Why would a fund consider investing in a country that has no functioning capital market, no land registration and no regulatory framework? According to IFC and FMO, the motive for setting up private equity funds in fragile markets is simple: it makes good business sense.
Some five years ago IFC, the private sector arm of the World Bank Group, jumpstarted a small and medium sized enterprises (SME) Ventures programme. The goal of the programme was to test and demonstrate the potential for private equity in some of the most difficult, post-conflict countries in the world. FMO, the Dutch Development Bank, with over 20 years’ experience investing in first-time SME Fund Managers in emerging and frontier markets, invested alongside IFC in one of the SME Ventures funds, the Central Africa SME Fund, in 2010.
Access to capital is scarce and in some cases non-existent in these markets. This, together with the risk/return profile of SMEs in high growth underserved markets, makes private equity an attractive and appropriate tool. Some 90% of all companies in these markets are SMEs aiming to fill the gaps between supply and demand with high quality and cost-competitive products and services to businesses and consumers. In the early stages of their development these companies need equity before they need debt, which provides a more patient form of capital as well as flexibility to support SMEs while mitigating downside risk. Private equity also supports high intensity engagement, which enables advice and knowledge transfer. Moreover, it also offers opportunities to embed environmental and social standards.
Investing in so-called frontier markets is an interesting option for a number of reasons. From a social perspective, investing in local SMEs has a direct positive impact. The high degree of knowledge transfer and capacity building from fund management to SMEs is one of the most obvious benefits. Investment also contributes to positive spin-offs in supply chains and can lead to other beneficial effects such as increased jobs, wages, higher savings and even encourage government reform. All these effects combined help to improve the business environment and make the market more attractive for investors. As a result, countries are able to grow even faster and diversify their economies in the process.
From a business perspective, emerging market private equity funds in general offer enormous potential. A study by IFC shows that returns outperform both developed market private equity and emerging market listed stocks, while exhibiting low correlation with developed market investment strategies. In addition, diversification over sectors and countries provides an attractive risk profile. Risk is also lower than commonly perceived and can be managed if the fund team has sufficient resources and is committed to its task. Net returns in Venture Funds in frontier markets are, however, expected to be lower than the average IFC private equity portfolio. A lot of work still has to be done to prepare these markets for investment. It is therefore a key objective of SME Venture Funds to create a demonstration effect and pave the way for a private equity market in fragile countries. This entails a three-way approach: informing the regulatory framework for PE, building the capacity of fund managers and investing in promising high-growth SMEs.
Promise for the future
Financially speaking, stepping into a market where there are good prospects for growth but little competition offers early mover premiums. Fragile markets do, however, require a special approach. Company structures are less formal and regulatory frameworks may be lacking or very different from ones in more mature markets. Patience is also required as it takes time for funds to get to scale and operate efficiently. And contradictory though it may seem, it also takes time to find suitable local businesses to invest in.
At present, private equity penetration in emerging markets remains relatively low. However, given the potential of the markets and the strong growth expected to continue into the future, it is an option that holds much promise for the future.
The fund perspective
The Central Africa SME fund, in which both IFC and FMO participate, has built up a portfolio of 20 investments in Democratic Republic of Congo and Central African Republic, two countries at the bottom of the human development index. After the relatively short period of two-and-a-half years the fund has begun to generate profits. Investments are diversified, ranging from healthcare and education to services companies and agriculture.
Potential investees were initially wary. Local banks do not offer SMEs access to long-term capital and NGOs cater almost exclusively for very small initiatives. So when the Central Africa Fund offered financing, local entrepreneurs thought that it sounded too good to be true. It took time and patience to win their trust and convince them of the benefits.
The quality and knowledge level of local service providers was another challenge. Private equity initiatives in fragile markets entail a lot of ‘hand-holding’: SMEs need advice and assistance in preparing their businesses for investment. Fund managers need a good network they can rely on to supply these services. If it is not already in place, it has to be built, as the fund has done with its local teams in both countries.
The Central Africa SMR fund clearly shows that building a fund in post-conflict countries and achieving both financial and social impact in SME investment is possible but does require patience and a long-term view.