Demystifying Private Equity as an asset class

The increased interest in Africa exhibited by Private Equity and Venture Capital funds provides a good opportunity for promising entrepreneurs and businesses on the continent to tap into these lucrative sources of capital.

According to statistics released by Emerging Markets Private Equity Association (EMPEA), an independent global membership association whose mission is to catalyze Private Equity (PE) and Venture Capital (VC) investment in emerging markets, 2010 saw PE activity in the emerging markets rebound from a sluggish 2009.

Total funds raised for investment grew by 4% to US$ 23.5 billion from US$22.6 billion - a low not experienced since 2005. The 2009 dip was manifested by investor apathy following the global economic meltdown between 2008 and 2009. This recovery marked a return on investor confidence in the PE asset class.

Sub Saharan Africa’s (SSA) share of this lucrative asset class, stood at US$ 1.5 billion or 6% of the total funds raised. I believe this portends well for the continent and perhaps will be key in helping the region achieve its economic and developmental objectives. To view the US$1.5 billion as paltry is in my view unfair; with the exception of Latin America and Caribbean which recorded a 149% growth in funds raised in 2010 amounting to US$5.6 billion, Africa was second with a 36% year-on-year growth.

On the flipside, investments made in SSA in 2010 stood at US$613 million which represented 41% of the committed capital while Latin America’s and Caribbean total investment of US$6.6 billion was 118% of committed funds.

Encouragingly, Africa’s participation in this asset class is slowly but surely growing. There’s the growing view that business and not aid will make SSA prosper. My opinion is that PE is here to provide the funds necessary to stimulate business. Business that will facilitate SSA’s primary industry, agriculture, to progress to value added activities such as agro-processing and thus improve the value of our exports, expand local small enterprises and enable them to compete with sophisticated global players, is what SSA requires.

However, the big question to ask is if PE as an asset class is a well understood across Africa. The level of penetration of PE investment as a percentage of GDP stands at 0.06% in SSA. This level of penetration is comparable to some of the leading emerging economies like Brazil, Russia and South Korea. But in nominal terms, the economies of these countries are many times larger in terms of GDP when compared to those of SSA countries. In my view, the relative understanding of PE as an asset class is low in Africa and at its nascent stage.

By definition, PE is an asset class that provides long term committed capital in the form of share purchases in private companies not listed any public stock exchange with the goal of helping these companies grow and succeed. So whoever owns or is running a business that is not listed on any stock exchange could potentially team up with PE funds to expand or turnaround a poorly performing business or even to start a new business venture.

According the British Venture Capital Association (BVCA), PE backed companies have been shown to grow faster than other types of companies. This is made possible by PE’s unique fiscal capital offering combined with highly skilled and experienced human capital from the PE executives.

In Kenya and in East Africa in general, there has been an influx of PE companies seeking investment opportunities. There have been numerous transactions across a wide range of sectors that have seen private equity investors close deals such as the fast moving consumer goods, power generation, financial services and real estate. In a recently concluded survey, most of the private equity investors cited the confidence in macro-economic growth potential, good economic fundamentals and increased GDP growth as some of the factors that will support growth of private equity in east Africa. It is therefore important for policy formulators to ensure that they consider this asset class as one avenue for driving development by providing the capital and also as an avenue for savings. It was encouraging the see the Retirement Benefits Authority (RBA) in Kenya host a workshop to educate trustees of pension funds on private equity early this year and plan for more educational seminars on the asset class.

The key question that many of the private companies ask is how to approach or make their businesses more attractive to PE investors. The simple answer is pegged on the ambition of the owners of the company. If your business is able to offer the prospect of significant profitable growth within five years, you are operating in an attractive industry where you seek to be a leader and have been able to distinguish yourself through unique capabilities then your business is a good candidate to interest PE investors.

For a start-up company, if there is real growth potential in the industry you operate in, then PE may be of interest to you regardless of the stage of development you will be in whether at start up or at buy-out stage.

When recently discussing the possibility of investing in an ambitious company in the ICT sector one of the shareholders and who is also an executive director asked me what benefit he would get from a PE investor. He candidly reckoned that he was going to give up a portion of his company to someone who will now ‘boss’ him around while hitherto he was the boss and hence questioned the benefit of PE investment.

Besides the contribution of fiscal capital which makes PE investors’ part owners in the company, PE investors also play a high level strategic role. They seek to increase the value of the company to both the incumbent owners and themselves by accelerating sustainable profitable growth.

This is what sets PE aside from other forms of finance. PE investors will seek to do this without taking day-to-day management control of the business. Another tangible benefit of PE investment besides improving the business’ governance and strategic capabilities is that the PE investor will often work in conjunction with other providers of finance to enable the business to access better funding packages. Although the entrepreneurs behind the venture may see themselves as being diluted and having a smaller ‘slice of the cake’ one should look forward to seeing that small ‘slice’ growing considerably and being more than the whole they owned before.

One key factor that entrepreneurs or business owners often miss out when approaching private equity investors is how to target the right partner. There are several considerations that one must bear in when sourcing a PE partner. These include;

· The stage of the company’s development

· The specialization of the PE investor

· The amount of financing needed

· The geographical location of the company’s business operations

The stage of the company’s development is important because the PE industry is itself segmented. Investors often have a preference in companies at different stages of their business life cycle. You will often find entrepreneurs who have great ideas and nascent intellectual property but need seed or start-up funding to develop and commercialize their concept. Such individuals will normally seek Venture Capitalists (VCs) and/or angel investors who are ready to take the risk at that stage by funding operations from scratch. These are typically high risk ventures but also promise very high returns. Some of the household global names in the ICT sector from Silicon Valley such as Google and Face book started in this manner.

There are other businesses that have a proven track record and are growing rapidly but to maintain this growth trajectory, need to increase investment to fund product development, expand production capacities and also provide for additional investment in working capital. This stage is typically referred to as ‘expansion’ or ‘growth’ phase. . It is in this space that most PE players focus on in regions such as SSA. Some PE players specialize in turnaround situations - financing a company at risk of bankruptcy while others seek to participate in management buy-outs.

The second consideration is to understand the industry in which the PE investor specializes in. Though many PE investors are generalists and will consider investing in a range of industries, they will typically prefer specializing in industries in which they have built competencies in. The PE investors will also tend to exclude industries they will not invest in due to perceived risk or just lack of competence. It is therefore important for one to do some research on a potential PE firm they intend to approach. By just looking at the investor’s existing and past portfolio of investments