Ladies and Gentlemen,
Thank you for having me here today…
I have been asked to give a presentation surrounding investing in Emerging Markets and Africa: the opportunities, the financing gaps and the relatively new, but popular, potential for private equity investment.
However, I am biased.
Instead, I am going to focus my presentation on Sub-Saharan Africa, which I believe will be the next big emerging market and discuss with you the opportunities for investing on the continent, where I believe the largest financing gap lies and the potential for private equity investors to embrace Sub-Saharan economies.
Firstly, please allow me to justify my seemingly bold statement and highlight that I am not alone in viewing Sub-Saharan Africa as the next emerging market. Indeed, Forbes and numerous financial analyst firms agree that Sub-Saharan Africa will continue to go through a growth transition over the coming decades, underpinned by stronger (and more stable) economic fundamentals and growing investor appetite.
Sub-Saharan Africa used to be deemed too risky for many investors due to its economic volatility (partly driven by a dependence on primary commodities) and a poor reputation for political instability and high corruption. However, since the turn of the millennium, governance has improved across much of the continent, which in turn has allowed prudent macroeconomic and fiscal policies to prevail, accumulate reserves and safeguard economic stability. Further, the penetration of mobile phones and general telecommunications infrastructure will only improve the business environment and render Sub-Saharan Africa a popular investment destination with strong economic growth, and thus the next emerging market.
What are the opportunities?
As mentioned before, there are vast investment opportunities in Sub-Saharan Africa, supported by recent improvements in the investment climate and growing appetite for investments in Sub-Saharan Africa. I will discuss just three areas that I believe present a rewarding opportunity: the quest for a yield, growing foreign direct investment and green development.
The quest for a yield
The quest for yield demonstrates perhaps the most obvious advantage to investing in Sub-Saharan African countries. For the past decade, since the financial crisis, financial markets in advanced economies have been characterized by low yields and high liquidity, thus presenting no domestic investment opportunities yet ample demand to invest. In the immediate aftermath of the financial crisis, yields across many emerging market economies in Europe and Asia increased, some reaching double digits and presented an attractive market for investors looking to make a return. However, more recently Treasury yields in emerging market economies in Europe and Asia have also fallen dramatically, presenting lesser opportunity for investment.
Yet, interest rates across Sub-Saharan Africa continue to be amongst the highest in the world.
This Sunday, average Treasury bond yields varied from minus 0.55% in the Eurozone to 1.44% in the US. In India, Russia and South Africa (three of the BRICS), Treasury bond yields varied from 5.90%, to 6.90% and 6.0% respectively. Meanwhile, in Sub-Saharan Africa, Treasury bond yields are mostly in double digits. The 10-year Treasury bond yield (no averages are calculated) currently stands at 12.97% in Kenya and 14.40% in Uganda.
Furthermore, whilst Sub-Saharan Africa was once considered a risky geography to invest in, and consequently high interest rates were considered an insurance mechanism against the risk, this sentiment has much reduced since the financial crisis. Indeed, since the financial crisis, economic growth in Sub-Saharan Africa has vastly outperformed that in the advanced economies (excluding what is expected to be a temporary blip in 2016) and inflation has largely been brought into single digits by prudent macroeconomic policy.
Since the financial crisis, Sub-Saharan Africa has experienced a substantial inflow in foreign direct investment (FDI), driven by the aforementioned attractive interest rate environment, but more so by the potential economic opportunities on the continent amidst better governance and arguably less corruption. As one example, investment from the Chinese government into Sub-Saharan Africa has more than doubled between 2013 and 2017, from US$26 billion in 2013, to exceed an anticipated US$60 billion in 2017.
In 2016 however, FDI inflows fell slightly, by 3%, due to the global fall in commodity prices. Yet are expected to have increased by 10% in 2017 again due to a recovery in commodity prices. Nonetheless, although FDI has largely increased over the recent period, Sub-Saharan Africa still only receives 3.4% of all global FDI flows, of which 57% are concentrated in just five (largely commodity abundant) countries: Angola, Egypt, Ethiopia, Ghana and Nigeria.
I strongly believe that if Sub-Saharan Africa could develop more diverse economies, as I believe is happening at present, then I am very confident that FDI inflows would increase dramatically and show more resilience to commodity price fluctuations.
Yet, increased foreign direct investment will reverberate through African economies, providing economic growth and developing financial markets, both of which will trigger additional investment opportunities, and create a more stable business environment for future investments. Some large investments also present an opportunity in themselves through syndicated financing, many of which may come with a form of government or donor guarantee against political and economic risk.
Finally, one sector that I believe is both critical to sustainable development, but also presents an attractive investment opportunity is green development. As the Director General of a regional development finance institute, green development is particularly high on my agenda.
Unavoidably, the whole world will have to adopt green business development in the foreseeable future. Although developed countries industrialised under mass coal burning, this is simply not an option for Sub-Saharan Africa. Given the current state of the world and the substantial, and rapidly growing, Sub-Saharan African population, a repeat of European industrial revolutions across Sub-Sahara would be extremely detrimental to the planet, very likely to tip climate change beyond the point of return.
So Sub-Saharan African countries have no choice but to adopt green business development as they pursue economic development. However, this presents an exciting opportunity for Sub-Saharan countries to use their deficits in infrastructure and industry to leapfrog to more modern, efficient and ultimately green technologies. Under the Paris Agreement, developed countries have been compelled to set aside vast pools of capital to invest in green development in developing countries as developing nation’s governments are increasingly coerced to focus on green investments. Consequently, many Sub-Saharan economies are awash with consultancies that offer technical assistance for green financing, policies and governments that favour green financing and grants and incentives for green investors. I believe that green investments in Sub-Saharan Africa truly present a lucrative, and worthwhile, investment opportunity due to their sustainability and the global appetite for them.
Where are the financing gaps?
Now, please let me continue to the financing gaps that hinder potential investments in Sub-Saharan Africa.
Despite the growing investment opportunities in Sub-Saharan Africa, there remain many financing shortfalls. In particular, I believe that the largest financing deficits, or hindrances, result from the lack of financial development, and thus the limited range of financial instruments to invest in productive economic activity, and from the lack of regulation that also affects what investors may use as collateral and the risk premium placed upon investments by many lenders.
Underdeveloped financial markets
Sub-Saharan financial markets are famously underdeveloped, characterised by prohibitively high interest rates, capital markets that are dominated by short-term government securities and a lack of diversity in financial instruments.
In Uganda, the weighted average commercial bank lending rate currently stands at 21.4%, over 12 percentage points above the Central Bank Rate. In Kenya, the weighted average commercial bank lending rate is currently capped at 14%, although this may soon change due to the distortionary (credit rationing) effect that such an apparently artificially low interest rate has provoked. Overall, lending interest rates in Sub-Saharan Africa are extremely high. High interest rates deter private investment through requiring an extremely high profitability margin in order to simply repay any debt incurred and thus prevent any marginal firms from being able to responsibly access credit.
Whilst many larger companies may be able to source alternative forms of financing through internal channels or on capital markets, this is simply not an option for SMEs or new enterprises. Particularly in Sub-Saharan Africa, where large informal sectors are characterised by either the self-employed or small and medium-sized enterprises (SMEs), SMEs provide an enormous contribution to the economy. Successful SMEs tend to locate themselves in an integral position in value chains, therefore becoming essential to economic activity in certain sectors and significant to economic value addition. However, SMEs frequently face challenges in accessing finance due to the high commercial interest rates available, little to no alternatives in raising finance (as they are too small to raise finance on capital markets), lesser investment capacity and a higher risk perception. Further, SMEs are more likely to seek finance from trusted local micro-finance institutions, which typically lack the knowledge and business acumen of larger financial institutions.
Finally, the lack of alternative forms of bank financing to extremely expensive debt also deters investment. Development of a wider range of financial products would allow enterprises to attract financing that meets their requirements and would thus encourage greater investment into the region. However, perhaps financial market development is also constrained by the regulatory environment, which I will consider next.
Lack of regulation
Part of the reason why interest rates are so exorbitant in Sub-Saharan Africa and why there are few alternative financial instruments relates to a general lack of regulation. Weak land registration and verification (which is commonly used as bank collateral), asymmetric information regarding borrower history and poor enforcement capacity regarding financial transactions all act to increase the risk premium attached to any individual transaction.
In Sub-Saharan Africa, less than 5% of rural land is privately owned; approximately two thirds of land is held under customary tenure, where land rights are embedded in the culture, but typically not formally recorded or legally recognised. Lack of land ownership, or even confidence that the claimant legally owns the land prevents many Africans from owning collateral that they may use to access finance. And where land is used as collateral, weak registry systems increases the risk that the land may not actually belong to the borrower and thus increases the potential loss from lending, thereby necessitating higher interest rates.
There will always be some aspect of information asymmetry between borrower and lender in any financial transaction. Elevated information asymmetry (where lenders have limited information on the borrowers ability to repay) is proven to lead to a situation of multiple borrowing and over-indebtedness, which eventually increases loan default. In many developed countries, credit reference bureaus enable banks to share customer information to easily identify borrowers that have defaulted in the past, thereby improving the lenders ability to predict default and reducing the risk cost attached to a financial transaction. However, credit reference bureaus are relatively new and much less developed in Sub-Saharan Africa, which again drives up the risk premium attached to any investment.
Overall a better-regulated economy reduces the risk and thus the cost involved in transactions. Better regulation would foster financial market development and encourage much greater investment into Sub-Saharan Africa.
Opportunities for private equity investors in Sub-Saharan Africa
Related to the above, I believe that despite the underdeveloped financial markets and risk premium attached to Sub-Saharan investments, there is an opportunity under the strong potential profitability (amidst a comparatively weak global investment environment) and increasing capital inflows to the region, to drive economic development, particularly through investments in equity.
The opportunity to invest in public equity in Sub-Saharan Africa has expanded dramatically since the turn of the millennium. In 2000, there were 16 stock exchanges (with varying degrees of activity) in Sub-Saharan Africa, with only 66 firms listed. By comparison, in 2017, there are now 25 active stock exchanges that serve 34 countries and contain 1,025 listed firms. Whilst some of the stock exchanges remain relatively small compared to those in advanced economies, and even in some emerging economies, their growth over the recent period is impressive and typically supported by government policies to attract more sustainable, private sector investment.
Commercial finance in Sub-Saharan Africa tends to focus heavily upon debt, yet private equity offers the potential to invest in enterprises that may not have the capacity to absorb large sums of debt, particularly in new enterprises that are poised to grow very quickly given the right financing.
However, private equity is beginning to develop across the continent. In 2017, pan-African investment funds contributed US$3 billion in private equity across the continent. Overall approximately US$57 billion was raised globally by investment funds in 2017, more than twice as much as was raised in 2016. The aforementioned quest for yield may be driving capital into investment funds, but it certainly provides a growing opportunity for private equity investments, globally and in Sub-Saharan Africa.
The development of impact investors presents a similar opportunity. Impact investors tend to focus on investments that will yield a positive social and environmental impact, alongside competitive financial returns. Globally, impact investment has grown by a compound growth rate of 18% per year over the past two years and is expected to continue to grow. Given its poor economic and social development, and generally weak scores in the UN’s Human Development Index, Sub-Saharan Africa presents a particularly attractive investment opportunity for impact investors, so long as investors can be promised financial rewards alongside development.
Compared to public equity, private equity investors also have the added benefit of avoiding government policies and interference and solely working alongside the (theoretically) more efficient private sector. Given the private sectors thirst for finance in many African economies, and equity investor’s desire to make profits, I believe that both parties’ priorities are very well aligned for successful investments.
To conclude, I have displayed the opportunities and shortfalls of investments in Sub-Saharan Africa. In particular, I believe that green development and growing equity markets provide particularly exciting (in terms of sustainable economic development), but also lucrative, investment opportunities. In addition, I predict that there will be a multiplier effect as investments onto the continent drive economic stability and responsible governance, and thereby encourage further investment.
I hope I have managed to persuade you into the strong rationale for investing in Sub-Saharan Africa and that you are all in agreement with me that the continent will be the next emerging market!