It was only a few years ago when an infectious wave of optimism poured over African shores from other frothy global markets and began to be felt in African commercial capitals from Lagos to Nairobi to Johannesburg. According to the African Private Equity and Venture Capital Association (AVCA), private equity fundraising for the region grew 24%, from $3.3bn to $4.1bn, for the years 2013 to 2014. By 2015 Africa focused fund managers had raised a record $4.3bn, bringing the cumulative 2010–2015 haul to an impressive $16.2bn. 823 private equity deals were done over the same period for a total value of $21.6bn.
Putting on the Breaks
However, the last two years have seen a marked slowdown in limited partner commitments to the continent’s 54 markets; existing GPs have had difficulty attracting support for follow-on fund offerings and new managers have struggled to get off the ground. AVCA reported that following 2015’s record total, only $3.4bn was raised by PE fund managers in 2016, a number that fell further still to $2.3bn in 2017. Africa, at least from a PE fundraising perspective, is no longer rising.
Weakness in global commodity prices and an overall souring on emerging markets (EMs) by institutional investors hit Africa and other so-called “frontier markets” particularly hard; investments targeting developing countries haemorrhaged fund flows as the market took a more cautious stance to EM bellwethers such as Russia, China, Turkey and Brazil. This was compounded by strong, often record, relative performance in more familiar developed markets.
Buffeted by weakening fundamentals and challenging macroeconomic headwinds, fundraising and PE investing in Sub-Saharan Africa were down, year-on-year, in 2016 and 2017 — decreasing 25% and 40%, respectively, according to the Emerging Markets Private Equity Association (EMPEA). With GDP growth rates slowing sharply in the continent’s biggest economies, Nigeria (which was in recession for much of 2016 and 2017), South Africa and Kenya, existing portfolio investments for many managers suffered, exacerbating an already troubling trend of modest returns for the region’s PE funds. The hard truth is that the underperformance of funds raised in better economic times set the industry up for a challenging investor marketing story in the aftermath of the downturn.
A New Model
Despite the recent slowdown, many still believe in Africa’s potential and hope that private equity will make major contributions towards that development. However, it has become increasingly clear that both long-term growth and the ability for Africa to attract fickle Foreign Direct Investment (FDI) and portfolio investor flows will depend on improvements to fundamental economic structure — as opposed to cyclical commodity prices — to be sustainable.
African private equity is beginning to run headlong into the central issue that has bedeviled African entrepreneurs and private sector participants for decades: Africa’s fundamental business model of earning hard currency by exporting raw commodities in order to purchase imported manufactured goods that satisfy the needs of its domestic residents creates an inherently fragile economy exposed to exogenous cyclical shocks with few local factors of production that present attractive or investible assets for investors. Today, investors can at best seek to profit from agents in this trading model (banks, retailers and distributors of imported product) or in developmental commodity reserves; but it does not have to be this way.
Local Markets to Replace Foreign Imports
African private equity investors would benefit from more focus on domestic and regional production opportunities where inefficient import-based supply chains may offer attractive opportunities to on-shore value chains. In a recent article in The Diplomat magazine, Matthias Lomas asserted that “manufacturing goods in China is now only 4% cheaper than in the United States, in large part because yearly average manufacturing wages in China have increased by 80% since 2010,” leading low-cost manufacturers to explore countries such as Vietnam, India, Malaysia and Bangladesh.
But even those economies are adjusting to a higher cost base; Forbes reported last spring that workers in Malaysia, Thailand and Myanmar successfully demonstrated for wage increases of more than 50% for this year. In Cambodia, a popular new destination for low-cost manufacturing over the last several years, Forbes reports that “Prime Minister Hun Sen announced an 11% increase in minimum wage for garment and footwear workers” in a bid for votes in an upcoming election. Just as labour costs begin to creep higher in the world’s major manufacturing centres such as China and the ASEAN region, which seek to graduate to higher value medium and high tech manufacturing, Africa is in the early stages of a major demographic bulge creating tens of millions of potential labourers.
A Young Continent
According to United Nations forecasts, by 2050 34% of the world’s population 15 years of age or younger will live in Sub-Saharan Africa with Africa’s under 15 population growing from 406m in 2015 to almost 700m by 2050; in China and India, this population will actually shrink from 255m to 204m, and from 364m to 317m, respectively, over the same period. Afri-Dev Info estimates that Africa will add 1.2bn people under the age of 35 to its population by 2050. In particular, as the UNFPA and African Union point out, the populations of West and Central Africa — which share time zones and natural shipping corridors to Europe — are particularly young: almost two-thirds are under the age of 24.
Young people between 15 and 24 years of age make up 60% of the unemployed in Africa and the few who do manage to find work are involved in the informal sector with low incomes. According to UN estimates, the population of Africa may reach nearly 2.5 billion by 2050 (about 26% of the world’s total) and nearly 4.4 billion by 2100 (about 39% of the world’s total) creating both enormous potential markets for producers and significant challenges for policymakers and civil society.
It is in everyone’s interest that Africa finds a way to domestically employ this enormous population of young people. Joe Walker Cousins, former head of the UK’s Libya mission says there may currently be 1 million African migrants en route to Europe and a leaked German government report identified up to 6.6 million more waiting to cross into Europe from waystations in North Africa and other points such as Libya along the Mediterranean. More than 590 of those attempting to migrate drowned in the Mediterranean in the 1st quarter of 2017, while 21,900 more reached Italy over the same period; up from 14,500 in the first quarter of 2016. 9,000 migrants arrived in Italy via Libya in 2014; by 2016 that number grew to 37,550. A study of migrants hailing from Nigeria concluded that up to 75% of them are economic migrants.
These men and women are voting with their feet: these are often young, able-bodied and, relative to their societies of origin, reasonably prosperous individuals who are gambling their futures on a binary option where the upside is selling trinkets — or worse — on the streets of southern Europe, and the downside is a watery end at the bottom of the Mediterranean. When the most vibrant and economically potent components of a labour force get this disillusioned and nihilistic, can serious instability be far behind? According to the Global Terrorism Index, in 2015 three of the world’s four deadliest terror groups were in Africa: Boko Haram, pastoral Fulani militias and al Shabab. The other was Isis — itself, in part, a product of a failure to harness a similar, but smaller, demographic bulge in the Middle East a generation ago. Under-industrialization in Africa is no longer just Africa’s problem.
Mr Cobb and Mr Douglas
Fortunately, the answer can be found in an introductory economics textbook: like China (facing its labour surplus) did so successfully over the last three decades, the markets of Africa need to focus on relentlessly optimising their Cobb-Douglas production functions and embark on massive capital deepening to compliment this prodigious labour endowment. Human capital development is a naturally occurring byproduct of the industrialisation process: mechanical and engineering skill development, wage stability, and an increased savings rate all occur organically alongside profitable production. This is where private capital can play a catalytic role.
Investment in the African capital stock offers the opportunity to increase African labour participation by employing the abundant youth population and in the process reducing migratory and extremist trends while also promoting healthier growth conditions and stronger consumer demand. Increased technical transfer from more developed markets, power & transport infrastructure development and production oriented capital expenditure in Africa will increase total factor productivity and create sorely needed export opportunities for developed markets experiencing declining growth. Developed markets financial firms may enjoy more fertile demand markets for credit, payment and financial management products.
While expecting Africa to compete with countries like Indonesia, Thailand and India which have made far more significant investments in power, transport and social infrastructure for opportunities in export manufacturing may prove ambitious, Africa’s rapidly growing population also offers immediate opportunities in the manufacture of locally consumed staples and necessities. This is an area that should be of particular focus for private equity investors with relatively near-term horizons for harvesting investment returns. Supply chain elements for basic staples such as food and commodity processing, construction materials manufacturing, FMCG production and fertiliser manufacturing enjoy large local demand and are mostly supplied by cumbersome imports that require complex logistical supply chains from far away markets. Investments in simple production value chains could, with manager assisted upgrades to operational management and governance, reduce local unit costs of production enough to credibly challenge these imports for local market shares.
Current timing for such manufacturing focused investment strategy in Africa is particularly opportune. The IMF recently raised global growth forecasts to 3.9% and signs of renewed vigour are evident in rapidly firming commodity prices such as crude oil and iron ore. These trends portend positively for African terms of trade, and improved hard currency availability is already evident in large commodity export markets from Nigeria to Zimbabwe.
A more buoyant macroeconomic environment will encourage African commodity exporter government revenues, support hard currency FX reserves, stimulate local demand and promote local consumer confidence; Africans will have more money in their pockets. This should maintain and potentially expand African bank and government access to Eurodollar bond markets, providing the necessary resources for the plethora of recently announced transport and power infrastructure projects across the continent. Updated electricity generation facilities, ports, air links, roads and railways will all benefit local manufacturing production interests. Despite these positive developments, African asset valuations are at attractive lows — with manufacturers, in particular, starved of both growth and operating capital; investors would be wise to avail themselves of this fortunate constellation of circumstances.
Importantly, the policy winds in Africa will increasingly be supportive of local production as local policymakers, particularly those stung by recent gyrations in the prices of export commodities on which they rely, have learned painful lessons. African governments are under increasing internal and external political pressure to diversify economies and reduce pressures on hard currency foreign exchange reserves by substituting imports with local production, especially for the supply of critical staple products; policy is likely to evolve in a manner hostile to exporters to these markets and protective of local production — via tariffs, subsidies, financial support and other market protections.
A more constructive part of this emphasis is focused on integrating neighbouring markets into regional unions that offer larger demand opportunities to potential producers. Just last week the African Union announced the Single African Air Transport Market (SAATM) initiative which should enhance connectivity between African nations, reduce flight prices and increase the number of direct flights between African countries, which will now be able to avoid awkward stopovers in the Middle East or Europe. Continued integration of regional markets in this way will offer opportunities to finally capture returns to scale for local producers and manufacturers.
Outside of Nigeria, Ethiopia, Kenya, the Democratic Republic of Congo and South Africa few African countries offer large enough populations to warrant significant investments in production infrastructure. However, advancing efforts by ECOWAS, UOEMA, COMESA and SADC to reduce and remove trade frictions on the cross-border transit of goods and people as well as the downward trajectory of intra-Africa tariff levels should make it easier for locally based manufacturers to access benefits accruing from returns to scale.
Also, an underappreciated benefit exists in regional cultural themes related to ethnic links pre-dating colonial borders which offer consumer opportunities in food, lifestyle, apparel and other consumer-facing manufacturing and assembly that can appeal to the shared tastes of consumers across several adjacent national neighbours. These scale benefits to efficiency and unit cost of production may make such manufacturing competitive with imported materials with their embedded transport and logistics costs (especially if external tariff policy of integrated regional blocs becomes more aggressive), particularly with renewed global growth threatening to drive up shipping day rates and transport fuel costs in the medium term.
As such, commercially driven institutional investors should focus on opportunities to meet the observable extant demand for defensive products in inelastic demand sectors whenever possible; importers have long extracted value from the willingness of local populations to pay premium prices for available staple products. As these trends evolve, investible opportunities that show potential for being plugged into broader supply chain networks for broadly consumed items are especially attractive — local sales and “last-mile” logistics expertise are especially valuable to the supply chains of global multi-nationals.
Such potential acquisitions, alongside increasing demand from foreign portfolio investors for more publicly listed equity product from emerging markets, may create increased opportunities for exits. With China’s average wage level having tripled between 2005 and 2016 according to Forbes — now standing higher than that of Brazil, Argentina and Mexico — select opportunities for contract and export manufacturing may emerge in the near term. Ethiopia is currently embarking on a large scale experimental series of state-led investments in such capacity, primarily in footwear and apparel, which have attracted the attention of some global brands. AGOA based projects, mostly in southern African countries like Lesotho and Swaziland have had similar success with denim jeans and other simple textiles.
Investments in local manufacturing require operationally intensive strategies, making them both challenging and defensible. Success will be a function of both pre-investment due diligence and strategic planning, as well as the post-close execution of management enhancements, efficiency promoting production cap-ex, process improvements, product line rationalisation, channel and logistics optimisation, sales growth (via both pricing and product differentiation) and governance improvements.
Enhancing investment attractiveness through enhanced reporting, prioritising transparency, investor community engagement, communication with other elements of the supply chain and focusing on environmental, societal, community and internal culture issues should create meaningful value for productive companies efficiently producing critical staple products. This should be great for Africa, but also very good for private equity investors and their LPs. Making Africa great again in this way should be highly commensurate with impressive IRRs for savvy investors in this space.
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