A question frequently asked is whether profitability is the only criterion to be taken into consideration when private equity is evaluated. By itself, profitability is not an adequate basis on which to assess the effectiveness of private equity. The questions surrounding investment funds go beyond merely securing the required profitability: private equity can also mobilise additional investments and play a key role in developing local economies.
The arguments against private equity and investment funds follow a well-trodden path: its critics argue that this funding mode is geared solely to securing short-term returns for investors at the expense of the entrepreneurs. This means, the argument goes, that investment funds actually create instability for businesses and also facilitate tax evasion, since the funds are frequently based offshore.
It is, however, no coincidence that private equity and investment in funds form an integral part of the range of tools available to development finance institutions (DFIs). DFIs see them as a way of boosting the impact of their funding, by providing indirect support to large numbers of businesses, and as a means of influencing the governance and strategy of these businesses. Beyond its function as a simple funding mechanism, private equity can help develop long-term local economic networks and support the transition to inclusive and sustainable business models.
Analysing PROPARCO‘s equity portfolio in sub-Saharan Africa will help to quantify these impacts and identify ways of maximising them (see Box).
The sine qua non of profitability
Profitability is a sine qua non of developing private equity. The assumption that it plays only a limited role has long acted as a brake on the development of a mode of funding that has become more prominent over the past few years. The debate has, however, moved on: African private equity, long provided by development finance institutions, now holds its own with other funding mechanisms.
Measuring the yield from equity is, however, particularly difficult in sub-Saharan Africa, since analysts use indicators from the developed world that do not yet, unfortunately, reflect the situation in developing countries. It may, therefore, be helpful to consider the portfolios of three development finance institutions that have historically been active in sub-Saharan Africa – CDC in the United Kingdom, FMO in the Netherlands, and France’s PROPARCO. The global internal rates of return (IRRs, both actual and potential) on sub-Saharan Africa funds are good at between 14% and 23%.1
In fact, their average profitability is better than in France, where – according to figures produced by the French Private Equity Association AFIC2 – the net internal rate of return at end-2010 was 9.1% (AFIC/Ernst & Young, 2011). Since 2004, IRRs in France reported by AFIC have ranged from 8.3% to 14.7%.
This demonstrated profitability is beginning to attract a growing number of private and local investors. For example, the Development Bank of Southern Africa (DBSA) has noted that the contribution of development finance institutions to the equity they finance declined from 54% between 1995 and 2000 to 36% between 2005 and 2009 (Mamba, 2010). The DBSA also notes that local investors, too, are contributing more to the funds in which the Bank has invested, their share rising from 30% between 1995 and 2000 to 52% between 2005 and 2009. This growth is a good sign: Africa’s image is improving and it is becoming more attractive to the potential capital investors its businesses need.
The economic and financial impact
One of the key roles played by equity funds is their ability to bring with them a wide range of investors keen to spread their risk. This enables development finance institutions or sponsors to act as catalysts by mobilising additional sources of capital, particularly from foreign investors. CDC has calculated, for example, that for every pound sterling invested in equity, the same amount is invested by other development finance institutions, while a further GBP 2.70 is contributed by private investors, increasing the initial investment to a total of GBP 4.70 per pound (CDC, 2010).
For businesses in sub-Saharan Africa, private equity is an invaluable source of finance: although local financial markets are constantly improving, access to finance – and particularly to equity, which is the key to ensuring growth – remains a major issue for African businesses.
The quantitative impact on local development
Private equity also contributes to develop local economies. To gauge its impact, PROPARCO has strengthened funds portfolio monitoring with a systematic reporting of the results of funds’ investees companies. To do this, it uses quantitative indicators relating to non-financial issues (Table 1). Its analysis shows that the 229 businesses funded by its private equity funds portfolio in sub-Saharan Africa employed 50,000 people for both skilled and unskilled labour. For those companies that reported data, workforce grow by an average of 11% a year.
In terms of economic activity, average annual growth in turnover has been 16.5% and the average growth in earnings before interest and tax (EBIT) 12%.4 The pattern and scale of growth in these businesses varies according to the stage they have reached in their development, the country in which they are located, their size, and the sector within which they operate. Higher turnover is noted in the countries of East Africa, for example.
This twin growth – a higher pay bill and a higher level of economic activity – also means businesses make a more substantial contribution to state revenue: the 87 businesses in the sample providing this information contributed more than EUR 230 million in taxes to domestic governments in the countries in which they were based during the last fiscal year.
Comparison with other geographical regions, including France, highlights the greater impact that private equity has in Africa than in Europe, where businesses have been harder hit by the economic and financial crisis.5 The added value of a management team in sub-Saharan Africa is also felt both in increased earnings and in improved business profitability. In more mature markets, such as the French market, by contrast, the added value tends to focus more on financial leverage or bargaining on the purchase or exit price.
The qualitative added value of management teams
Beyond these quantitative benefits on local economic development, though, private equity also offers an effective lever for value creation within a business. As shareholders, management teams can instigate good management practices, good governance arrangements, more appropriate organisation, more transparent financial reporting, and more efficient human resources. This added value is particularly marked in sub-Saharan Africa, where businesses frequently still operate informally or are based on family structures. Some management teams are instigating financial reporting arrangements geared specifically to improving corporate governance, including such measures as increasing the number of businesses subject to auditing, setting up committees to monitor activity, establishing performance indicators, or monitoring budgets. The impact is even greater where the investor has a majority shareholding or where he is investing in a start-up that is still structurally underdeveloped. In such cases, the investor can boost development of the business, for example by putting forward key managers from within his own networks.
The presence of development finance institutions means that investment is increasingly being used as a vector for improving environmental and social (E&S) performance. Before they make their investments, management teams assess each business’s main E&S risks, identify ways in which they can be mitigated, and set out action plans for helping the business reach compliance with national and international standards. These improvements also act as levers for boosting performance in other areas: acquiring certification can, for example, open up new markets, while reducing energy consumption helps to drive down overheads.
How can the impact of private equity be maximised?
If private equity is to make a greater contribution to developing the continent of Africa, then high-quality management teams need to be convened and consolidated that are able not only to structure and support businesses but also to embed the development criterion as a key objective for investment.
Ultimately, however, the tried-and-tested criterion of profitability is based on the quality of the management team. A good team should have good operational skills. Creating value in sub-Saharan Africa takes place largely through the lever of growth, unlike in European markets, where it relies heavily on the lever of debt and on cost rationalisation. The organisational skills of the fund manager therefore become more important than skills in banking syndication, which are more highly valued in more mature markets. The local profile of fund managers is also particularly vital for success in sub-Saharan Africa, given the greater significance of informal networks there than in other parts of the world. Finally, it is also important to be able to form partnerships with investors, entrepreneurs and other parties involved.
A high-quality team is also a team able to support good governance and improvement in a business’s environmental and social performance. As a result, some funds make technical assistance envelopes available to businesses to strengthen specific aspects of their management or organisation. 43% of the investee companies surveyed within PROPARCO‘s sub-Saharan Africa funds portfolio had their compliance with international environmental and social standards evaluated before investment was made, and all these businesses reported that they had received support to improve their performance in these areas.
Where local development is considered as important as financial indicators, it shifts to being one of the main objectives of investment. A number of specific development objectives need to be defined and assessment tools need to be developed in order to evaluate results transparently through a reporting standard or by means of an external evaluator. Governance should also be structured to achieve these objectives.
There are a growing number of examples of this happening. The Africa Health Fund, for example, which was set up to develop high-quality and affordable health care for populations in sub-Saharan Africa, especially those at the bottom of the income pyramid has linked fund managers’ remuneration to achieving this specific objective. Governance has been supported by external evaluation of the targets for populations affected by the businesses.
Effective measuring of impact has become one of the key issues involved in boosting the effects of private equity in sub-Saharan Africa. Reporting of indicators has limitations and does not by itself ensure that all the relevant qualitative data are taken into account, such as type of business, level of maturity of the business (start-up, growing business or turn-around, for example), quality of employment, integration of populations excluded from economic opportunities, or sectors affected (for example, social sectors).
Moreover, there are still no standardised tools for measuring such impact, which may be reported in very different ways by management teams. For example, one of the first projects carried out by the Global Impact Investing Network,6 through the ‘Impact Reporting and Investment Standards’ initiative, involves defining a standard for measuring the social impact of an investment on the investor.
In contrast to their public image, private equity funds can be major vectors for development in low-income countries. Impact on development and financial profitability are certainly not mutually exclusive. The opposite is true, in fact: profitability enables sustainability of business and means that the reach of development can be maximised but also that new investors can be recruited. Development organisations have a greater part to play than ever in terms of promoting environmental and social performance and boosting the transition to sustainable and inclusive economic models. They also need to fulfil the function of catalyst to cover sectors and countries that investors have neglected, sometimes because they do not know the area and consider it still to be a risk.
1 It is very difficult to compare the internal rates of return of different investors because the reported figures cannot be verified and there is substantial variation in methodology (in particular in terms of: (i) the scope of equity held, either in the investment phase or liquidated, (ii) inclusion of the remuneration of the manager as a gross or net IRR, and (iii) the method used to assess latent added value).
2 Based on a survey of 475 funds with total assets of EUR 38.6 billion (between 1988 and end-2010).
3 The average multiple on invested capital measures cash inflow against cash outflow but does not take into account the temporal dimension of IRR.
4 EBIT reflects net turnover minus operating costs, such as salaries, social security contributions, materials, energy, and so on.
5 AFIC, study by Ernst & Young 2010: as at 31.12.2009, 848,954 jobs in the 1,268 businesses receiving investment funds from 213 private equity funds. The dynamic analysis of growth in the labour force and in turnover carried out in France between 2008 and 2009 highlights a 5.9% decline in turnover in France and a 1.8% contraction in numbers employed over the period.
6 The Global Impact Investing Network (GIIN) brings together about 20 organisations, including banking institutions (such as JP Morgan and Citigroup), alternative investment funds (such as Acumen), and philanthropic foundations, including the Bill & Melinda Gates Foundation and the Rockefeller Foundation.
REFERENCES / AFIC/Ernst & Young, 2011. Performance nette des acteurs français du Capital Investissement à fin 2010, étude, 1er juin. / CDC, 2011. Annual Review 2010, report. / Mamba, G., 2010. The changing profile of Investors in African Private Equity, EMPEA Insight, Special Edition, Private Equity in sub-Saharan Africa, November. / Wilton, D., 2010. A Comparison Of Performance Between First Time Fund Managers & Established Managers Moving Into A New Market. How Important Is Track Record ?, IFC, September 15th.