Challenges facing venture capital in Africa

The African private equity industry is still in its infancy, but it has been growing steadily in the past few years. At the end of 2000, the South African private equity industry had approximately ZAR33bn under management. Paul Inbona from Modern Africa looks at the key obstacles that venture capitalists must overcome in Africa if the industry is to grow.

In June 2001, Modern Africa had its semi-annual meeting at Phinda Game Reserve, a very private and exclusive reserve in the beautiful province of Kwazulu-Natal in South Africa.  The short trip by plane leads you to a typical African landscape with thorn bushes and low lying trees, hosting numerous zebras, boks, birds and of course lions and the odd leopard.  One night, on the river, we watched the sun setting on this wonderful landscapes and we reflected on the challenges of doing business in Africa as a private equity/venture capital professional.

Just as one might get surprised on a game drive by the mighty lion or the lunatic hippopotamus, private equity in Africa has its own share of surprises and risks.  If one defines private equity as the MBOs, LBOs types of transactions, then private equity does not really exist in Africa, except for the privatisation transactions that have not been as widespread as was anticipated a couple of years ago.  The few that have happened took years to complete.  For instance, the privatisation of NITEL (PTO) in Nigeria has been discussed for the last 20 years and the process is not yet complete.  And even when such transactions exist, the risk is so high that it is probably closer, in term of risk profile, to a venture capital deal.  In addition, the minuscule capitalization and turnaround of African Stock Exchanges makes any pre-IPO transaction a fantasy for African venture capitalists.  Liquid Africa (www.liquidafrica.com), one of Modern Africa's portfolio companies, is focusing on improving trading and liquidity on these exchanges and has developed a trading platform that its network of brokers are currently using very successfully.  It is expected that this initiative and others will improve substantially the efficiency and liquidity of capital markets on the continent and will attract more attention in the years to come, leading to an increase in Foreign Direct Investment - FDI (note: according to an UNCTAD dated January 2002, FDI flows to Africa increased from $9 billion in 2000 to $11bn in 2001.  However, this represent a tiny fraction of the global FDI flows to developing countries, estimated at $255bn in 2001).

African stock exchanges

	Number	Market	Annual	Annual	Average Daily
	Listed	Capitalisation	Trading Value	Turnover	Trading Value
	Companies	(US$m)	(US$m)	(%)	(US$ million)
North Africa
Egypt	1,075	28,500	11,795	41%	46.4
Morroco	53	10,900	3,600	33%	6.1
Tunisa	44	2,802	650	23%	0.7
	1,172	42,202	16,045	38%	53.2
Sub Saharan Africa
South Africa	616	205,000	71,018	35%	279.6
Nigeria	195	5,820	505	9%	2.0
Zimbabwe	71	2,190	224	10%	0.9
Botswana (*)	16	1,350	67	5%	0.3
Mauritius	48	1,340	74	6%	0.3
Kenya	53	1,290	47	4%	0.2
West Africa Bourse	40	1,200	68	6%	0.3
Ghana	22	530	8	2%	0.0
Zambia	12	236	6	3%	0.02
Namibia  (*)	13	155	18	12%	0.1
	1,086	219,111	72,036	33%	283.60

Source: Liquid Africa - www.liquidafrica.com

While the private equity industry is very small, it has been growing steadily in the past few years.  Even the well researched South African market is dwarfed by the American or European private equity industry. At the end of 2000, the South Africa private equity industry had approximately ZAR33bn (US$3.3bn) under management. The number of professionals in the industry topped 300 in that year within no more than 20 firms. There is no data to measure the size of the African private equity market, but it is likely that the SA market would represent at least 50 per cent of the total market estimated at $6bn.

African venture capital funds are more often than not supported by government agencies and multilateral agencies such as DEG, Proparco, FMO, OPIC, CDC, IFC.  Some independent players exits, but are generally very small (smaller than $10m).  In the recent years, private independent players such as Ethos Private Equity or Brait Capital have managed to raise funds in excess of $400m each, exclusively for the South African market and focusing essentially on later stage transactions.

Although Africa's image in the press is too often that of despair, war and diseases, in many instances, African risks are not much different from those experienced by investors in other African markets.  They may be amplified sometimes, due to the prevalence of conflicts and diseases such as AIDS and due to the very low income levels and lack of infrastructure, but they are certainly not unique to the continent.  The key lies in dealing with these risks from evaluation, close monitoring to mitigation.  Interestingly, Africa is recognized as a high return investment by many of the investors in Africa, exceeding other emerging markets.  The table below tries to summarise and illustrate the key risks that African venture capitalists are faced with.

Risk	Discussion point	Mitigating Factor
Industry	Comparable to other parts of the world	Focus on industries that have global/regional markets with export potential (pharmaceutical, agriculture, mining, oil&gas)
Country	Although the general environment in Africa has improved (refer to article from The Economist: “Stronger than you think” January 12th, 2002), many countries have not established and maintained democratic rule.  Others are the theaters of conflicts that significantly disrupt the economy.	Choose countries that are stable: easy to say, but who would have predicted that Côte d'Ivoire, who had experienced a long period of stability would be rocked by a coup in 1999? Take a regional approach in order to dilute the country risk
Legal system/law enforcement	A reasonably adequate legal system is in place in many countries but the law enforcement is problematic due to lack of capacity and corruption.	Tightly review all legal aspects of a transaction and choose jurisdiction in Europe or the US with clear arbitration clauses.  As a result, legal costs of transactions can reach 20 per cent of the amount invested (!)
Currency	The CFA block of countries (linked to the Euro) and a couple of other countries such as Kenya have experienced relative stability.  However, many countries such as South Africa, Ghana, Nigeria, Zimbabwe have seen their currency dropping substantially in the last few years.  In 2001 alone, the Rand lost 40% of its value.	It is essential to focus on businesses that provide a natural hedge.  The mismatch between funds currency and portfolio currency can have dramatic impact on the performance of the fund, when calculated in the currency that the investors used to invest in the fund initially.
Exit	In my view, this is the key risk.  The volume of private equity transaction and the absence of liquidity through a regulated exchange makes it very real and very prevalent.	Perform a careful analysis of the sectors that are likely to attract attention from global players is key (media, mining, telecom, timber, agriculture…), Include a strategic investor in the transaction from the start, Build in the exit path from the start.
Management	Talented managers are generally hard to find.  In Africa it is harder.  The perceived risk makes it difficult for talented people to come and work on the continent.  In addition, it often loads the cost base of the project to an unbearable level.	Make use of some NGOs and other multilateral agencies that provide management support.  AMSCO, based in The Netherlands and a company associated to The World Bank, provides such talents. Develop a web of local contacts to identify talented individuals
Access to debt/second round finance	The lack of private funding makes it difficult to raise second-round finance or even debt finance.  The crash of the telecom sector has also reduced considerably the leverage generated by suppliers credit.	Network, network, network! Get to know the “donors” who have a multitude of vehicles to finance feasibility studies, exports, infrastructure building…
Regulation	Regulation is sometimes unclear and can change without notice, completely shifting the playing field.	Enlist the assistance of a local lobbyist otherwise called “helper” who can walk you through the administration. Carefully study licenses to ensure that they comply with the regulation Keep in touch with government officials
Property rights/Ownership	In some countries such as Ghana or Côte d'Ivoire the land is owned by the local tribes and in other countries such as Eritrea or Tanzania it is owned by the state.  Some confusion can arise as to who is the rightful owner of the land.	Need to understand very clearly how the land registration work and what is the ultimate proof of ownership Draft very tight long lease contracts Work with communities when required
Control	Control is of utmost importance to ensure that decisions are taken quickly and efficiently in an already difficult environment.  It also reduces the exit risk considerably.	Negotiate up-front ownership Build in the documentation tag along/drag along rights Ensure board representation commensurate to the shareholding Be very close to your investment
Growth/Market	Local markets are very small and fragile, except for regulated industries such as power, water, telecom, mining… The insufficient growth of the economy impacts negatively the prospects for many industries	Adopt a regional approach to access a regional market Focus on export products
Infrastructure risk	Africa's infrastructure is globally very inadequate and poorly maintained. This results in more mechanical breakdown of vehicles, high cost of power/telecom, power shortages/outages (in Nigeria, up to 80% of the time), increased time to produce and deliver.	Focus on the large urban areas that are reasonably well serviced Arrange alternate power generation (diesel generator in most instance), Allow for more time, Expect the unexpected
Tax	Tax laws and regulations are very complex and very different from country to country. They are also prone to change often and without notice.  Tax controls can be arbitrary and lead to very material tax penalties sometimes unjustified	Need to understand the local context and tax administration, Keep close contact with the tax authorities: enlist the assistance of a local lobbyist otherwise called helper who can walk you through the administration.
Transparency/Governance	A major issue that is prevalent in many countries in Africa. The cost of such breakdown in governance and transparency can have a substantial cost. It has been shown that corruption and success of a venture are not correlated and my own experience is that one can do business without having to resort to corruption.	Need to understand the local context and enlist the assistance of a helper. Ensure that all transactions are done in an irreproachable manner. Adhere to the highest level of ethical standards at all times. Be prepared to lose the business as a result
Security of assets and people	Industry and country specific. Very important in unstable countries and in the natural resources sector, which often overlap.	Hire security company. Perform a security audit
Environmental impact	Very prevalent in heavy industries (cement/steel…), infrastructure and natural resources.  Can result in dispute with tribes that have resided traditionally on the property.	Environmental impact assessment plan and mitigating plan. Sometimes, necessary to negotiate relocation of tribes sometimes and financial compensation.
Human rights/workers rights	Some industry have a history of employing children and providing very poor working conditions.  These conditions have been allowed to continue due to corruption of the administration and/or plain lack of capacity to enforce regulation	Need to select carefully potential investment and avoid altogether industries where such practices are prevalent.  Lobby the government and the NGOs to improve and enforce legislation.
HIV-AIDS	The prevalence of HIV-AIDS in Africa is such that it threatens the fiber of society itself.  The fact that it touches essentially the working forces puts a real threat on the companies who require a large number of unskilled/low-skilled labour	Need to focus on industries that are more pro-active and less labour intensive, Need to focus on countries that are doing more to deal with the scourge (such as Uganda, Senegal, Ghana), Need to ensure that a prevention and healthcare plan is available to the work force.

The exit risk

As explained above, except maybe for South Africa, the IPO is not yet a viable option.  And even in South Africa, the performance of the stock exchange in the last two years combined with poor corporate governance which has led to a stream of insider trading scandals, dreadful performance of the Rand on the currency markets and the crash of the technology sector has led to a complete drought of IPOs.

But how bad is the exit problem in emerging markets?

One survey of 227 Latin American private equity investments between 1995 and mid-2000 indicated that only 15 investments had been exited, or 7 per cent of the total.  In Asia, divestitures in 1998 and 1999 averaged about $2.5bn per year in the region compared to the $35bn invested between 1992 and 1999.  In Africa, information is not available but by experience, outside South Africa, exit has been a recurring problem for most players.

As in every market, the rule of thumb is BLASH: buy low and sell high.  In order to enable such scenario, it is essential that one address the exit issues upfront. These include:

• Focus your investment approach on sectors that are more likely to generate an exit: for instance, a real estate investment will be hard to exit (hotel, shopping center, residential), whereas a media or telecom investment will be relatively easier,
• Structure your deal in such a way that all the relevant exit clauses are included (drag-along, tag-along, put and call options…),
• Manage the relationship with the entrepreneur so that he is prepared long in advance to the reality of your exit.  More often than not, entrepreneurs are resisting a process that will see them losing control and they prefer an investor that would stay in for ever,
• Provide incentives for the entrepreneur to sell: structure the deal so that he can unlock extra value for himself only at time of exit,
• Study the exit opportunities carefully.  Although in the US, the liquidity of the markets is such that exiting through an IPO is on average, the most likely option, in emerging markets and in particular in Africa, the most likely option is a trade sale.
• Tie in, as early as possible, with a strategic partner who would provide you with a natural exit.  The identification of such potential partners is done through networking and to a lesser extent, research. Research is made difficult due to the lack of data and the very private nature of many transactions.
• Think about taking control: preferably from the outset, in order to get additional leverage to execute the exit process,
• Instill good corporate governance principles from the outset. They will increase the potential value at exit, especially in a market where it is not the norm,
• Get the exit process right: gather market intelligence, define sales approach, compile information memorandum (if necessary with the support of a local/international merchant bank), market the company (roadshow), negotiate with buyers, close the sale,
• Be proactive in generating competition for a deal.  That can only come from deep market and industry research to identify all potential buyers.  One very important tool in Africa, where formal research is non-existant, is the use of trade fairs and conferences (whether on a specific industry, country or a more general VC/PE event)
• Negotiate an MBO as the next best exit mechanism after a trade sale.  However these are more difficult to execute due to asymmetry of information and the shift from a cooperative relationship to an adversarial relationship with the entrepreneur.
• Be creative: equity-to-debt conversion, royalties/management fees, aggressive dividend policy, accelerated interest payment, spinning off parts of the business, licensing agreements… All these mechanisms aim at accelerating access to cash and therefore reducing the exit risk,

These comments, which are coming from our daily experience in the private equity/venture capital industry in Africa, are sometimes common sense, sometimes thought provoking but should be seen with a positive light that all venture capitalist in Africa are aiming at contributing, at their own level, to the African Renaissance that has been laid out by Thabo Mbeki and other African leaders (refer to the UN sitehttp://www.un.org/ecosocdev/geninfo/afrec/ for more information).

It is vital that the environment for business improve to channel more investment in this part of the world.  This would unlock tremendous value for all parties involved and would make Africa an even more exciting place to do business. 

The more funds are available and the easiest the exit.

Paul Inbona is an Associate Director at Modern Africa.  Prior to that, Paul Inbona worked for 6 years with Andersen. He holds a Msc in Engineering from a leading French Engineering Institution and an MBA from INSEAD.

Modern Africa Growth & Investment Company(Modern Africa) is a leading investor in Africa's expanding economies.  Modern Africa is a direct equity fund investing in companies with strong growth prospects in Africa's deregulated markets.  Its investment capital and value-adding support helps fuel the entrepreneurial initiative required for Africa to achieve fuller integration into the global economy.  The fund is managed by Modern Africa Fund Managers out of Johannesburg, Abidjan and Washington and has closed in nine investments in various sectors. 

 Source: Modern Africa. Paul Inbona