Private equity could boost African entrepreneurs

15 Oct 2018, 12:00 am
Modi Kutua
Private equity could boost African entrepreneurs

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Some African private equity firms are investing in early-stage and even pre-revenue companies using up to 100% equity financing.

Modi Kutua

Private equity funds in Africa are increasingly investing in early-stage businesses in the search for earnings growth. This is partially driven by the rising trend in purchase prices of private companies in Africa as indicated by the latest Bright Africa 2018 report.

Bright Africa is an ongoing research effort into investing in Africa compiled by global investment firm RisCura.

According to the report, the average purchase price of private companies has risen from 4.8x EBITDA to 7.3x EBITDA* between 2009 and 2017. As a large amount of investment capital has yet to be deployed by funds, purchase multiples could increase even further. Due to this, funds may continue to invest in early-stage businesses as they search for earnings growth. Assuming risks remain controlled, this could be a huge boost to African entrepreneurs who normally find it difficult to raise funding for their businesses.

In developed markets such as the United States, most private equity funds invest in mature stage companies. They primarily use debt to buy companies, as it’s cheaper than equity; a strategy that can materially increase returns. It also enables funds to buy companies with much smaller amounts of their own cash, while still reaping the full rewards when a company is eventually sold. Returns are ‘leveraged’ using the additional debt; hence the term Leveraged Buy-outs, or LBOs.

By contrast, some African private equity firms are investing in early-stage and even pre-revenue companies using up to 100% equity financing. In developed markets, these transactions would generally be considered venture capital and would not fall into the ambit of typical private equity funds.

There are a number of reasons why African private equity funds have started investing in venture capital type transactions. In contrast to the US environment, debt can be difficult to get in Africa and is usually expensive. For example, at the end of 2017, the lending rates in South Africa, Kenya and Nigeria, some of Africa’s most popular investment destinations, were 10.25%, 13.64% and 17.71%, respectively as per the International Monetary Fund (IMF). By contrast, the lending rate for the US was 4%.

African banks are also often too small to finance large transactions and tend to be more conservative in their lending practices. Banks in Africa can also make compelling returns simply by lending to their governments, which makes riskier practices such as private equity lending less attractive.

Historically, private equity firms were able to depend on multiple expansion as a reliable component of returns. This was contingent on buying in at low multiples then improving the business so that potential buyers attached a higher value to each unit of earnings. As competition in private equity has increased and significantly more capital is chasing a small amount of assets, purchase multiples have risen sharply over the years.

The high earnings growth potential of early-stage companies generally comes at the price of increased risk, as their business models haven’t been extensively proven in the market, if at all. A testament to the skill of African PE fund managers is that they have generally been successful at navigating this risk and have outperformed listed markets over time.

Modi Kutua is Senior Private Equity Analyst, RisCura

*This is measured using the Enterprise Value / Earnings Before Interest Tax Depreciation and Amortisation (EV/EBITDA) multiple, a common way of assessing the relative value of companies, whether listed or unlisted. In simple terms, if you take the EBITDA of a company and multiply it by the EV/EBITDA ratio, you will arrive at an estimate of the Enterprise Value of the company.

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