African investment insights by Robert Appelbaum, Partner
Over the last few years, there has been a growing focus on Africa as international investors increasingly see the opportunities in resource- rich, consumer-driven economies of the second largest continent in the world.
During the global economic crisis, much of Africa (out- side South Africa) remained relatively unscathed. GDP figures for many economies on the continent have remained remarkably robust.
Since the global financial crisis, private equity fundraising for Africa has been challenging however there are signs that the fundraising environment is improving. Investors are beginning to re-examine their perception of risk and see Africa as a diversification away from China and India. However the funds raised for Africa compared to Asian markets still remain relatively modest because of investors’ perceptions that African risks are higher than other emerging markets.
Experienced investors on the African continent feel that such perceptions are outdated. Many private equity funds have been active in Africa for years and have developed strong track records in a number of different industry sectors such as telecoms and the financial services sectors, benefiting from an un-crowded market.
We now see a growing recognition of African opportunities from a broad range of funds ranging from Pan-African funds, South African based GP's, country or regionally focused funds in the larger markets in West and East Africa.
The debate about the risks of investing in Africa is often too generalized - as if Africa was one country. The reality is that it is a continent of 54 countries each with its own mix of political, cultural, religious and language factors. There are many different legal systems in place. The underlying influence in those systems is often linked to the country’s colonial past. One sees the influence of common law in East and some parts of West Africa, civil law in Francophone Africa, Lusophone Africa and North Africa as well as Roman Dutch law in Southern Africa. These systems are overlaid with local customary or indigenous laws and often incorporate legal concepts from other international jurisdictions.
We also see regional legal developments such as the harmonization of business laws in the sixteen countries in the OHADA (a system of business laws and implementing institutions adopted by sixteen West and Central African nations) region and the development of the East African economic community with its own legislative body.
Many of the perceived risks are not necessarily particular to Africa. However there are some fundamental “must haves” when considering any investment. Choosing the right local partner is key. Extensive due diligence on the industry, and on individuals’ position and reputation in the local business community through the use of risk consultancy advisers is essential. If one is investing in natural resources or infrastructure projects, it is also important to fully assess country and political risk and to evaluate the impact of regime change.
Much of private equity investment on the continent involves taking a strategic but not necessarily a controlling stake in a business. This has an impact on the legal structuring and documentation of any investment to ensure that the private equity investor retains effective influence on the portfolio company. Monitoring the investment on an ongoing basis requires active involvement and presence in country. Given the size of the continent and the lack of direct flights between countries, this presents its own challenges. Finding good management is often seen as one of the major challenges. So far the predicted return of many well educated and trained executives from the diaspora has not yet lived up to expectations. Exit is also seen as a challenge. Despite a growing number of stock exchanges in Africa, liquidity is low.
Many investors are familiar with the black economic empowerment regulatory framework in South Africa which has an impact on the structuring of transactions. However a number of other African countries are also introducing some level of local participation or citizen empowerment such as Botswana, Mozambique and Zambia. This is not necessarily just focused on equity participation. It can take many forms including skills development and training, construction and maintenance of related infrastructure as well as CSR programs.
Zimbabwe of course has introduced its own indigenization regulatory program which is continually modified making it hard to give definitive advice.
Over the last few years much of the investment in investment project in Africa has been driven by the DFIs direct foreign investment. This has meant that we have seen a growing focus on addressing concerns of corruption, money laundering, environmental issues and CSR principles.
This has broadened well beyond government- or infrastructure-related projects. As more global investors become involved in Africa, the impact of legislation such as the US Foreign Corrupt Practices Act, the Dodd-Frank Act and more recently the UK Bribery Act is growing.
In support of these objectives, Mauritius has also been focusing on the development of partnership vehicles with legal characteristics designed to attract fund monies.
South Africa is seeking to compete with Mauritius in terms of making itself attractive as a gateway into Africa for private equity investors. Recent legislative measures to achieve this include the introduction of a headquarter company regime. Under this, many of South Africa’s more onerous tax provisions relating, for example, to transfer pricing, are waived for qualifying companies.
One of the challenges in structuring private equity investments in emerging markets is trying to use developed structures and investment instruments for which the regulatory framework in the host country doesn’t allow to be used. Patience and out-of-the-box thinking is required in dealing with regulators who can be reluctant to embrace innovative deal structures.
Some tax systems in Africa tend to be relatively unsophisticated in global terms, certainty with regard to tax treatment can be difficult to attain.
Issues such as whether carried interest and proceeds on the disposal of investments should be taxed at capital gains rates or normal income tax rates (in countries where a distinction exists) are likely to arise. The answers usually need to be found through the application of general principles, in the absence of specific relevant legislation or case law.
African countries tend to impose high levels of withholding tax on cross-border cash flows, including dividends, interest and management or advisory fees. Minimizing these taxes through the use of appropriate tax treaties can present challenges because, with a few exceptions, most African countries have very few tax treaties. As with the legal systems generally, the influence of the colonial past can often be discerned in the choice of treaty partners and many treaties are very old.
Mauritius has deliberately sought to build an attractive treaty network with African countries and has been successful so far. However its treaties with some countries with robust economies such as Nigeria and Zambia are at the time of writing, signed but not yet in force.
As a result of this and other attractive tax features, Mauritius is often chosen as a gateway into Africa (especially sub-Saharan Africa) both by private equity funds and other foreign investors. If Mauritius can maintain its momentum in building its African treaty network, it has also provided legislative protection against certain potential South African tax exposures for investors in funds that make use of a South African GP.
However, these investor-friendly policies have been significantly undermined by a recent attack launched by the SA tax authorities on debt push down structures that have been used by private equity investors in SA for many years to compensate for South Africa’s lack of tax group relief (such relief is rarely available in Africa). This move illustrates the tax perils of deal structuring in Africa. Although these structures have been known to, and endorsed by, the tax authorities for some time, this has proven no protection in circumstances where the SA Government is aggressively seeking to balance its budget.
Nonetheless, with appropriate advanced planning and a detailed understanding of the tax playing fields in the target jurisdiction, it is possible to design relatively tax efficient deal structures for African investments.