Manufactured Opportunities
By: Brittany Girling & Tanju Dutta
The Ivey Business Review is a student publication conceived, designed and managed by Honors Business Administration students at the Ivey Business School.
When thinking of Africa, poverty and war are themes that come to mind well before good investment opportunities. The continent, however, is on the tipping point of a manufacturing and export-driven boom not seen since late twentieth century East Asia. Despite the potential to monetize this growth, private equity remains sluggish in entering the region, making Africa the best destination for new private equity funds.
There is one region in Africa, the East African Community (EAC) – consisting of the stable nations of Tanzania, Kenya, and Uganda, as well as recovering Rwanda and Burundi – that holds great promise for private equity investment in the manufacturing sector. With low-cost labour, significant natural resources, devaluing currencies, and rising infrastructure investment, the EAC’s underdeveloped, fragmented manufacturing sector is a prime entry point for a private investment strategy.
The opportunity is attractive as the EAC has recently undergone significant development, becoming a common labour and goods market. It is set to introduce a common currency and become both a monetary union and a single political federation by 2015. There is also potential for strong returns as companies within the region generally trade at lower EBITDA multiples and are less levered than those in Western Africa. Also, the EAC is still in its development stage leaving room for potential multiples expansion.
Labour’s March from Asia to Africa
East Asia’s low-cost labour has been a fundamental advantage drawing manufacturing from the West to the region. Due to China’s recently rising labour costs, however, the World Bank projects that 80 million manufacturing jobs will be transferred out of the country, most of which will land in Africa.
The EAC is able to capitalize on this migration, as it is undergoing a powerful demographic transition. The working-age population is expected to climb from 53% to 60% by 2050. EAC’s average monthly wage for low-tech manufacturing is also far below that of China, and even below other comparable African nations, such as Zambia. This labour supply has made Africa, and specifically the EAC, the new hot spot for low-cost labour.
Natural Resource Advantage
Another advantage of the EAC is its abundance of natural resources. The EAC has an even greater proportion of forest than the Economic Community of Western African States (ECOWAS), and a greater proportion of arable land than the rest of Sub-Saharan Africa. This implies easy access to raw materials and a strong potential for industries such as timber production and low-tech manufacturing requiring arable crops (e.g., cotton) to develop in the region.
Bottlenecks
One historical obstacle for African nations has been their underdeveloped infrastructure, which is estimated to decrease the continent’s annual real GDP growth by 2% and has reduced productivity by 40%. Manufacturing has been hit the hardest by unreliable utilities, with an estimated 13% of the working day being lost to power outages.
However, the situation is improving with the American private equity firm Blackstone set to invest $3 billion over the next five to ten years in African power products; contributing to the $25 billion invested in Africa’s infrastructure annually. Driven by these investments, the United Nations Industrial Development Organization estimates per capita manufacturing value added (MVA) to be growing at 6.7%, and expects up to 9.7% MVA growth as infrastructure develops. This is not far from China’s average MVA growth of 9% from 1980-2000. The improved infrastructure investment should lay the foundation for a much needed productivity boost.
Past the Tipping Point
In the 1980s, the Chinese government took action by consolidating the fragmented manufacturing sector into state-owned enterprises. It then encouraged private investments in China through tax breaks, strengthened private property rights, and legal reform. These reforms, cheap labour, and a stable currency helped propel China to a 9.5% average real GDP growth from 1987-2002, driven largely by manufacturing exports.
A closer look at EAC uncovers similar policy decisions, seeking the same results. The difference being that EAC nations, such as Tanzania, are currently encouraging privatization of their state-owned enterprises through improvements in foreign direct investment policies. This has spurred an attractive industry for foreign private investments, setting the stage for foreign private equity funds.
The small scale of fragmented manufacturers (with an average market capitalization of $50 million) is preventing them from being competitive. To combat these issues, the 2010 EAC Common Market Protocol trade-bloc has allowed capital and labour to flow freely within the region, allowing manufacturers to operate within a greater geography and benefit from accompanying economies of scale. As a part of this Protocol, EAC nations have also allowed their currencies to devalue, making exports more attractive to foreign consumers. Now, all that is needed to catalyze high export growth is foreign investment.
The Private Equity Play: Strategic Partnership and Consolidation (SPC)
Private equity funds, due to their large commitment and illiquid nature, have shied away from the region until recently. Of the cumulative $212 billion raised for private equity investments in emerging markets, less than 5% was committed to Africa. As a high level of capital committed to private equity globally sits idle, African manufacturing is sure to be a promising area for investment.
An SPC strategy will first involve joining forces with a large global manufacturing-intensive company and subsequently acquiring and merging multiple manufacturers in East Africa. Due to Africa’s access to natural resources and low-cost labour, companies with experience in low-tech manufacturing will benefit more from the partnership. Low-tech manufacturing companies such as 3M and Nike that have experience with production in Africa, but are not currently in East Africa, are likely to understand the landscape and create the most benefit from expertise and economies of scale.
The strategic partnership with a large global manufacturing player will be set up to create a holding company to act as an acquisition vehicle. This partnership, or syndication, will allow the private equity firm to leverage the partner’s operational expertise, intellectual property, and relationships, which are instrumental in navigating and profiting in a regional market that is not yet mature.
Case Study: Helios Investment Partners & Telecommunication
The telecommunications industry in Africa in the mid 2000’s was fragmented, with mobile penetration rates lagging behind more developed economies. This was blamed on the lack of coordination in the industry as well as poor management and human capital, making it an attractive target for the SPC strategy. When Helios, an Africa-focused private equity firm, set up shop in 2004, they partnered with Portugal Telecom to create the holding company AfricaTel, which purchased stakes in four smaller telecommunication companies. They recapitalized AfricaTel with debt, and have been working with Portugal Telecom to consolidate and grow the existing businesses, including further acquisitions. Having a large consolidated presence has allowed AfricaTel to benefit from leverage, while claiming a market-leading position, with an estimated IRR of 38-40%.
In a consolidation, or roll-up strategy, multiple acquisitions would be made within the same space and integrated by the holding company to grow the businesses into a stable and defensible player. One of the barriers to African manufacturing development is a lack of skilled labour and innovation in production methods. However, strategic partners can create operational advantages by transplanting best practices to acquired companies.
Consolidating and creating synergies is difficult, though plausible in a roll-up strategy. Even without operational integration, the consolidated entity will have increased debt capacity, as well as access to a larger universe of strategic buyers (including the strategic partner) and the option of an IPO. Manufacturing in East Africa is especially poised to benefit from increased leverage. The average leverage for public firms in East Africa is 9.2% compared to 21.7% in West Africa and 33.2% for all other emerging markets. This gives investors opportunity to lever up these companies, further boosting returns.
Execution
Manufacturing private equity deals only accounted for 21% of private equity in East Africa in 2013. This is largely due to investors shying away from smaller sized deals, with the average deal being $25 million, in contrast to a $37 million regional average. Therefore, a deal target around the $20 to $40 million average is recommended, as it will yield the maximum deal flow; though the consolidation strategy allows flexibility to pursue larger or smaller opportunities where sensible. Ultimately, the fund should attempt to build a consolidated entity with a dominant market position, which will require multiple acquisitions of this size, likely resulting in an overall entity value between $250 to $500 million.
Debt Financing
This private equity roll-up model requires access to debt. Private debt arrangements with investment funds are the most common source of debt for private equity, with a record $155 billion being invested in emerging market debt in 2013. Further, to promote African development, the World Bank has created programs to attract financing to the continent and increase investment attractiveness. The Bank offers loans to finance private equity transactions at a rate that is 3-6% less than market rates, and the Bank will also facilitate syndication with other debt providers and provide Private Equity Insurance. The insurance costs about 1% of insured assets per year for a maximum 15 years and $220 million to protect from war, political risk, and natural or economic disaster. A company must demonstrate developmental opportunities and long-term commitment to their projects. Private debt arrangements alongside World Bank financing are recommended as they lower the cost of debt while avoiding the inherent risks in other popular instruments such as Eurobonds.
Exit
It is important to plan an exit for investment opportunities to realize returns at the end of a private equity transaction. Portfolio companies have the option of exiting via an IPO on domestic exchanges, or on foreign exchanges; such as through the use of American Depository Receipts (ADRs). Although ADRs were the most common African IPO exits until the turn of the millennium, local offerings have been outpacing them since, and serve as an attractive form of exit.
Selling to a strategic buyer is another option if capital market development lags. The first avenue to explore is the strategic syndicate partner used through the investment period, especially if they are a strategic operation company looking to vertically integrate production in Africa.
Capital inflows to Africa are almost inevitably labeled “charitable” or “social.” With its current economic trajectory, however, Africa is bucking this trend, becoming not just a place for social investment but the best opportunity for new private equity funds, period.
