By Brendan Mullen and Rushil Vallabh
Private equity has not been the catalyst for growth in Africa that everyone had hoped.
There have been success stories in terms of funds (e.g. Ethos, Abraaj) and companies (e.g. Ethiopia’s Afriflora, South Africa’s Tekkie Town), but speak to any capital provider and they will tell you: the standard private equity model is not structurally sound for the African ecosystem – as evident by the large amount of dry powder, too few deals, limited human capital to run portfolio companies, and constrained levers for liquidity events.
So, can we deconstruct the Find-Fund-Support value chain to build a new model for investing in Africa?
Borrowing pieces from the best capital and value creators is a great place to start: Search funds are useful for embedding management talent into a business through smart investors; holding companies can focus long-term on ‘boring’, enduringly profitable businesses in ignored and undervalued sectors such as agri-business; investment/advisory firms can align their interest with clients by putting fees at risk, and traditional private equity provides a great framework around which to manage investments and investors
When finding businesses to invest in most funds have specific mandates (e.g. green energy reducing emissions by a certain percentage or tech returning a percentage on capital per annum) – and their performance is tracked against those mandates.
Fund managers need to raise sufficient capital to both provide them with the necessary dry powder as well as pay themselves a decent salary from the management fee. Thus, you have a myriad of funds focused on the same sectors, competing over the same deals from a limited pipeline.
Consequently, that fintech startup with a US$5 billion dollar total addressable market is offered 6 term sheets of increasing check size and valuation, with the goal to list in three years. We assert that this company probably needed 10 percent of the money and a longer horizon-line for growth.
By raising patient capital instead, and not taking the management fee, the fund size can reduce dramatically. This enables you to now target the bulk of the economy, small and medium sized enterprises (SMEs), writing smaller check sizes in ignored sectors and thus solving for the missing middle.
The lack of management fee needs to be addressed, and having a holding company model with equity stakes for the manager go a long way to aligning incentives.
When funding a business, most funds have one shot at investing capital and one or two ways of allocating it. If capital is returned, it goes back to the limited partners (LPs) and said LPs are most comfortable with a standard equity term sheet or convertible debt.
The benefit of structuring as a holding company is that you can allocate capital in multiple ways: you can invest in the standard equity subscription manner (it’s not always so bad), but you can also use innovative tools such as SAFE agreements, which places the burden of agreeing to a valuation to the next conversion event. You can also multiply cash equity with “sweat equity” from operating companies, thus aligning you and your operating company’s interests for long-term value. You’re also able to recycle capital to support other companies within the portfolio rather than raising additional capital or debt.
When supporting a business, most funds view themselves first as capital providers. They write a cheque, take an advisory role via a board seat and offer expertise on how best to exit in about 3-5 years. This is what they are designed for and there is nothing wrong with that. Some funds have portfolio improvement teams (admittedly a newer trend that we like), but few can access (or afford) the level of management talent to second into a firm and create value.
A design that is operational from the start helps direct the strategy towards a more boots-on-the-ground approach, particularly important in the context of SMEs who may not have formal education, or experience. Having high-quality resources join the management team of an operating company solves the human capital challenge of many SMEs but also provides the fund with a first-hand account of the business. This way, you work with the team not as financiers or consultants, but as operators, teammates. By addressing the management gap you create value for the long-term, while you maintain focus on the short-term priority initiatives (and have fun).
In this model, we minimise risk, while maximising investment capital and impact. It is maybe not a panacea for African investment, but can be extremely successful when executed in the right ecosystem and in the right way. The model is based on being builders, not flippers and scaling for depth, not breadth.
The companies best served by this model are in the “missing middle”; they need help addressing the management gap; and they must want to grow the company, to create financial value for themselves and for investors, and to create new jobs and up-skilled workers.
Brendan Mullen and Rushil Vallabh are the co-founders and co-managing directors of Johannesburg – based Secha Capital – a patient capital impact investment holding company. Secha Capital is working within the bounds of the Find-Fund-Support model.