Africa: A Frontier for Private Equity, but a Pitfall as Well

Courtesy of Knowledge at Wharton, a report on Africa’s frontier markets:

For Azeem Zainulbhai, finding opportunities in Africa’s frontier markets means thinking outside the box — or, in the case of one recent transaction in Angola, living inside a box. OK, not really a box, but a shipping container — technically, a bunch of shipping containers used as building material instead of concrete and steel.

“We had this idea to construct buildings out of shipping containers because it was cheaper,” said Zainulbhai, president and CEO of Crescat Excolatur, a private equity fund with investments in sub-Saharan Africa. “So we brought in the technology ourselves. We set up our own company to do it. And we set up a separate construction arm and a real estate asset management arm. We found a management team for it, we found a few expats to help with construction, and now we own two luxury residential buildings in Angola. We didn’t leverage at all. We signed deals with the landowners [and got] cash up front. And we were able to build 45 apartments in six months as opposed to 24 months typically. We got our money back in 13 months.”

Whether investing through traditional mutual funds or aggressively deal-by-deal, global investors are increasingly seeing Africa as the next horizon of opportunity. Six of the world’s 10 fastest growing economies over the past decade were in Africa. Africa’s middle class, already spending as much as US$680 billion annually, is projected to grow to 1.1 billion by 2060, up from 355 million in 2010. This year alone, Africa’s economy is expected to grow at a rate close to 6%. For global investors, Africa’s impressive growth has made it a necessary part of their portfolio.

At the Wharton Africa Business Forum 2011, a panel on “The Frontier of the Frontier: Investing and Building Businesses in Post-Conflict Countries” explored different ways investors can get involved in Africa’s growing frontier markets. According to Zainulbhai, one of the experts on the panel, there is “no standard protocol” for his investments. “It’s very opportunistic. We find this gap in the market and we just attack it, either by acquisition or by setting up our own venture.”

A Risky Proposition

Investing in Africa still holds risk, of course. Investors fret about corruption, political instability and asset security. Many of the most exciting opportunities remain difficult for the average global investor to tap, and others may be more hype than substance. But overall, say industry experts, Africa’s frontier markets today are more accessible to investors than they have ever been.

“There’s tremendous opportunity if you believe in growth and capacity,” said panelist Ashley Bendell of Renaissance Capital, a Moscow-based investment bank focused on Central and Eastern Europe, Central Asia and Africa. Bendell is the firm’s New York-based pan-African specialist, representing the firm’s trading across Ghana, Nigeria, Kenya, Zambia, Zimbabwe and South Africa. Investing in Africa requires a long-term view, he said. “If I got worried about the headlines that come every day, I’d have pulled all my hair out by now.’ Investors “have to fully understand these countries and the longer-term implications of what is going to happen” in the future.

Countries in Africa have been growing at a very fast pace, Bendell added, and hold a variety of investment opportunities, depending on the time horizon. Rwanda, for example, is an “unbelievably beautifully managed, clean, fairly straightforward country to do business in.” Zimbabwe holds promise in the next five years. Nigeria and Kenya also hold many opportunities in the short term.

More investors are starting to pay attention. A recent survey by the Economist Intelligence Unit found that institutional investors “see Africa as holding the greatest overall investment potential of all frontier markets globally,” ahead of frontier markets in Asia and Latin America. Bribery and corruption were reported as top concerns, followed by weak institutions and illiquidity in capital markets. Still, the majority of respondents — 158 pension and insurance funds, hedge funds, wealth managers and private banks — said they would explore investment in Africa sometime within the next decade, and nearly one third of investors surveyed (33%) said that they planned to put at least 5% of their fund value into Africa by 2016.

Growth Is the Magnet

“The fund managers themselves are starting to look at the frontier because they see a lot more growth and opportunity there,” said Bendell. Some funds in the U.S. are launching new products to take advantage of the opportunities, he noted. “The U.S. has a lot of global and American market fund managers [but] they don’t necessarily have regionally-focused funds — Africa, Asia, Latin America. So the frontier markets of Africa form a miniscule part of that [portfolio]. You’re starting to see a few funds — like GE or Lazard — launch frontier products so they can take advantage of the opportunities across Africa.”

Defining frontier markets can be a challenge. Some loosely classify frontier markets as regions with illiquid capital markets, lower transparency or a recent history of conflict. “The definition of ‘frontier’ is not nearly as settled as the term ’emerging,'” pointed out panelist Christopher Grune, a vice president at State Street Global Advisors and a senior portfolio manager in the firm’s active emerging markets team. “In the MSCI Frontier Market Index, you have everything from Qatar to Kenya. There’s a huge variation in terms of the size and development of the economies.”

Zainulbhai pushes the definition of “frontier markets” way beyond the MSCI Index. His benchmark is the activity of other private equity funds. “The big pan-African private equity funds are investing in Nigeria, Tanzania. We’re going to places that they can’t go to, like Angola and Cameroon. Those are the frontier markets where we believe we can get the highest returns.” From Crescat Excolatur’s point of view, Nigeria is already an “emerging” market, he said. “When we go to private investors across the world, when we say ‘frontier markets’ in Africa, they think Nigeria. But when we say ‘Angola,’ they say, ‘Really? How? How does that even work?'”

Often, it requires a lot of negotiation. “Before we even make an investment, we go with our in-country accountants and lawyers and we always have a conversation with the bureaucrats, asking, ‘Is this structure workable?'” Zainulbhai noted. “If we’re going to put in US$5 million, does it mean that when we make US$10, we can take five of that out and pay a dividend? What are the tax structures? A lot of times, we find they are very receptive. They want you to put that money in and therefore they want to help you take that money out if that’s necessary. And we’ve found that when you talk to these guys, especially if you keep an open mind, we end up walking away with more incentives than we originally had been planning on.”

Will the Money Come Back?

Many investors remain skittish about legal issues, stability and the security of their investments. One question investors always ask, according to Zainulbhai is: How are we getting our money back? “That’s very critical,” he said. “There’s not a lot of experience on export of capital [from Africa]. There’s been a lot of import of capital but not a lot of export of capital.”

Being able to easily repatriate funds is extremely important for most State Street clients, said Grune. “For our clients, it’s a very big issue. That is probably almost equal to concerns or desire for superior returns.” The last thing clients want to worry about is “somebody going out the backdoor with a briefcase,” he added.

Depending on the investment, some of those concerns may be overblown. “If you look at transparency and corruption, Russia is way higher up than some of these markets we cover,” Bendell noted, arguing that technology is making many markets in Africa more accessible than before. “You can upload all the major stocks onto Bloomberg and figure out how they’re trading on an inter-day basis. And yes, you do have chalk board at some of the stock exchanges themselves, but ultimately, a lot of information feeds into Bloomberg and you have access to a lot of real-time information. From a financial perspective, a lot of these companies are reporting [using] global standards. You have access to a lot more information and comfort than people think.”

For global investors, “the tables have been turned,” said Grune. Since the global financial crisis, investments in more developed countries have become uncertain, while the growth in emerging markets makes investments there more appealing. “In so many ways, the world is almost on the flipside of how it was back in the 1980s and 1990s, when on a routine basis you had crises in emerging markets, [and] you had countries defaulting. Now, emerging markets are on much better financial footing. For the most part, the emerging markets — the larger emerging markets, the BRIC countries — have become mainstream.”

Still a Dark Continent

Frontier markets, however, still remain largely unexplored. “Emerging markets aren’t seen as exotic anymore. They’re seen as a necessary part of your portfolio, Grune stated. “But frontier isn’t there yet. And that’s where we need to get over quite a few hurdles. Legal protection and rule of law are some of the big questions that come up.”

Some of the most exciting opportunities in Africa remain closed to global investors because the markets have not fully developed. For example, most small and medium enterprises are not listed on any stock exchange. “The potential for upside is greater in that small and medium space, but many of those firms are unlisted so that makes many of them inaccessible,” Grune said. “It’s a bit frustrating. If that entire part of the economy is inaccessible to you as a potential investment, you’re missing out. So that would be a big challenge: How do you formalize those businesses — to help them and also help our prospective investors?”

Even when frontier markets are stable, growing and accessible, returns are never guaranteed, Grune cautioned. “High growth doesn’t necessarily lead to high returns. Sometimes it’s a lot of hype, and there’s a lot of enthusiasm priced into the valuations of the stock market. China is one example of a country that people are excited about but it has provided disappointing returns.”

Perhaps. But for an increasing number of global investors, betting on Africa is a risk they are willing to take

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Wildcats & Black Sheep is a personal interest blog dedicated to the identification and evaluation of maverick investment opportunities arising in frontier - and, what some may consider to be, “rogue” or “black sheep” - markets around the world.

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