African Private Equity: Missing the middle

Parallel to the global narrative of Africa’s economic progress, the discourse about venture capital in the region has taken on a bipolar nature – either there is too much money chasing too few deals or there is a dearth of capital for African countries’ entrepreneurs. 

The Economist warned in 2015 that “too much money is pouring into too few funds, chasing the few big deals on offer" The International Finance Corporation (IFC) estimates that “up to 84 percent of small and medium-sized enterprises (SMEs) in Africa are either un-served or underserved” in terms of access to venture capital. 

African private equity (PE) is, but, emerging as an institutional asset class. In the 1990s, there were approximately a dozen Africa-focused private equity firms, collectively managing around $1bn. This number has since spiked to over 200 firms, managing more than $30bn. 

Between 2010 and the first half of 2016, there were 928 reported deals, with a value of $22.7bn. Firms raised $17.3bn from 2010 to the first half of 2016 and invested in every region of the African continent. 

But of new money raised in 2016, nearly 70 percent was accounted for by three of the largest funds – Abraaj, DPI, and Helios. Given their size, they need to make large cap investments to put the capital to work and the pool of potential targets is limited.

There are only 400 companies in Africa with annual revenues greater than $1bn. Whilst the consultancy firm McKinsey has estimated that there are over 10,000 African companies with revenues of $10m to $100m. Many of these SMEs could then be well served by private and the ability and discipline it can bring, including technology-transfer, managerial capability and financial acumen. 

Jerome Kisting Managing Director and Portfolio Manager of venture capital fund Baobab Capital based in Namibia explained, “While we inject capital into businesses, we are also involved in managing the businesses. We believe the monetary investment is not enough on its own. People need access to a level of financial management expertise, networks, and other markets. With every investment we make we try to understand how we can add value as well.”

Especially since they are operating in previously under-developed high-growth sectors that have yet to reach scale, such as education, healthcare and other consumer-facing industries, but, despite the vast number of SMEs operating in African countries, the overall market for risk and growth capital available to these types of businesses stay small and fragmented.

A persistent “equity-financing gap” is prevalent in an environment where sourcing any external capital, even debt, is challenging for these companies. Overall figures for the equity gap are difficult to determine, but the World Economic Forum has identified a persistent gap in financing for businesses that need between $50,000 and $2 million in external capital.  

Furthermore, due to changes in commodities prices and shifts in African nations national economic policies, the import and extractive industries that have dominated African economies for decades are giving way, and allowing for consumer-facing and service orientated firms to enter critical growth phases that could lead to economic transformation. These companies need capital in the form of private equity or venture capital financing tailored to their needs. 

A new wave of “missing middle” funds will, therefore, create a dynamic pipeline of future investments for the bigger, traditional players in African private equity. Whilst at the same time growing smaller African companies into larger companies is not only good for private equity firms at all points in the financial value chain; it is also good for economic development overall with the result of growth-focused private equity in Africa having a vital impact on job creation and economic development. 

A study by the African Venture Capital Association (AVCA) examined 199 African companies backed by private equity between 2009 and 2015. These companies generated a net increase of 10,990 jobs, a growth of 15 percent. And financial firms taking part in the study created 6,399 jobs. The AVCA study also found that PE firms in Africa educate investees and transfer actionable skills, implementing job-quality initiatives and strengthening competencies in human resources, corporate governance and general management expertise. 

More and better jobs translate into aggregate positive effects on, among other things, health and education. Both are contributors to stability, which is conducive to creating an attractive business environment for new companies, the development of which will, in turn, make it easier to find new growth-oriented targets for middle-market funds, starting the virtuous cycle again. Jerome Kisting, “When you are in a developing country, it is difficult to remove the development impact of capital. It is, going to have a socioeconomic impact.” 

Given the dire need to create jobs for millions of young people in Sub-Saharan Africa and the positive outlook for small and medium-size companies in the middle-market Africa private equity space should be of greater focus for investors and venture capitalists of all sizes and specialisms.  

While African countries account for only 3 percent of global GDP, they make up less than 0.1 percent of institutional investor portfolios. The expansion of investment allocations for first-time funds and emerging managers, alongside the creation of fund of funds that can bridge institutional investors’ constraints and the small size of middle-market funds, would go a long way to supporting the next wave of private equity and venture capital investment in African markets. 

Thus, the more private equity and venture capital funds step into the missing middle breach, the more Africa as a whole will benefit.