Unprecedented growth. For example in Kenya, Safaricom 3G covers 80% of the country with pans afoot now to roll out 4G. A bigger factor is the rise of MPESA - more on that below. This rise is one of the fundamental reasons that the African economies will continue to improve despite all the headwinds.
The following were the risks we pointed out in 2012 and a review of where they now stand:
- Political risks are relevant and need monitoring – still true but still manageable. Overall it is hard to see any further alleviation of this risk. There are less violent elections and less wars. However corruption has not decreased which makes it difficult at times to do business. Increased terrorism was a new issue thrown into the mix.
- Lack of infrastructure – The Chinese have pledged $1 trillion in infrastructure financing to Africa by 2025. Of course the majority of that will be spent with Chinese companies. Infrastructure is improving but still has a long way to go. Just try the traffic in Nairobi to verify.
- Corruption and corporate governance. This remains a risk area. African corporates are still not at European levels of governance and the losses are felt daily. Having worked as a CFO in Africa over the past year, I can say it remains a serious issue but can be managed with strong controls and company ethos towards fraud.
- Paucity of management talent – still true and a huge risk but manageable depending on individual company conditions. Middle management is the key area where the standard is just not yet at the European standards. Upper management is easier to plug – mainly as you need fewer people therefore returning African’s whom have worked abroad fit the bill. The education standard is good though; so with the right PE fund intervention and coaching, vast improvements can be made.
Factors which had a huge positive impact which we did not foresee in 2012, and are still proving to be a tailwind for African PE:
M-Pesa proliferation – this has become a pseudo banking and saving system allowing greater commerce for many Africans. Trade has increased greatly because of this.
New technologies developed in Africa now can take over the world. What natural advantages has allowed a country like Kenya to compete in technology development?
Actually it is more pertinent to ask – what natural disadvantages has given Kenyan entrepreneurs the need and drive to develop their own business models and technologies not seen anywhere else in the world? What problems do Africans have, to induce such technology advancements that can then be applied to the rest of the world?
Here are some examples where a geographically specific disadvantage is leading to technological innovation.
- Credit scoring – In Africa there is no banking and bill payment data on the majority of people to aid credit scoring. Africa has had to develop new methodologies linked to social media and other esoteric sources. These methodologies can also be useful as alternative credit indicators in the western world.
- Off grid power – The lack of reliable grid power has pushed companies like MKOPA to redefine how people get and pay for power.
- Mobile banking – Branches may become a thing of the past in Europe soon – in Africa they never even got started.
- Mobile payments – M-Pesa leads the world.
- Online Education – Companies like Bridge international have redefined how teachers work using technology. They instruct teachers over tablets on lesson plans. Parts of the innovation to cope with producing quality education at a price point suitable for the African market, may also now make its way to western world education models
Conclusion – Buy, Sell or Hold?
Hold and selectively add. Be patient. Mitigate those risks where you can. Support your management teams strongly.
I would continue to Hold African PE from my Buy in 2012. Theoretically, I am just about breaking even – having bought the market at that time, not deal picked and in places I am feeling some real pain. Of course the currency depreciation from the Kenyan shilling to the dollar is punishing.
However, with quality fund managers who really work on plugging management weaknesses in their portfolio companies (middle management is the key weak area which can make a difference), drive strong governance, controls and process disciplines into cash management and growth – the future is still bright. I would selectively add in areas – a few tech VC plays and middle market buyouts (large cap is crowded with only so many deals for Actis, KKR etc to chase and drive prices) and add a sprinkling of debt/mezz deals with strong protections. East African would be my geography of choice. In summary African private equity continues to ripen slowly. The challenge for funds will be to see which can win the available quality deals without overpaying, and which can take the diamonds in the rough and make them shine.
By John Rowland
John is currently in Kenya as a consultant CFO for Bridge International Academies and Managing Partner of the White Lake Group.