Debt, Debt Market, Private Equity, Capital Market, Finance, Banks, Management, Growth, Leverage, Aruwa.
Founding Partner & CEO, Aruwa Capital Management.
Is now the time to increase your investment allocation to Africa?
While reading Bain’s latest annual PE report – the Global Private Equity Report 2023, which highlighted some interesting facts and predictions for the year, one thing really stood out, the seismic shift in debt markets and its impact on the PE industry. The Federal Reserve’s rate hikes, which started in March 2022, have seen the benchmark rate increase by five per cent, a level not seen since 2007, in an effort to curb inflation. This is a theme that has been mirrored across the world’s central banks and has signified the end of cheap debt, impacting in particular the PE buyout markets.
Fears of a recession, driven by a cocktail of high interest rates coupled with persistently high inflation has spooked banks. Banks have significantly reduced their willingness to issue leveraged loans, on which western PE has heavily relied in its deal making. This has seen year-end totals for global PE deals and exits as well as fund-raising for private equity plummet globally as at YE 2022. While the overall trend for alternative investments in 2022 was downward, the buyout and growth categories bore the brunt of the macro headwinds.
Multiple expansion has been the largest driver of buyout returns over the past decade, rather than traditional and fundamental drivers e.g. revenue and margin growth. This sudden and fundamental shift in one of PE’s main tools i.e. cheap debt, is likely to make the path ahead for PE buyouts more turbulent.
Looking at the chart above multiple expansion has contributed over 55% of value creation over the last decade. Bain suggest that in order to emerge victorious in this new economic environment firms will need to adapt their strategy to meet the new economic reality. One comment in particular caught my attention: “Success will be less about piling on “max leverage” and playing multiple arbitrage and more about improving operating leverage and generating organic growth.”, i.e. growth will be achieved through improving the fundamentals of businesses rather than relying on financial engineering.
While leverage has, until recently, been an undeniably successful tool for developed markets PE, returns in Africa and other frontier markets have been and continue to be driven by revenue growth and margin expansion. African PE has never been about piling on max leverage, in part because that option is limited to non-existent, but also because the growth potential of businesses is so vast, leverage is secondary.
In the US and other developed markets, the availability of debt is consistently a determinant of the multiples paid for PE transactions. Consistently low levels of debt available to industry in Africa, as shown above, demonstrate that African PE is not reliant on debt to generate its returns. This is largely a reflection of poorly developed local debt markets; in Nigeria, domestic credit to the private sector as a % of GDP is 14%, in Ghana it’s 13% and has remained at these levels for the last decade without much improvement. Levels in our developed market counterparts are vastly higher, 10x in the UK and 16x in the US.
So instead of debt, what has been driving PE returns in Africa? Since the emergence of PE on the continent, the core value driver has always been revenue growth and earnings growth through margin expansion driven by increased operational efficiency leading to real EBITDA growth, which ultimately leads to multiple expansion at exit.
The African continent presents an enormous organic growth opportunity with 1.3 billion people with a predominantly young demographic and increasing disposable incomes. The continent will account for over half of global population growth by 2050. Nigeria my home country, will be the third largest country in the entire world by 2050. Urbanisation will also be a driver for growth with an additional 200 million Africans living in cities over the next decade. Ironically, given the vast and rapid growth potential of the continent and its businesses, multiples in African PE are lower in comparison to the West. As seen in the above graphic from Riscura’s Bright Africa report - average EV/EBITDA for African transactions is just above 6.0x whereas its above 12.0x in the US. African PE funds also tend assume the same entry and exit multiple in their projections or a very modest multiple increase at exit due to the lack of a viable IPO and capital market exit routes.
I am not naïve to the fact that rising interest rates, persistent inflation and low investor risk appetite will also impact frontier markets such as Africa, where we invest. We have already started to see some of those effects with the impact on fundraising and deals in Q1 2023. However, my hope is that the slowdown and compression in more developed markets may cause developed market investors to start to look more seriously at investing in frontier markets such as Africa for portfolio diversification. These issues are not new to the African markets in which we operate, inflation, high interest rates and investor risk appetite are a daily hurdle, but businesses and PE funds have not only survived, but have thrived in these environments.
Organic growth and margin drivers are all we have (and have always had), not by choice but as a function of the state of our debt markets. This has meant that strong company fundamentals and our ability to improve them through a local and hands on approach are our main focus in assessing and executing investments. We simply don’t have the luxury of piling on maximum leverage and financial engineering through multiple arbitrage, that our Western counterparts have, or rather had, to drive value.
What does this mean for my fund Aruwa Capital Management? The good news for us is that given our focus on providing growth capital to proven businesses in the SME segment, between 2021 and 2022 our portfolio companies’ revenues grew by an average of 70%. In addition, we invest at a stage where companies are at the inflection point of their growth trajectory, which typically, naturally results in revenue growth and margin expansion due to the economies of scale that come from that injection of scale capital and our hands on approach to driving value.
Perhaps this Bain article will be a catalyst towards redirection of capital allocation towards lower leverage alternative investment models like Africa PE? Our investors will not require the benefit of hindsight.
Those that ignore African growth PE investments as part of your capital allocation strategies – do so at your peril in this new market reality.