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Private equity in East Africa

By David Lekerai

What is Private Equity?

Private equity is a type of investment class that involves the purchase of interests in private companies. While some investors may opt to purchase shares in publicly-traded companies such as those listed on the Nairobi Securities Exchange, private equity investors instead focus on acquiring controlling stakes in private companies, often referred to as "portfolio companies". This is usually achieved by acquiring the majority of the issued shares of a portfolio company or acquiring a minority stake with significant veto rights. The goal in private equity is to control a portfolio company and steer it towards increased profitability, thereby resulting in a return for investors when the stake in the portfolio company is sold after a period of time.

The process described above is achieved through a private equity fund: an investment vehicle formed and managed by a fund manager with the goal of making investments in portfolio companies. Fund managers are key players in the private equity space, as they are ultimately responsible for determining which investments the fund makes, when to divest from those investments and all investment-related decisions in between. Some prominent fund managers operating in East Africa include Actis Capital, AfricInvest, Catalyst, Helios Investment Partners, Kuramo Capital and Ascent Capital Partners. These fund managers will often operate multiple private equity funds at a time, with each fund focusing on a different industry, sector or even region.

The work of the fund manager would be futile, however, were it not for the investors who choose to invest in private equity funds. Due to the risk associated with private equity investments and the large amounts of capital required to invest in portfolio companies, private equity is typically restricted to institutional investors that are sophisticated enough to appreciate the risks involved and have adequate capital reserves to withstand a potential loss of their investment.  These investors include development finance institutions, pension funds, endowment plans, sovereign wealth funds and other similar entities. In Kenya, pension funds are increasingly considering private equity investments as a way to diversify their portfolio. This has been made possible by the amendment to the investment guidelines under the Retirement Benefits Act 2016 which allowed pension fund managers and trustees to invest up to 10 percent of assets under their management into private equity and venture capital funds.

How Do Private Equity Funds Operate?

Once a private equity fund has been formed and its investors have been on-boarded, the first order of business is to identify the investments that the fund should make. This entails screening several portfolio companies to identify investments that meet the fund’s particular investment criteria, which could include a specific lifecycle stage of the business (e.g., start-up, growth, mature), size, location and industry, among others.

To achieve this, fund managers will leverage their vast networks and extensive experience in the investment space to source proprietary investment opportunities. Portfolio companies may also come to the attention of fund managers through public auctions, in which case the fund manager will competitively bid to acquire the portfolio company. Alternatively, fund managers may hire investment banks to assist with the sourcing of investment opportunities that meet the fund’s criteria.

The screening process does not stop there, however. Even after identifying a potential portfolio company that is the right fit for the fund, fund managers still need to “kick the tires” on the business to ensure it is indeed a viable investment opportunity. This is achieved through a process known as due diligence: a comprehensive appraisal of the various facets of a business to confirm the assets and liabilities of the business, as well as to identify any latent issues that may affect the value of the business. For this reason, the due diligence process can be quite extensive and time-consuming. The time and effort expended during due diligence is crucial, however, as it is the only opportunity the fund manager will have to analyze the business and determine if it is indeed the right investment for the fund. 

Once the due diligence review is complete, the fund manager will make a decision as to whether to proceed with the investment. Adverse findings during the due diligence process could lead to the fund manager walking away from the deal altogether. Alternatively, the fund manager could use these adverse findings as leverage to negotiate a lower purchase price due to the increased perceived risk of the business. Fund managers will often also condition the completion of the transaction upon certain changes being made to the business’ operations in order to cure issues that were diagnosed during due diligence.

What Value Does Private Equity Offer?                     

In light of the time-consuming and expensive process involved in forming a private equity fund, on-boarding investors, sourcing and screening potential investment opportunities and eventually making an investment, it is worth pausing to discuss the actual benefits of private equity investments. After all, why would one go through all this trouble if the reward was not worth it?

For a business, the immediate upside of a private equity investment is quite straightforward: capital. Businesses need capital to purchase assets, maintain and scale their operations, pay debts and salaries, integrate their value chains, etc. Capital is essentially the life-blood of a business, and private equity funds offer capital that is often less expensive than the more traditional sources of capital available in the East African market.

In addition to injecting capital into the business, private equity funds will work to improve the corporate governance and management of the portfolio company. As a shareholder in the portfolio company, the fund will often appoint new directors to the board to oversee the operations of the company and hire new executives to bring fresh perspectives and ideas to the company, as well as improve the standards, efficiency and corporate governance of the business. Increasingly, private equity funds will also require their portfolio companies to adhere to heightened standards with respect to environmental, social and governance policies, anti-money laundering and ‘know your customer’ safeguards, as well as anti-bribery and anti-corruption procedures, to mention but a few. In this way, private equity funds encourage responsible investment by promoting businesses that contribute to the economy, the society and the environment.

For investors, private equity is an attractive investment class because it has the potential to generate returns that are superior to those available in other types of investments, such as government securities and listed securities. The case study discussed further below demonstrates the types of returns that can be achieved in the private equity investment class. 

Private Equity in Kenya: A Case Study

Private equity is still a fairly recent entrant into the Kenyan investment landscape. Just over a decade ago, the commercial private equity industry was largely based out of Southern Africa. However, East Africa, and particularly Kenya, has become an increasingly important destination for private equity investors, as evidenced by a recent survey which revealed that Kenya is considered by the highest proportion of fund managers as an attractive country for private equity investment in Africa. In fact, Kenya now ranks third behind only South Africa and Nigeria in terms of private equity transactions in Sub-Saharan Africa, with private equity funds investing more than US$750 million in Kenya from 2013 to 2015 and US$1.2 billion from 2017 to 2019. The rest of East Africa is also becoming a key investment destination for private equity funds. Uganda and Ethiopia, in particular, have recently emerged as the second and third countries of choice for private equity investments in the region, as evidenced by their capturing of 15% and 6% of the deal volume in East Africa from 2017 to 2018, respectively.

Encouraged by the increased private equity activity in the region and the focus of fund managers on the continent, various lobby groups have sprung up to buttress the industry. The East Africa Venture Capital Association ("EAVCA") and the African Private Equity and Venture Capital Association ("AVCA") are two examples of such lobby groups whose purpose is to promote and enable private equity investments regionally and across the continent, respectively.

Even with increased interest in private equity and a growing lobby to support the industry, there have been few success stories in the Kenyan private equity space. One critique that is often leveled against the private equity industry in Kenya and much of sub-Saharan Africa is that although there are plenty of investments being made, there are relatively few successful exits. After all, private equity investors and fund managers primarily recoup their investment when the investment is exited (i.e., when the fund’s interest in the portfolio company is eventually sold) and the proceeds of the sale are distributed to the investors and the fund manager.

While there is clearly room for improvement in this regard, recent statistics indicate that the prospects for private equity exits are improving. Based on 33 exits achieved by private equity funds operating in the East African region between 2013 and 2018, exit yields on average ranged between 17 and 23 percent on a dollarised internal rate of return.[1] Kenya alone accounted for 26 of these exits.

Take the recent example of Fanisi Capital’s exit from Hillcrest International Schools.[2] In 2011, Fanisi, a Kenyan-based fund manager, invested in Hillcrest, which was on the verge of bankruptcy at the time, and paid off its creditors to the tune of Kshs 1.8 billion. To ensure that it fully understood the state of the business prior to the acquisition, Fanisi retained legal counsel to perform a legal due diligence review on Hillcrest with respect to the business’ corporate status, real estate holdings, intellectual property rights, licensing and regulatory requirements, material commercial contracts, financing arrangements, as well as other material matters. This required the involvement of several practice areas, including corporate, real estate, commercial, dispute resolution and tax. The role of legal counsel also entailed drafting and negotiating the various transaction documents in order to capture the terms of the transaction as between the parties and managing the satisfaction of all other requirements to achieve completion of the transaction.

Seven years down the line when Fanisi was ready to exit the investment, Fanisi instructed DLA Piper Africa, IKM Advocates ("IKM") to represent the fund manager as legal counsel in the exit process. IKM’s role involved coordinating with the buyer, Dubai-based GEMS Education, to provide all the information GEMS required in order to conduct its own due diligence on the business. IKM then negotiated the exit agreement on behalf of Fanisi, a document which set out the terms upon which Fanisi would sell its interest in Hillcrest to GEMS. Finally, IKM assisted with the related completion matters to ensure a smooth transition of ownership of Hillcrest from Fanisi to GEMS.

In this way, Fanisi was able to invest in Hillcrest and successfully exit at a profit. This deal is a testament to the earnings potential of private equity in the region and particularly in Kenya.  In fact, this transaction was recently crowned the “Private Equity Deal of the Year” at the DealMakers Africa Awards.  This deal also showcases the role legal firms play in private equity deals: from structuring the investment and conducting thorough due diligence to negotiating the transaction agreements, assisting with regulatory approvals and satisfying other requirements to ensure deal completion.

There is clearly still much work to be done to transform private equity in East Africa into an industry that can consistently produce attractive returns for its various stakeholders. However, as has been exemplified by the Fanisi exit from Hillcrest, it can be done. Under the stewardship of responsible fund managers advised by experienced legal firms and with increased participation from a broader range of investors (such as pension funds), more capital can be put to work to build better businesses and unlock improved returns for investors. This is the formula that will strengthen the private equity industry in Kenya and build a stronger and more vibrant economy for the nation, the region and even the continent.

The article was also featured in the East African Newspaper on 21 March 2020.