2018 was a watershed year in many respects for private equity in Africa. In the wake of the Abraaj collapse and other market fluctuations, we will in 2019 likely see significant shifts in the industry, with key changes to all stakeholders’ strategies expected to emerge.
General observations and trends for 2018/2019
An on-going theme with private equity funds in Africa (and other emerging markets) is exits. It is clear that some funds have found themselves holding more assets at the end of the fund life than they had anticipated; other funds have not performed as well as expected due to currency and political risks, amongst other challenges.
Investors will be looking closely at the 2007/2008 vintage funds and their ability to exit assets at value before the end of the fund term. In allocating commitments to funds, we have seen prospective investors placing much greater weight on a manager’s demonstrable experience in dealing with their end-of-life funds. Extensions to fund terms have increasingly come under pressure with investors requiring extensions to be approved by investor consent (rather than the just the limited partner advisory committee) and penalising the manager on fees during any such extension.
During 2018, we witnessed more GP-led restructuring and stapled deals internationally, with Europe leading the way. According to Forbes, GP-led secondary deals - restructurings permitting the collective transfer of long-in-the-tooth fund assets from one group of investors to another - rose to a record US$22 billion or a third of secondary volume last year (up from US$12 billion in 2017), with the fastest growing portion being single-asset secondaries, where GPs arrange the full or partial sale of just one asset. It will be interesting to see if this will be the case in our market, particularly considering the exit challenges outlined above.
There has been an increase in the use of borrowing facilities by private equity funds to maximise returns. The Institutional Limited Partners Association (ILPA) has expressed concern as to this growing use of leverage and has recommended capping credit lines at six months, with greater disclosure as to the use of borrowed money. Investors are also seeking transparency as to how a fund’s returns are generated. We have discussed below the likely impact that the Abraaj collapse will have on such leverage in the African market.
Private equity fund managers are increasingly looking to expand their product ranges across different asset classes and strategies in order to grow their fee base, consolidate costs and minimise risks associated with a single asset class or market. New product lines may well encompass private debt funds – these funds continue to grow in number each year given the lack of available credit for small to mid-sized companies.
Finally, the focus on impact investing should continue to gain ground in 2019, particularly given the increased realisation that this does not need to be at the expense of returns.
The impact of Abraaj on leveraging
The impact of the Abraaj collapse will almost certainly be felt in relation to the leveraging of private equity funds in this market. As we found out in the 2008 financial crisis, there is no such thing as “too big to fail”.
A quick summary of how private equity funds are leveraged: Funds borrow money in order to bridge capital commitments, either to boost returns (given low interest rates in comparison to the hurdle rate on drawdowns) or as an interim measure while capital is called from their investors. The bank takes security for its loan facility over the fund’s undrawn commitments, often with the right to issue capital calls directly to investors in the event of the fund defaulting on its loan repayment obligations.
There are, however, significant risks involved with this model. Where the market deteriorates and the fund’s investment income is insufficient to cover the repayment of the debt, investors may resist writing cheques to creditors on investments that have already failed. Another risk for lenders is where investors seek to freeze capital calls as a result of the conduct of the fund manager. In Abraaj Private Equity Fund VI, investors were released from commitments in February 2018 after the fund suspended operations, leaving the lenders exposed. Although we note that certain of the Abraaj lenders – such as Commercial Bank of Dubai (CBD) and Noor Bank - have been more successful in exercising their security following a court action by Noor Bank.
Drawdown funding has been considered low risk by lenders over the year. Lenders who have been burned by Abraaj, or have simply watched the Abraaj events unfold, will, however, likely be more cautious when negotiating their security package with private equity funds going forward. We have already seen banks requiring investors in private equity funds to acknowledge the bank’s security at the time of the loan. Banks are also looking to include default provisions in the loan documents that catch early allegations of mismanagement.
The impact of Abraaj on fund documents
Abraaj was able to negotiate fund documents that were significantly GP-friendly given the market position of Abraaj at the time of its fundraising, and the lack of investor protections in the documents has become all too evident as Abraaj has unravelled. Investors (and their advisers) will pay more attention to the fund documents of African-focused private equity funds going forward, particularly with respect to those provisions dealing with general governance (consistent and transparent reporting, use of drawn funds, borrowing powers etc.) and the removal of the GP. We are finding that investors are requesting powers (usually exercised through the limited partner advisory committee) to, inter alia, demand a forensic fund audit at any time, interview the internal auditor, be granted access to the fund’s bank statements, obtain information directly from the fund’s administrators and review the administrator’s mandate periodically.
This increased due diligence will lead to a longer lead time in negotiating fund documents and reaching first close, higher legal fees and increased costs associated with internal governance and operational compliance.
Private equity firms may look to blockchain technology to increase transparency and audit trial. Blockchain allows companies to record their transactions directly into a joint register with a number of permitted parties, and this in turn creates a highly secure, interlocking system of verifiable and enduring accounting records. This fosters integrity of accounting records and fully traceable audit trails that greatly reduce the problem of human error and do not permit variation of the data.
Given the cross-jurisdictional nature of the Abraaj structure and the legal and governance complexities, the full implications of the Abraaj collapse have not yet been dealt with.