SMEs provide opportunity for Africa to grow its debt market

Investments into private firms in Africa are funded by a relatively low proportion of debt compared to equity, especially in contrast to developed markets, where debt is more readily available and affordable, writes Kelsey Tanner, senior private equity analyst at RisCura.

This is according to RisCura’s latest private equity update of its Bright Africa report, released in October 2017.

With a relatively small value of assets under management, there is capacity for the development of the private debt market in Africa. The undercapitalisation of traditional lenders, such as banks, and the current uncertain economic environment have led to the development of alternative sources of capital.

One such alternative is the private debt market where fund managers provide finance to private businesses seeking credit. These businesses, such as small and medium-sized enterprises (SMEs), which do not fit into the traditional financing paradigm, provide a pool for private debt funds to tap into. A funding supply gap exists because SMEs are not able to access finance through traditional channels and private debt fund managers have limited investment opportunities.

This gap is fast being closed by private debt funds that have taken on the role to provide the necessary capital to SMEs. African funds that are already targeting SMEs with this type of finance include Vantage Capital’s third mezzanine fund with a US$280 millio commitment from investors in 2017, and the Investec Africa Credit Opportunity Fund 1 with a 2015 investor commitment of US$226.5 million.

SME owners are largely unaware of private debt as a funding option, how to access it, and its benefits and risks. This problem is compounded as fund managers cannot easily identify businesses that require funding, and therefore rely on potential borrowers to approach them.

Private debt can be accessed through a number of strategies. Private debt funds such as mezzanine and credit opportunity funds are frontrunners in meeting demand from SMEs seeking growth capital and debt refinancing.

Advantageous to SMEs is that private debt funds may offer them finance and management support, but often do not pursue a direct ownership interest. Credit opportunity funds have a broad mandate and may involve a range of debt instruments, allowing fund managers to provide solutions that are suited to each individual company. This is critical when deploying capital effectively in diverse business environments.

Research has shown that mezzanine and credit opportunity funds perform well during the contraction and early expansion phases of the business cycle. After two consecutive quarters of GDP contraction, South Africa emerged from recession in the second quarter of 2017. Renewed business confidence, albeit amidst low forecast growth of around one per cent in 2018, could make this the opportune time for investment.

South Africa’s over two million SMEs could thrive with an improvement to cash flow, working capital and management, thereby helping to realise the National Development Plan’s forecast that the sector will create 90 per cent of jobs by 2030. Funds with dry powder – cash available for investment – can therefore provide liquidity in the early stages of economic recovery when traditional lenders are unprepared and uninterested.

This market also offers investors the opportunity to diversify their fixed income exposure away from government bonds and listed credit, to high-yield investments. Mezzanine and credit opportunity funds typically have positively skewed returns, with more unexpected gains than losses.

Due to the broad range of strategies that mezzanine and credit opportunity funds may follow, investors can earn interest income and equity-like returns through convertible debt strategies. Funds can gain exposure to assets that should predictably recoup principal and generate alpha (excess return relative to a benchmark). Another advantage is that private debt funds can incorporate diversification of investments by country, sector, or rating. Thus, lowering volatility of returns.

The pursuit of high returns, however, is not without risk, as these private debt strategies take a bet that returns exceed losses in the case of SMEs defaulting on payments. Mezzanine and credit opportunity funds often carry a higher premium to compensate for this.

As can be seen from developed markets, a flood of funding into the debt market could lead to private debt funds hastily pursuing even riskier options, such as “distressed debt” (lending to companies on the verge of bankruptcy), resulting in eroding industry returns. This has sparked fears of a “private debt bubble”.

In Africa, however, the debt market is a long way from reaching capacity. Private debt in Africa is expected to have potential over the long-term as an established part of investors’ portfolios. Investors in Africa willing to accept the risk could create real value for SMEs, the key drivers of economic growth. The development of the private debt market is essential to unlocking this potential.

Courtesy Disrupt Africa