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LAGOS (Capital Markets Investors are desperately searching for new opportunities in order to counter the challenging current low-interest rate environment. For those who have turned to “frontier markets”—and particularly Africa—there has been something of a roller-coaster ride.
In 2000, as the world entered the new millennium with great optimism, Africa was viewed with suspicion. It was even branded “the hopeless continent” by The Economist. And yet, between 2002 and 2008, the African stock markets enjoyed some spectacular growth. The MSCI Emerging Frontier Markets Africa ex South Africa Index rose by a factor of 10 in US dollars—an astonishing turnaround.
Like other markets, the global financial crisis dealt Africa a devastating blow. But African stock markets soon began to rally once again, with values doubling between 2008 and 2014. This engendered fresh optimism and a new, positive narrative: “Africa Rising”. Even The Economist changed its tune, referring to “the hopeful continent”. This followed a decade of GDP growth of more than 5 percent, improved political and corporate governance, foreign direct investment—particularly from China—and increased investment through a growing number of emerging markets and frontier markets funds.
Since September 2014, however, when African markets hit a post-crisis peak, stocks and currencies have tumbled, with the MSCI index falling by 35 per cent to end 2016. Some of this decline reflects local setbacks, particularly on the political front. Above all, however, this can be explained by exogenous factors including the slowdown of China’s economy, the concomitant effect of falling commodity prices, and the collapse in the oil price.
This has badly affected countries reliant on Chinese investment, commodity exports and oil—notably Nigeria, Africa’s largest economy. At the start of 2016, its GDP was forecast to grow by +4.1 percent, but in fact, the economy actually shrank over the year. As a consequence, some investors have been turning away from Sub-Saharan Africa, switching their assets to North African markets—notably Egypt, which has its own challenges but is less sensitive to commodity prices. At the same time, a number of Africa-focused public equity funds have suffered significant redemptions and been forced to close. Of the 40-plus funds that still operate, about half have less than $50m of assets casting some doubt on their profitability – and viability.
But should investors abandon Africa altogether?
In our view, the answer is “No”. On the contrary, we think that Africa offers significant opportunities for investors searching for alpha—outperformance. The middle class is growing, there is a youthful population brimming with entrepreneurial energy, and there are vast tracts of uncultivated land ripe for development.
But how should investors tap this potential?
We believe that they need a different approach. Around the world, we see striking potential in private markets. According to Cambridge Associates analysis, private markets have markedly outperformed public markets over the long term. And Africa reflects this global trend. Comparing public and private markets over 10 years (to September 2016), African private equity returns, measured by Cambridge Associates, have outperformed Emerging Market public investments by more than an annualised 270 basis points—a big difference. This calculation is based Cambridge Associates’ Modified Public Market Equivalent (mPME) Index, which replicates private investment performance under public market conditions.
How can investors capture these kinds of returns?
One option—for those investors who want to continue to access the public markets—is to look for investment managers who take a more “private equity” approach to stock market investing. This recognises the fact that many of the companies listed on African stock exchanges have some of the characteristics of private companies: among other things, they are often small, traded infrequently, lack transparency, and have little or no analytical coverage.
Managers following this approach seek out the less liquid listed companies, with higher return potential, and may actively engage with the companies to influence and support management. It is important to understand that this does not really work in the popular UCITs fund structure: daily liquidity is an illusion for many African listings—especially smaller stocks — and can force punitive transaction costs. So, in our view, it is wise to look for funds with appropriate lock-ups and liquidity terms.
But, clearly, the main option for those who want to capture the kinds of returns available in the private markets is to invest directly in unlisted firms. The opportunities are significant and the private markets are expected to grow further. A short example to provide some context: although Africa’s GDP is more than double that of Scandinavia, it has a similar number of private equity firms and roughly half the investment volume —$12bn versus $24bn— of the Nordic region.
Moreover, private equity funds offer access to a much greater diversity of companies. For example, the S&P index of African markets beyond South Africa comprises over 50 percent in financial companies (banks especially). By contrast, the Cambridge Associates Africa Private Equity Index is more broadly balanced, with significant weightings in consumer discretionary, financials, information technology, healthcare, industrials and the telecommunications sectors. In other words, private equity funds allow investors to tap into the full, wide-ranging economic potential of Africa.
But if the opportunities are significant, so too are the challenges.
Some of these relate to the characteristics of the regional economy. Africa remains heavily reliant on the Chinese economy. The performance of African private equity funds, as measured by internal rates of return (IRR), shows some link to the rise and fall of the Chinese economy, as measured by GDP growth. In 2007, when China’s annual GDP growth exceeded 50 percent, the 5 years rolling IRR of African funds was more than 30 percent. By 2015, as China’s GDP growth fell to 7 percent, the 5year-IRR slumped to around 1 percent.
Also, there is the problem of foreign exchange volatility, which can significantly undermine returns for international investors. Taking South Africa as an example: in the three-year period to March 2016, South African private equity funds showed an IRR of +10 percent in the South African rand (ZAR), which translated into negative 6.3 percent in US dollars. However, over a longer 15-year period, the currency effect was more mixed with a US dollar performance “only” 440 basis points below the ZAR returns (8.2% versus 12.6% IRR).
There are some other practical challenges too. For instance, there are relatively few private equity funds, giving investors only a limited choice when looking to enter the biggest frontier market. Also, since the African private equity industry is relatively young, there have been only limited exits to date, providing a less clear picture of the final, true performance of the sector. In addition, given the issues around the liquidity of public markets, these offer less of an exit route. Just 1 percent of private equity exits were achieved through an IPO in 2014-2015.
But, for all of these practical challenges, the trajectory is a good one.
Since 2012, more than ten new private equity firms have been launched, and more are likely to be established over the coming years. Moreover, the average number of exits each year has risen from 27 in the period 2007-2009 to 41 in the period 2013-2015. Meanwhile, local institutional investors are increasing their private equity exposure, offering significant support to the industry. African pension funds have started to invest in private equity, with governments encouraging them to do so. In 2015, Kenya’s Treasury minister announced that pension funds would be able to invest up to 10 percent of their portfolio in private equity and venture capital funds licensed by the country’s Capital Markets Authority.
This is a step in the right direction. But, to be truly effective, investors should consider allocating significantly more of their assets to private markets. Most African markets are classified as “Frontier”—that is beyond the standard “Developed” or “Emerging” market indices. But at Cambridge Associates, we also talk about another frontier: the “15 percent frontier”. In some separate research, Cambridge Associates found that global investors allocating 15 percent or more of their portfolio to private investments—ranging across venture capital, private equity, distressed securities, infrastructure, real estate and private debt—have enjoyed significant outperformance over the long term.
In a survey of the trailing returns of 242 endowments and foundations for the ten-year period ending June 30, 2015, we found that the median annualized return for those with 15 percent or more in private investments was 7.6 percent, 150 basis points higher than the return of the group with less than 5 percent in private investments. Compounded over a ten-year period, this differential can have a meaningful impact on the financial health of an institution. And for institutions that invest in this way for more than ten years, the rewards are greater still. Over a 20-year period, the median return for institutions with more than 15 percent allocated to privates outperformed the median for the group with less than 5 percent in privates by a cumulative margin of 182 percentage points, or 180 bps per year.
In other words, the value of private investments is clear in any region of the world, and, in our view, Africa too merits consideration as part of a “private equity approach”.
This article is featured in the March 2017 edition of INTO AFRICA Magazine, Africa’s Lions: Trust in Fundamentals.
Martin White is a Managing Director at Cambridge Associates and is based in the firm’s London office. He heads the EMEA public equity research team and is responsible for researching managers in Europe, the UK, Middle East and Africa. Before joining Cambridge Associates, Martin worked for 25 years in the investment management industry. He was a Principal at Barclays Global Investors (latterly BlackRock) where he worked as lead portfolio manager then senior strategist in quantitative active equities covering equity long-only, partial short and market neutral hedge funds strategies.
Nicolas Schellenberg is a Senior Investment Director at Cambridge Associates and is based in the firm’s London office. He co-heads the ex-US private equity and venture capital research team in Europe and is responsible for performing due diligence on private equity and venture capital opportunities in Europe as well as across some emerging markets, including Latin-America and Africa. Before Nicolas joined Cambridge Associates, he worked at Macquarie Investment Management, in the Private Equity Fund of Funds team in London, where his responsibilities included the due diligence and quantitative analysis of primary, secondary and co-investments, as well as portfolio management.