Current News
September 2011
Breaking into the ‘BRIC’
PUBLISHED: Private Equity International Africa Handbook September 2011
BY: Ngalaah Chuphi, Partner, Ethos Private Equity
Click here to view the pdf version of Breaking into the ‘BRIC’
In April this year, in recognition of its special economic and political position within the African continent, South Africa was formally admitted as the fifth member in the elite group of the fastest-growing emerging market economies, officially adding an ‘S’ to the acronym now known as BRICS.
While the country’s size and population aren’t comparable with its BRICS colleagues, Africa as a whole is attracting more foreign direct investment than ever before and South Africa, as the continent’s largest economy, has become the economic gateway to sub-Saharan Africa. The World Bank has said that “Africa could be on the brink of an economic takeoff, much like China was 30 years ago and India 20 years ago,” and with its ability to provide investors with access to the economic activity of over one billion consumers on the continent, among other factors, South Africa is rapidly becoming a sought after private equity investment destination.
Apart from benefiting from its sub-Saharan Africa gateway status, South Africa itself offers a compelling value proposition for emerging market private equity investors. This perspective is grounded in several drivers; each of which is independently persuasive and when combined, create an undeniably compelling private equity investment case.
There are four key drivers which continue to support the prospects for private equity namely: the country’s emerging market growth characteristics; a sophisticated economy that offers developed-world infrastructure and strong corporate governance; private equity enablers that allow ease of execution relative to other emerging market destinations; and a favourable demand / supply balance in the context of capital availability and deal flow. This combination means that South Africa can continue to offer strong private equity returns which can be demonstrated by the 10-year aggregate average net returns of circa 22.8 percent in US dollars as shown in an independent analysis by actuarial firm, RisCura.
Emerging market growth characteristics
Since democracy in 1994, the South African government has implemented initiatives, the best known of which is Broad Based Black Economic Empowerment (BEE), to bring black people into the mainstream economy. This group represents almost 90 percent of the country’s population of 50 million. While there is some criticism about these programmes’ ability to eradicate poverty, BEE programmes have been effective in creating a new and growing black middle class which is fuelling consumption expenditure, driving investment and creating an aspirational class to inspire the younger generations. According to the 2010 living standard measurement (LSM) survey, there has been increased participation by black people in LSMs five to seven, which is considered to be the market of the middle class. Black people now represent 78.6 percent of this LSM segment up from 66.9 percent in 2004.
It is a well-known fact that South Africa is well endowed with natural resources. For example, it is the world’s largest producer of platinum and the third largest producer of gold, and it has significant reserves of coal, iron ore and manganese to name a few. The growing demand for commodities in general, and more specifically as a result of increased demand from India and China, provides a substantial benefit to South Africa. The private sector has taken advantage of the strong commodity prices to expand operations. And the government has embarked on an infrastructure expansion programme to increase its road, rail and port capacity to facilitate the export of these resources. These efforts support continuing economic growth for South Africa for the near to medium term.
South Africa is widely considered the gateway to sub-Saharan Africa. With a regional population in excess of 800 million people and GDP growth that is estimated to be the second fastest in the world, sub-Saharan Africa is becoming a very interesting investment destination for international investors.
South Africa’s geographic location and world-class infrastructure make it an ideal base for foreign companies looking to exploit the burgeoning consumer base. Recent examples of global companies doing just this include the acquisitions of local businesses by Japanese multinationals; Kansai Paints and Nippon Telephone & Telegraph. As well as Wal-Mart from the United States with the intention of using South Africa as a base for expanding operations into the sub-Saharan region. In addition, several regional economic zones such as SADEC, COMESA and the East African Community all promote free trade amongst member states which will benefit South Africa immensely, given its ability to provide goods and services from its developed industrial base as demonstrated by the number of South African corporate such as banks, retailers, telecommunications operators that have established successful operations in other sub-Saharan countries.
A sophisticated economy
South Africa has world-class infrastructure, well developed institutions and very strong corporate governance. The discovery of gold, in what is now Johannesburg, in 1886 was a turning point in the history of South Africa and augured the modern industrial state giving South Africa an industrial base that is in excess of 100 years.
According to the 2011 World Economic Forum Global Competitiveness Report, South Africa is the most competitive country in the region. The country is particularly strong on measures of the quality of institutions and factor allocation, such as intellectual property protection (27th), property rights (29th), the accountability of private institutions (3rd), and goods market efficiency (40th). South Africa also has one of the most sophisticated constitutions in the world and the independence of the judiciary is jealously guarded.
Globally its financial system is ranked ninth overall and local banks emerged from the global financial system relatively unscathed. South Africa is one of the very few emerging market destinations where debt to facilitate private equity transactions is readily available. This is currently available at levels of three to four times EBITDA multiples.
Private equity enablers
South Africa’s private equity industry is active and dynamic and has been supported by well-established enablers that facilitate private equity investing in a manner similar to that practiced in developed markets.
The availability of entrepreneurial management is a key enabler for private equity investing. In addition, investors can also count on a strong adherence to the rule of law, transparent accounting and sophisticated service providers including debt providers as alluded to previously.
Recent changes in legislation provide evidence of South Africa’s improved approach to creating an attractive investor base for local and foreign investors. This includes a general relaxation of exchange control regulations and changes to Regulation 28 of the Pension Funds Act that has allowed the quadrupling of the levels of funds that can be invested into private equity and is expected to increase local participation in the industry.
Prominent and leading international private equity investors have been investing in the South African private equity industry for over a decade. This has ensured that the local private equity industry continues to meet the standards required to satisfy the expectations of sophisticated global investors.
A unique feature of South Africa is the ability for exits to be achieved in a variety of ways rather than mostly through Initial Public Offerings (IPOs) as is the case in other emerging market destinations such as India and China. The preferred local exit mechanism for private equity is through sales to trade buyers. Recently, this has been augmented by the entrance of foreign trade buyers looking for South African assets as a platform for their sub-Saharan Africa strategy. The IPO option is also available and can be exploited when appropriate.
The Johannesburg Stock Exchange (JSE) is ranked the 20th largest in the world by market capitalisation and is 17 times larger than the Nigerian Stock Exchange and 50 times greater than the Nairobi Stock Exchange; an indication of South Africa’s relative size in sub-Saharan Africa.
A favourable private equity landscape
South Africa has a sophisticated private equity industry established in the early 1980s. This heritage has resulted in a few dominant and trusted local players with established networks and proprietary relationships. This allows for a greater level of exclusive deals that often have associated pricing benefits relative to other emerging markets.
The level of private equity capital relative to the level of economic activity is low. While other BRIC countries have larger economies, they have attracted significant capital that has driven up asset prices and deal values with most deals concluded at double digit EBITDA multiples. In South Africa, deals are still being concluded at single digit EBITDA multiples. Even when one takes into account that these other destinations are experiencing relatively higher GDP growth rates, this will not necessarily translate into higher returns. South Africa’s private equity returns are compelling as illustrated by the RisCura analysis.
Conclusion
Like all emerging markets, South Africa has its own political and economic challenges—notwithstanding; in the past 17 years, the country has emerged as an attractive, compelling investment destination. Additionally, it has a unique combination of drivers that enable the possibility of strong private equity returns relative to other emerging markets. When coupled with the gateway opportunity to a developing economic region, investors can access a population expected to reach 1.4 billion by mid-2025 with consumer spending in excess of $1.5 trillion.
The real question investors should ask is, ‘Why not?’
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