Tech-Startups: Investing in Africa’s Small and Growing Businesses (SMBs)

Background

“Africa is the fastest-growing continent in the world. Step by step, it has built the fundamentals for strong structural growth: an unprecedented demographic dividend, improved macroeconomic indicators and the development of a domestic market led by the middle class. These changes have made the continent very attractive for European, North American, Middle Eastern and Asian investors.

In just a few years Sub-Saharan Africa has become the new frontier for private investment. The trend was initially limited to infrastructure, mining and financial services, but is now reaching small and medium businesses, in other words, the generators of jobs that can speed up inclusive growth in Africa. In spite of undeniable challenges, many investment funds are proving that investing in Africa’s SMEs can be viable and have a significant impact on development.

Today, we must go much further. Indeed, Africa’s growth is not generating enough employment and is not sufficiently sustainable. To foster the emergence of Africa’s future job-creating champions, we need to invest today in the high-potential small and early-stage businesses looking for between 100,000 and 300,000 Dollars. Yet, their financing needs fall far below the typical ticket size of investment funds. Just like microfinance revolutionized banking practices by adapting financial services to the needs of the poor, now is the time for investors to adapt their tools to the needs of African SMEs. Though a few pioneers have ventured into the gap, this new industry is still in its infancy.

This article makes its modest contribution by illustrating the practices of the sector and by introducing the specific approach of private equity. It brings together the experiences of investors who have collectively raised and invested several hundred million dollars in SMEs in Africa and shares the view of a dozen African entrepreneurs who received that support.

This document is intended for professionals willing to invest in African small businesses, for African entrepreneurs and for anyone interested in the topic of SME financing in developing countries.”

Small and Growing Businesses

Africa’s growth: faster but not sufficiently inclusive:

During the 2000-2010 decade, 6 out of the 10 fastest-growing countries were located in sub-Saharan Africa1. Today, with average GDP growth of 5% per annum, the region is only surpassed by East Asia. Foreign Direct Investment increased six-fold since 2000 and investor perceptions have changed significantly: private equity investors now identify Africa as the most attractive emerging market2. They invested more than 8 billion USD on the continent in 20143. Growth in the last decade was underpinned by the rapid expansion of new sectors and greater opportunities for a growing middle class. This growth benefitted from profound structural changes brought about by urbanization, expanding domestic markets, improved governance and more robust macroeconomic fundamentals.

Nevertheless, growth remains concentrated in a few sectors (telecommunications, infrastructure, oil and gas, mining and financial services) and has yet to pervade more labour-intensive and value-adding activities (such as agriculture and manufacturing)4. For example, only 3% of Africans are employed in manufacturing as opposed to 15% in Bangladesh5. Human development indicators are therefore fragile, with 46% of the sub-Saharan population living below the threshold of USD 1.25 per day and only 16% having access to a regular wage-paying job6. The poorest countries are also facing serious social tensions resulting from demographic pressures and climate change, two factors that place considerable stress on employment supply and access to basic services. Recent political crises in West and Central Africa are often rooted in economies and the difficulties young people have in finding employment7. With 125 million Africans arriving on the job market between 2010 and 20208, governments and economic operators must find new sources of sustainable employment, both for unskilled workers and new graduates.

SGBs are key to large-scale job-creation in Africa

Increasing production capacity and creating sustainable jobs are necessary conditions to reduce poverty, ensure political stability and nurture the continent’s economic emergence. Unfortunately the African private sector is not structured enough to absorb the newcomers on the job market: only a small number of large formal companies are able to create high quality, sustainable jobs, and the low productivity informal sector (mostly microenterprises and small farms) still accounts for 84% of all employment9. Formal Small and Medium Enterprises (SMEs)10, the pillars of job creation in both developed and emerging countries, are rare in the region. This is the notorious “missing middle” of the African economic fabric.

Formal SMEs not only create large quantities of jobs; they also create good quality jobs. These jobs with higher wages than in the informal sector (50% to 60% higher according to data from Ghana and Tanzania11) are more secure and give access to training and social security12. In addition to its significant impact on income, the regularity of formal wages enables a family to plan for the future, to save money and improves access to credit, housing and children’s education13.

Formal employment is a decisive factor to lift unskilled workers out of poverty, and to allow skilled workers to enter the middle class. The development of a fabric of job-creating formal SMEs is therefore, a key ingredient for inclusive growth in Africa.

In a recent interview with Randall Kempner of Aspen Network of Development Entrepreneurs (ANDE) – a global network of organizations that propel entrepreneurship in emerging markets, he said

“Sub-Saharan Africa suffers from the narrowness of its formal economy: there are so few medium-sized companies in Africa that we call them the “missing middle”. Yet they are key pieces in the puzzle of Africa’s inclusive growth. It is the Small and Growing Businesses (SGBs) of today that will fill this “middle” by becoming the fully formal and sustainable medium-sized companies of tomorrow. We define SGBs as small businesses with at least five employees that are led by management with the ambition and potential to expand rapidly. These firms typically seek growth capital between US$20,000 and $2 million – above the size of most microfinance loans, but below the size of most international private equity investments.

Research has found that job creation is historically concentrated on a fraction of firms in the developed world, where “the top performing 5-10% of enterprises in an economy are responsible for 50-80% of employment generation”.

This has proven to be true in emerging market countries as well: in Indonesia, high-growth enterprises represent 16% of all firms but 52% of job growth; in Colombia, the corresponding figures are 8% and 45%15.

A key challenge for Africa’s inclusive growth is to identify these job-creating SGBs and provide them with the insight and finance they need. Fortunately, we have seen an increase in the number of actors focusing on SGBs in emerging markets, and especially in Sub-Saharan Africa. But while the amount of support is increasing, there remains a significant gap in financing for early-stage SGBs, which have as much potential but are a little younger, a little less organized, and typically require initial investments below US$500,000. Such early-stage SGBs are much more numerous than well-established companies, yet very few investors reach them. Closing this gap is the biggest challenge in SME financing today, and one of the most exciting frontiers of impact investment in Africa.”

SGBs face three major structural obstacles

Small and Growing Businesses (SGBs)16 benefit from the resurgence of economic growth and the development of domestic markets; they are teeming with growth projects that can create value and employment. However, their expansion is hampered both by the general weaknesses of the business environment in Africa (weak infrastructures, size of the informal sector, etc.), and by three major obstacles that affect them in particular: lack of long-term finance, limited access to skills and insufficient standards of governance.

Access to long term finance

African SGBs suffer from a very limited access to the formal financial sector: more than 40% of them mention access to financing as the major factor17 limiting their growth. Indeed in most countries,

existing financial institutions are not tooled to address their long-term investment needs.

The microfinance sector is growing fast in Africa, but its streamlined procedures (with high-interest rates, short term maturities and loans rarely exceeding 20,000 Dollars) are not adapted to SGBs that need to make long term investments.

Commercial banks are increasing their penetration of Africa’s economic fabric, but the typical SGB remains very far from their typical clientele, because of four structural features:

• SGBs do not produce reliable financial data and most countries do not have efficient credit bureaus: this creates strong asymmetries of information.
• SGBs bear higher levels of risk because they are fragile and work in uncertain environments. As a result, the share of non-performing loans for small businesses in Africa is 14.5% as opposed to an average of 5.5% of developing countries18.
• SGBs lack the equity cushions and the financial management capacity necessary to mitigate those risks.
• SGBs have small funding needs which generate high relative transaction costs, due to the time necessary to appraise and monitor the loan.

These four factors increase the cost of financing and risk perception. With neither the tools nor the incentives to adapt to this risk profile, commercial banks limit their exposure by setting stringent conditions for SGB financing:

• Asset-based and cash-based collaterals that exceed the amount of credit.
• High equity requirements.
• High-interest rates.
• Rigid credit conditions with short holiday periods and short maturities.

Few SGBs can meet these conditions. As a result, most banks finance large companies and a few well-known sectors such as trade and real estate. They limit their SGB financing to short term products (e.g. overdrafts and working capital). As a result, credit to small businesses represents only 1.5% of all credit in Africa, four times less than the average in developing countries19.

Equity investment remains unorganized in most African countries: it essentially comes in limited amounts from the entrepreneur’s friends and family circles. It is rare to find structured networks of business angels or investment companies capable of financing a significant number of SGBs.

Challenge #1

In order to grow and create sustainable jobs, SGBs need investors that can adapt to their level of risk and provide personalized long-term finance.

Access to skills

Access to finance alone does not guarantee an SGB’s success. Indeed, mismanaged growth can weaken a business instead of strengthening it. Unfortunately, SGBs are characterized by important operational limitations: a “one-man-band” entrepreneur concentrates most responsibilities and often plays the roles of financial director, sales director and production director at the same time. Quality middle management is hard to retain and entrepreneurs are often overwhelmed.

Periods of fast growth generate a lot of pressure on the company and in particular on the entrepreneur: strengthening internal capacities is often a matter of survival. Unless financial and accounting practices are upgraded, the company cannot achieve sustainable growth. Similarly, unless the SGB’s key operational functions are reinforced (sales, quality, production, etc.), new issues arising from rapid growth may push the company beyond its capabilities and into a minefield of potential mistakes.

Challenge #2

In order to manage growth sustainably, SGBs need support in strengthening their management and operational capacity.

Low governance and management practices

There is little awareness of the importance of governance among entrepreneurs: few are implementing satisfactory governance and management standards. Even when a formal governance is set up (e.g. a board of directors), the nature of the shareholding (often a sole shareholder, or friends and family) often deprives this governance of the necessary discipline and checks and balances required to be truly effective. In some cases, this situation can weaken the business by allowing decisions that are not in its long-term interests (recruiting family members, confusing owner’s assets or cash-flows with that of the company, etc.). These shortcomings are even more frequent when the entrepreneur is both a single shareholder and the CEO.

Finally, the lack of strong governance deters new investors and banks to establish relationships with the SGB. The entry of new shareholders can provide the opportunity to improve standards of governance and management. The single shareholder or family shareholding model is not always an obstacle to development, as proved by the success of numerous family-held companies.

Nevertheless, attracting outside investors with additional skills and networks can be a big advantage for SGBs when they evolve in a context of difficult access to talent and financing. It will also improve the credibility of the business vis-à-vis external partners.

Challenge #3

In addition to the lack of long-term finance and skills, most SGBs are hampered in their growth by their own insufficiencies in governance and management practices.

In a recent interview with Olivier Lafourcade, President of I&P Développement – an impact investment group based in Paris, Abidjan, Accra, Dakar, Douala, Ouagadougou and Tananarive.

“One of the reasons why small businesses are still poorly financed is the investor’s natural behaviour of “creeping up”: even if an investor begins by financing small companies, its average investment ticket naturally increases over time. This is what happened with I&P, which began with investments of between 100,000 and 200,000 USD and now invests between 300,000 USD and 1.5 million USD. This trend is largely explained by transaction costs: it is more profitable to make an investment of 2 million USD in a medium-size business rather than to invest 200,000 USD in 10 different SGBs. Indeed, providing support to ten different companies requires spending 10 times more time, which increases management costs and decreases net profits for the investor. However, we should go beyond the simple arithmetic of transaction costs: first of all, the sheer number of small businesses allows for a very high selection by investors, focusing on the best entrepreneurs. Also, SGBs are at a stage where rapid growth and substantial gains in productivity are possible. The enormous potential of this segment remains largely untapped.”

3. Private equity in Africa: the partial development of a new solution for SGBs

A solution adapted to the needs of SGBs

Private equity investment consists in taking participation in the equity of unlisted businesses for a limited time period, usually 5 to 7 years, at the end of which the investor sells its shares back to the historical shareholders or to new shareholders. The investor may be a majority or minority shareholder and may provide shareholder loans bearing flexible conditions. Equity investment is a “high depth” and “low breadth” model. Investors select a small number of high-potential companies each year on which they concentrate all their financial and operational resources so these businesses achieve rapid growth. As shareholders, they participate in the company’s governance and strategy. Their success is directly proportional to the performance of investees and so it is in their interest to provide the most effective support possible. Equity investors aim for higher returns than banks: when they provide shareholder loans, they typically bear a higher interest rate than traditional bank loans. By acquiring shares of the company, they also qualify for dividends and profit from increases in the share price. If equity investors fully benefit from the company’s growth, they also share all the risks, just like the entrepreneur.

Compared to other financial institutions such as commercial banks, the equity investor distinguishes itself by its ability to effectively meet most of the needs faced by African SGBs:

• Personalized long-term risk finance: SGB investors are equipped to take greater risks since they are very selective and able to closely support entrepreneurs. They can thus provide long-term equity and quasi-equity finance, often without asset-based collateral. The financial structuring is custom-tailored to the needs and cash-flow profile of each investee.
• Accessing skills: as a shareholder, the SGB investor provides individualized management support to the investees in a number of areas of expertise: strategy, financial management, accounting and organizational procedures, marketing and sales, etc.
• Improving governance: as an institutional investor, it structures the governance of the investees and improves management standards.
• Catalyzing effect: the presence of SGB investors facilitates bank financing by increasing the reliability of financial information, reducing the risk of bad management and increasing equity and
• assets that can be used as collaterals.

The SGB investor acts as a growth catalyzer by helping SGBs overcome their three main stumbling blocks: personalized long-term finance, management support and improved standards of governance and management. By including SGBs into the financial and banking system, the investor also plays the role of a springboard: it becomes the missing link in the broken chain of SME financing in Africa.

4. Very limited penetration of the African SGB segment

Most private equity investors active in sub-Saharan Africa do not invest in companies whose investment needs are below USD 2 million: out of the USD 34 billion in African private equity transactions between 2007 and 2014, only 2% were in deals below 10 million USD20. Even below 10 million USD, large companies and well-structured medium-sized companies reap most private equity investment. Investors are also highly concentrated in geographic terms: between 2011 and 2013 more than 60% of investments went to only 3 countries: South Africa, Nigeria and Kenya21.

Finally, private equity investors mostly target sectors where SGBs are not competitive: energy and natural resources represent half of the capital invested in 201322, followed by telecommunications and financial services. That being said, the investment landscape has rapidly evolved over the last 5 to 10 years. An increasing number of investors are now targeting SGBs. They are capable of investing less than 2 million USD per transaction, sometimes as little as 300 000 USD and can target early-stage businesses or start-ups. Some of these are “impact investors”23 who finance businesses that have a strong environmental or social impact, or which are too small to be financed by conventional investors. These investors generally accept below-market returns in order to achieve impact goals.

Nevertheless, most of these investors prefer to finance medium size and already well-structured businesses; they only exceptionally finance smaller businesses with needs under 500 000 USD.

They also remain largely concentrated on just a few countries (mainly South Africa, Kenya, Nigeria and Ghana):

• Grassroots Business Fund (Kenya)
• Acumen Fund (Kenya, Nigeria, Ghana)
• Cauris Management (French-speaking West Africa)
• Injaro Investments (West Africa)
• Pearl Capital Partners (Kenya, Uganda)
• Maris Capital (East Africa)
• Fanisi Capital (Kenya)
• Bamboo Finance (East Africa)
• Oasis Capital (Ghana)
• SONAPAR (Madagascar)
• TBL Mirror Fund (Nigeria, Kenya, Tanzania, Uganda)
• FIARO (Madagascar)
• Investisseurs & Partenaires, through the I&P Afrique Entrepreneurs fund (pan African).

A panorama of the African investment landscape shows that few investors are willing to finance the smaller and more early-stage SGBs, although these companies are much more numerous than medium-sized businesses and are led by some of the best entrepreneurs.

These businesses usually have 5 to 50 employees and a turnover of between 50,000 USD to 500,000 USD; they cannot absorb investments in the range of 1 million USD. Despite their high potential for value creation and impact, they face the absence of relevant investors in most countries.

A new class of investors can seize the opportunity to promote future African champions by investing smaller amounts (e.g. between USD 50,000 and USD 500,000) in early-stage businesses. Some investors have already demonstrated that this is both profitable and produces a significant impact on development. These players developed innovative models which adapt to the constraints of financing early-stage SGBs, for example by relying strongly on quasi-equity in their financing packages. Their value creation strategy focuses on turnover growth and investment rather than internal reorganization or consolidation through merger/acquisition. The following investors target small businesses with needs between 30,000 USD and 500,000 USD, generally early-stage businesses or startups:

• Business Partners International (Southern Africa, East Africa)
• XSML (Democratic Republic of Congo, Central African Republic)
• Grofin (East Africa, Southern Africa, Ghana)
• Sinergi (Niger)
• Savannah Fund (Kenya)
• SME impact fund (Tanzania)
• Kukula Capital (Zambia)
• Sinergi Burkina (Burkina Faso)
• Teranga Capital (Senegal).

Conclusion

Private equity can act as a catalyzer of Africa’s private sector development by providing high-potential SGBs with the adequate financial and human resources to grow and become large and formal companies.

Equity investment can efficiently meet the three main needs of African Small and Growing Businesses: access to long-term risk finance, access to skills and improvement of governance standards. In particular, early-stage SGB investment promises substantial value creation along with developmental impact and stands as one of the frontiers of impact investment. Working closely with some of the best entrepreneurs in Africa also makes it a very stimulating work.

Nevertheless, investing in SGBs is a continuous challenge: a first-time fund manager must combine a number of favourable conditions in order to mitigate the risks associated with this activity.

A few pioneering players have shown that it is possible. They have surrounded themselves with a skilled team, a pool of patient and committed investors and an ecosystem of partners who find a common interest in the emergence of tomorrow’s champions. They showed that SGBs led by strong entrepreneurs can overcome structural obstacles and perform extremely well if they receive the right catalytic push.