Arnold Ekpe, CEO of Ecobank recently stated: “We don’t have an African strategy, Africa is our strategy.” Ecobank is one of several African private equity success stories of the past decade, growing from a small regional bank to a pan-African bank with the largest branch network on the continent. Much of this has been achieved with the help of private equity funding, which until recently was a novelty in Africa.
The story of private equity in Africa was almost purely a South African tale until as recently as ten years ago, when money began to flow into the new frontier markets. The South African private equity industry was begun in the 1980’s with backing from local banks, but gained momentum as investment from the European Development Finance Institutions (DFIs) began to flow in the 1990s. The DFIs identified the shortage of capital in South Africa at the time, and recognised that significant developmental gains could be made by financing this shortfall. The African Development Bank (AfDB), Industrial Development Corporation (IDC) and the Development Bank of Southern Africa (DBSA) also contributed as African DFIs.
The DFIs funding the nascent private equity sector recognised the risks inherent in investing in the continent, and implemented strict governance and reporting standards. This included reporting on Environmental, Social and Governance (ESG) in the underlying portfolio companies.
In recent years, DFIs have seen that much of Africa has stabilised and conditions have become more conducive to investment targeting developmental impact as well as strong returns. This has led to a shift in the allocation of DFI funding away from South Africa, to focus on the rest of the continent where the capital can have the greatest impact. This shift is largely responsible for the creation of the formal private equity industry in sub-Saharan Africa.
Today, private equity in Africa is growing from its small base, with more than 2502 managers active across the continent, managing a total of between $25 – $30 billion (RisCura Fundamentals analysis). Most of these managers are managing fairly small amounts of capital, and the bulk of the total amount of capital is managed by the largest 25 managers.
Valuation of unlisted companies is difficult anywhere in the world, and this is certainly the case in Africa. The usual complexities of expectations of the future, management skill and cost of capital are exacerbated in Africa where listed market information is limited, capital markets are largely still developing and general economic data is scarce.
Valuation is not only important at transaction time, but throughout the fund life so that investors can have confidence in the value of their assets.
Like most private equity industry bodies around the world, the African Venture Capital Association (AVCA) has endorsed the International Private Equity and Venture Capital Valuation Guidelines (Valuation Guidelines). These Guidelines, which have recently been updated, allow the use of certain methodologies such as Market Multiples and Discounted Cash Flows (DCF). The Valuation Guidelines favour market based measures wherever possible, which means an emphasis on valuing companies with reference to the valuations of similar companies in listed markets.
The stage of development of the investee companies can also add difficulty, as many African private equity firms invest in fairly early stage or turnaround businesses. This means that many businesses may be loss making initially, or may rely on securing new financing to make the company viable. While this brings the possibility of high returns, it also brings complexity and significant judgement when valuing these companies.
This judgement is a concern for investors looking to invest in African private equity, and has driven the independent valuation of private equity fund investments. The use of independent valuation specialists who are familiar and comfortable with the difficulties of valuing companies in Africa gives additional comfort to new investors in the continent.
- Why is performance measured?
- Why is it different to other asset classes?
- Current measures
- Possible improvements
Reliable, accurate performance measures are essential for investors to properly consider investing in private equity. Institutional investors in particular must consider the balance of risk and return to determine an allocation to African private equity. In the absence of return data, and with a high-risk perception, it is understandable that many investors have not yet ventured into this space.
Measures of performance
The private equity industry typically measures performance using an Internal Rate of Return (IRR), as well as a Times Money (also known as a cash multiple or Total Value to Paid-In capital (TVPI)). IRR is a measure of the implied rate of return that discounts a series of cash flows to zero, and is used to take into account the timing of cash flows. The Times Money is used as a sense check, and is the ratio of capital returned and due to investors, divided by capital invested.
A new measure called Annualised Rate of Return (ARR) has been suggested by eFront, a private equity software vendor. This measure seeks to address some of the shortcomings of the IRR measure, the most significant of which is the assumption that realised cash flows are re-invested at the achieved rate of return. ARR uses the Times Money approach but annualises this measure by dividing the computed Times Money by the duration of the cash flows.
South African performance
Since 2010, RisCura Fundamentals in collaboration with the Southern African Venture Capital Association (SAVCA) has published the returns of the South African private equity industry. These returns show strong long-term performance of the asset class in this region, and outperformance of the listed equity markets. This outperformance is necessary to justify investment, as investors must sacrifice some liquidity to invest outside of the listed markets.
Private equity has enjoyed a strong annual return of 18.1% over the three years to 30 September 2012, according to latest SAVCA RisCura South African Private Equity Performance Report.
This is a significant improvement over the 11% reported for the three years to September 2010, the first time the Report was released, and the 11.4% it achieved for the three years to September 2011. Returns are calculated on the basis of a pooled internal rate of return (IRR) since inception, the most widely used IRR measure of private equity performance. All returns are calculated net of all fees and expenses.
Private equity is showing returns that are justifying the lack of liquidity that investors need to tolerate with this asset class.
The SAVCA RisCura Report tracks the performance of a representative basket of South African private equity funds, and is released quarterly by RisCura Fundamentals and the Southern African Venture Capital and Private Equity Association.
Because of the long-term nature of private equity investing we regard the ten year return as the headline measure of private equity returns. However, the three year returns are also significant. Three year returns are important because they indicate the direction of the private equity market, and are the best indication of how private equity has responded to recent market conditions.
The pooled IRR performance for the ten years to September 2012 is 17.4%, in comparison to the 22% achieved for the ten years to September 2010 and the 21.7% achieved for the ten years to September 2011. This is partly due to the financial crisis, as well as the fact that some of the very strong returns from the early 2000s which we saw in the initial Report, have dropped out of the ten year period. For the five years to September 2012 the performance is 12.6%.
The lower returns over the five year period, in comparison to the three and ten year periods, reflect the downturn in South African growth brought on by the global financial crisis. This has also affected the ten year returns, but to a lesser extent than the shorter periods.
An important indicator of performance in private equity is vintage year, the year when a fund first begins to invest its capital. Funds starting in or after 2005 have been negatively impacted by the downturn in the economy, particularly funds making investments in the period from 2007-2008. Part of the reason for the current poor results of the most recent vintage grouping is that these funds are still in the early stages of their development cycle where management fees play a significant role in determining fund returns. In addition, the investments made by these funds still need to be enhanced by the private equity fund manager.
The best measure available to determine whether private equity has outperformed or underperformed listed equity is the Public Market Equivalent (PME) methodology. RisCura Fundamentals uses a variation of the PME methodology where the result is expressed as a ratio. This measure seeks to equate the heavily timing dependent returns of private equity funds with the returns of public market indices. The measure is a ratio of the the net outflows from PE funds re-invested into a public index to the reporting date, divided by the inflows into a PE fund invested in a public index until the reporting date. A ratio of above one reflects outperformance of private equity, while a ratio under one reflects underperformance.
African (excl. SA) performance
Anecdotally, African private equity has had excellent returns, with several DFIs with wide exposure to this market reporting unofficial returns of around 20% per annum in USD. However, official statistics are hard to come by. AVCA has begun the process of mobilising its membership base to provide data to allow the computation of industry performance, and expects to release data in the second quarter of 2013.
- Manager perspective
- Investor perspective
Risk management is a key aspect of private equity fund management. African private equity managers must deal with higher than normal political risks, legal risks and risks arising from less experienced management and governance systems.
As a result of the DFI involvement in African private equity, close attention has been paid to risk management through the lens of managing environmental, social and governance risks. The DFIs have ensured that African PE managers mitigate and monitor these risks to limit the harm that DFI funded companies can cause to the environment, communities or to businesses and markets through poor governance.
Managers further manage the overall risk of their portfolios by sticking to exposure limits. For example, a pan-African fund may have a limit on the percentage of capital that can be allocated to a particular country, or invested in a particular currency. In addition there would be sector exposure limits to reduce the risk of the portfolio as a whole.
On a deal by deal basis, managers focus on due diligence, the sustainability of the business model, quality of management and potential exit avenues as up front risk mitigation techniques. Most, if not all PE managers say that the quality of company management is the key factor that will determine the success of the enterprise.
Exits in Africa occur through several avenues including trade sales (sales to corporates in the same sector); sales to other financial buyers (other PE funds, banks etc.) and occasionally initial public offerings on an African or foreign stock exchange. Another important exit mechanism is the use of self-liquidating instruments. These instruments are set up with expiry dates where the company either has to produce the cash to repay this obligation or re-finance the company and buy out the private equity firm with the proceeds.
While African private equity is relatively new, there is a buzz around it at present and opportunities abound in many African countries. Evidence of returns is starting to come through, and risk mitigation processes are well established. There are challenges of course, but given Africa’s changing demographics, relative peace and strengthening economies the successes are likely to outweigh the risks.