Has the Private Equity Industry Failed Sub-Saharan Africa?

East Africa has not been a beneficiary of African Private Equity (PE). In fact, according to a 2020 Preqin Global Private Equity & Venture Capital Report, PE firms raised less than $20bn in the decade leading up to 2018, the equivalent to just 2.5% of the capital raised by the world’s emerging markets. Moreover, most of that African capital was invested into the relatively advanced economies of South Africa and North Africa, with very little flowing into the rest of the continent.

This limited investment into Sub-Saharan Africa (SSA) is explained by investors in PE funds as a result of the low returns from such investments. The PE firms themselves acknowledge the limited returns, but claim these markets are still nascent and that returns will rise as these economies evolve. Yet the reality is that it may be the approach taken by Sub Saharan Africa’s PE investors that is causing them such poor returns.

As it is, nearly two thirds of the region’s private capital investment is made by larger PE firms who inject more than $50m per investment. However, the scale of such sums can make for a reduced risk appetite. As a result, such funds seek out traditional business models with limited operational risks, established profits, and the potential for exit within the fund’s lifetime. Typical have been banks, insurance companies, manufacturing, and consumption-led businesses targeting the top 5% of African consumers.

But the limited number of such businesses in SSA has created strong competition for any eligible transaction, pushing investors to enter at high valuations into businesses serving a customer segment that is barely growing – compared with the 95% of underserved Africans. As a result, many of these transactions are sales by existing shareholders rather than investments into the company, further limiting the new growth they generate. Such dynamics clearly limit returns.

In recent years, however, smaller investment firms have begun backing young, entrepreneurial businesses with investments as low as $500,000. But with smaller capital pools and limited scope to support capacity building, these investors have struggled to take these investments to their full potential. Consequently, these businesses are also suffering some inherent issues that are driving low returns. While they are targeting large local problems, they are often relying on the developed markets’ business models, which are not supported by the fragile infrastructure and under-developed fundraising ecosystems of our region.

A case in point is the proliferation of digital credit for the unbanked in East Africa. Digital data, which worked well as an underwriting tool in developed markets, has proven woefully inaccurate in Kenya. As a result, large numbers of loans have been granted which has led to defaults, with Bloomberg recently reporting that 1 in 10 adults in Kenya has defaulted on a digital loan. This has damaged both the new loan businesses and the borrowers too. The lesson in such cases is to pursue and support the development of local solutions.

At Aavishkaar Capital, we faced such a situation after the India Microfinance Crisis of 2010-11, when local government stepped in to curtail the industry’s recovery practices, which had led some borrowers to suicide. Rather than demonising microfinance and shutting down the sector, regulators put in place checks and balances to protect consumers and investor with industry leaders revising the sectors’ underwriting and strengthened self-regulation. Subsequently, microfinance bounced back as a $28 billion industry serving more than 60 million customers. If regulators, industry and investors can come together to achieve successful digital credit for the informal sector through microfinance, there is no reason such success cannot be emulated elsewhere.

Indeed, impact investors in emerging markets, such as India, have repeatedly demonstrated that backing indigenous businesses and local entrepreneurs in finding solutions to large social and economic problems creates successful businesses. In less than 20 years, Aavishkaar Capital has made 67 investments in India and South Asia that provide profitable solutions to complex social problems – and secured 36 exits along the way. Our portfolio is positively impacting more than 105 million lives (more than 50% of them women) and addresses 13 out of the 17 SDGs. Examples of recent successful businesses include Nepra, a dry waste recycling company that has cleaned up our congested cities, and Agrostar, an ag-tech company helping farmers to access quality inputs. We believe Africa offers similar opportunities, based on its structural parallels, including a young aspiring demography, deepening technology footprint, rapid urbanisation – with its unwarranted side-effects – underdeveloped public infrastructure, and a largely agrarian and unorganised workforce. Business solutions such as dry waste management through recycling and upcycling; enabling access to quality inputs, knowledge and markets for small-holder farmers; and providing working capital financing to informal sectors through physical and digital underwriting offer huge potential.

In this, businesses in Africa operate in smaller markets and are handicapped by a dysfunctional banking system and inadequate capital markets. But we believe that where investment funds can source exceptional local entrepreneurs, with on-the-ground experience, and back them with enough capital and capacity building, they can execute a successful investment strategy. Even as Africa offers the potential to be the growth engine of the world, private investors must wake up and recognise that what hasn’t worked in the last two decades is unlikely to work going forwards and make amends, or risk becoming irrelevant forever.

By Abhishek Mittal, Partner, Aavishkaar Africa Fund, Aavishkaar Capital