Tineyi Kuipa, Director, Enko Africa Private Equity, Naleni Govender, Managing Director, Enko Capital, South Africa

 

The unlisted market in Africa presents an opportunity for investors to access diverse sources of alpha within an investment strategy whilst contributing towards the sustainable growth and development of the continent.

 

Africa offers significant opportunities for attractive returns driven by economic growth, the demographic dividends underdeveloped industries and key infrastructure. With over 1.3bn people living on the continent, the potential to contribute meaningfully towards the global economy is real and waiting to be unlocked. With that said, the region presents unique risks that require careful mitigation strategies and many of them are not always obvious unless you have a deep, on the ground understanding of the various regions.

 

Here is our detailed examination of the critical risks and measures by which we believe these can be managed for investors.

 

1. Political and Regulatory Risk

 

Political instability and potential violence, sudden regime changes, and unpredictable changing regulatory environments in many African countries pose major risks to private equity and private sector investments in general. Governments can alter foreign ownership laws, tax regimes, change currencies of trade or even nationalise industries, which can lead to major disruptions for investors.

 

Often corruption and bureaucratic inefficiencies are also common concerns and serve to either frustrate or hinder the growth potential for private investments and these need to be identified and managed prior to making any investment. We think it’s prudent for investors to try and mitigate against the political and regulatory risk by applying the following strategies:

 

Due Diligence on Political Climate: It’s important to monitor the political landscape in target countries, including the history of governmental transitions, election cycles, and relationships with international investors prior to making any investment.

 

Diversification Across Countries: Where macro-economic and political risk factors are a concern in any particular jurisdiction, one should look to diversify investments across multiple countries or regions in Africa to reduce exposure to single country or country-specific political or regulatory shifts.

 

Political Risk Insurance: To the extent this is available, one should seek to protect your investments by leveraging political risk insurance, and other incentives offered by multilateral organisations such as the Multilateral Investment Guarantee Agency which aids in covering losses due to expropriation, currency inconvertibility, political violence, and breach of contract by a government.

 

Leveraging Local Partnerships: Having a local partner on the ground with the right stature and in-depth knowledge of the local environment and government institutions can help navigate sudden changes in policy, often proving to be an invaluable tool across the investment portfolio.

 

2. Currency Risk

 

A great deal of African countries trade in currencies that are extremely volatile due to fluctuating economic conditions, government overspending and fiscal deficits and related monetary risks of money creation, inflation, a s well as political instability. Devaluation of local currencies on the one hand is generally viewed as a positive alignment with local market forces, however this can significantly erode investor returns (especially, when reporting to investors is in hard currencies). Currency risk can be reduced by applying the following strategies:

 

Hedging: This is an obvious tool however in Africa challenges such as availability and cost of hedges, (which can erode investor returns) need to be closely considered. Investors can use currency hedging instruments such as forwards, options, and futures to lock in exchange rates and minimise currency exposure.

 

Diversification between local and hard-currency deals: Focus on sectors or deals that generate revenue in hard currencies, or export-driven businesses. It is also important to weight investments in favour of hard currency instruments such as debt or mezzanine structures or at the very minimum use a combination of local currency and hard currency investment instruments in each investment to benefit from a natural hedge.

 

Select Stable Economies: Target investments in African economies with relatively stable currencies, like the CFA Franc region of West Africa which is pegged to the Euro or other countries with relatively stable currencies like Botswana and Namibia. Countries where the macro-economic policies have demonstrated resilience and close attention to fiscal and monetary policy is adhered to also present better investment opportunities. Where this is less certain, the potential returns need to counter-balance the currency depreciation risk.

 

Exit faster:  Exiting faster may reduce the risk associated with currency depreciation in situations where reasonable growth has been achieved and a decent offer is received. In fact, in some circumstances exiting faster can reduce the overall currency depreciation suffered in respect of an investment.

 

3. Economic and Market Risk

 

Many African economies are dependent on unprocessed commodity exports, such as oil, gas, and minerals. This dependence exposes them to global commodity price volatility, which can negatively affect economic stability, per capita spending and corporate profitability, and overall investment returns. In addition, many markets in Africa are underdeveloped, limiting exit options for private equity investments. We suggest considering the following when managing for economic and market risk:

 

Sector Diversification:  One should aim to avoid concentration in commodity-dependent sectors. Instead, invest in industries such as financial services, telecommunications, or consumer goods, which are less correlated with global commodity prices.

 

Macro-Economic Monitoring: One should also carefully track economic indicators such as GDP growth rates, inflation, commodity price trends, and external debt levels. This allows for strategic timing of entry and exit in markets and helps in risk forecasting.

 

Local Expertise: Clients should engage with fund managers and advisors who have deep local knowledge of economic conditions and trends to make more informed decisions. On the ground understanding and insight is critical for risk management.

 

Long-Term Investment Horizon: Given the cyclical nature of many African economies, adopting a long-term horizon can help private equity firms ride out periods of economic volatility.

 

Identifying Exit Options on Entry: Having an eye on exit options prior to making an investment. This requires an exit  due diligence at the time of making the investment, in other words, speaking to potential interested parties prior to making an investment and investigate their medium to long-term growth strategy. As part of this process, one could also assess whether an asset you are considering making an investment into would be appealing to their stated growth strategy in the future, particularly when it comes to trade buyers. This reduces the uncertainty surrounding your future exit options.

 

4. Operational and Execution Risk

 

Challenges related to underdeveloped infrastructure, inefficient supply chains, weak financial reporting systems, and limited human capital can hinder the successful operation of portfolio companies. These factors may cause delays, cost overruns, or even failure of investments if not managed appropriately. To address and safely manage the operational and execution risks, we recommend:

 

Investing in Strong Management Teams: Invest in companies that have experienced, reliable local management teams or who deploy expatriate talent with relevant expertise to strengthen operations.

 

Infrastructure Investment: Consider investing in sectors that improve infrastructure, such as energy, logistics, and telecommunications, to not only enhance operations but also generate positive returns in high-demand growth sectors.

 

Operational Due Diligence: Conduct thorough operational assessments to understand potential execution risks, including technology systems, supply chain issues, and local labour market dynamics.

 

5. Legal and Governance Risk

 

Our experience in the African private equity market has taught us that weak legal frameworks and inconsistent enforcement of property rights or business contracts are prevalent in certain African countries. This creates challenges in enforcing shareholder rights, resolving disputes, and maintaining good governance practices within portfolio companies. Such risks may be alleviated by:

 

Aiming for control deals: Maintaining a majority control in a deal, or at least in deals where together with other institutional investors, the investor can exert control over the investment collectively to further encourage proper governance.

 

Choice of Jurisdiction:  Structure deals in jurisdictions with well-established legal frameworks for private equity, particularly those which offer protection for foreign investors.

 

Robust Contractual Agreements: Ensure detailed and enforceable contracts, particularly regarding minority shareholder protections, exit clauses, and dispute resolution mechanisms. Engaging local legal experts is crucial.

 

Corporate Governance Standards: Prioritize investments in companies with a strong commitment to governance and transparency. Introducing international best practices in governance can reduce risks and improve performance.

 

Arbitration Agreements: Include international arbitration clauses in contracts to allow for dispute resolution outside of local courts, in neutral jurisdictions such as the UK, South Africa or Mauritius.

 

6. Liquidity and Exit Risk

 

African capital markets are relatively illiquid, with few active stock exchanges and limited investor depth particularly outside of the financial services sector, making it difficult to exit investments via IPOs. Furthermore, secondary markets for private equity deals are often underdeveloped, limiting the range of potential buyers particularly towards the top end of the market where deal valuations approach the US$100m mark. To address these risks, we recommend the following:

 

Plan Exits Early: Develop a clear exit strategy at the time of investment, whether through trade sales, secondary buyouts, or other means. Early exit planning can improve timing and returns.

 

Strategic Buyers: Identify strategic acquirers who may have an interest in the portfolio companies, such as multinational corporations expanding into Africa.

 

Co-investment: Co-investing with other Private Equity and Venture Capital firms, or with Development Finance Institutions (DFIs): DFI’s often have patient capital and a long-term perspective. Co-investment may reduce pressure on timelines for exits and provide more flexibility, while bringing considerable influence to bear on individual policy decisions.

 

Private Sales and Secondary Markets: Focus on creating a network of potential buyers, including local and regional private equity funds, as well as regional trade buyers, to sell stakes in secondary markets.

 

7. Environmental, Social, and Governance (ESG) Risk

 

Failure to consider ESG factors can lead to reputational damage, legal liability, and financial losses. For instance, environmental degradation, labour issues, or poor community relations could result in regulatory fines or civil unrest, particularly in regions where natural resource extraction is prominent. We recommend the following when looking to invest into a company:

 

ESG Integration: Integrate ESG considerations into the investment decision-making process. Engage with companies to reduce their environmental impact, increase their social impact and governance practices.

 

Stakeholder Engagement: Work with local communities, governments, and other stakeholders to ensure investments are socially responsible and promote sustainable development.

 

Monitor and Report: Regularly assess and report on ESG performance metrics to ensure ongoing compliance and minimise risk.

 

Oftentimes, well managed ESG practices help improve the financial return of investments, it is a common misconception that they necessarily add to the overall investment costs and investors must take a considered approach when investing.

 

Conclusion

 

Investing in private equity in Africa presents substantial opportunities, but it comes with a unique set of risks that need to be carefully managed. Diversification and thorough due diligence are essential to overcoming the barriers and seizing the opportunities that Africa offers.

 

By employing a mix of operational expertise, strategic planning, risk management tools and local partnerships, the industry can successfully invest into real assets on the African continent and unlock the regions potential for sustainable alpha. Connect with partners who have a deep understanding of risk and risk management within the region and are able to successfully navigate these challenges, delivering competitive returns for clients.

 

ENDS