By Edmund Higenbottam, Managing Director, Verdant Capital, manager of the Verdant Capital Hybrid Fund
Greater macroeconomic volatility, as well as outright macroeconomic headwinds, are likely to impact the asset allocations of both LPs and GPs for the balance of the decade. The early years of the 2020s, which were overshadowed by the COVID-19 pandemic and preceded armed conflict in Europe and sharp monetary policy changes in the US, saw a growth in the private credit asset class as a proportion of private capital in Africa, albeit from a low base. Will private credit continue to enjoy growth – both relative and absolute – in these uncertain times?
2022 proved to be a year of extreme shifts in the global policy environment as well as many other market-moving events both in Africa and further afield. It was also the first year of the investment period of the Verdant Capital Hybrid Fund I, which reached its first closing in December 2021.
During the course of 2022, the Fed increased the US federal funds rate by 4 percent, the largest increase in absolute terms in a calendar year since 1980. These two years were very different in relative terms, however, with interest rates having started 2022 around 0.50 percent, whereas they started 1980 at 13.35 percent! The recent rate hikes may bring the US into recession and may have an even larger impact on Africa. As a firm, Verdant Capital sees this as one of several significant negative mechanisms impacting the macroeconomic outlook in Africa, including lower foreign direct investment, lower demand for exports, local currency depreciation and domestic interest rate rises. Simply put: “When the US sneezes, the world catches a cold.” Furthermore, Africa is the continent with the shallowest financial markets, offering the least ballast to global shocks. As for the timing of these impacts, we believe that there is likely to be a lag before the effects on Africa are felt in full.
Closer to home, on December 20, 2022, Ghana announced its sovereign default. This had been widely foretold, and early in 2022 Verdant Capital had significantly deprioritised Ghana in its investment strategy. Looking forward, Ghana’s default may not be the only sovereign default we see in this market cycle.
With resilience in mind, the Verdant Capital Hybrid Fund changed its investment priorities in 2022 in three critical ways: (1) investing only on a floating rate basis, thereby enjoying the recent rate increases to offset greater contextual risks; (2) tightening our underwriting criteria; and (3) introducing a strong bias towards investments with cross-country exposure. On the second point, we have been more focused on key macroeconomic risks, such as foreign exchange risk, including requiring hedging by our investees. On the third point, two out of three of the Fund’s investments so far benefit from guarantees from group entities outside Africa, and one benefits from exposure to multiple African countries. Equally important is to look for specific business models which are proven, but at the same time provide a differentiated solution to the market and offer resilience to the overall macro-economic environment and credit cycle.
On the positive side, we believe that the terms available for new investments have improved since the mid-2010s. Valuations in the M&A market in Africa are more realistic, given the proper recognition of political, economic, and operating risks that had been underestimated previously. A key driver of this is supply-demand dynamics in the private capital market, i.e. fewer large and mid-sized private equity funds buying up the limited pool of bankable deals. This new valuation environment arguably favours prospective private equity returns more than prospective private credit returns. That said, our experience is that in addition to being able to pass on higher base rates in 2022, we have been able to increase margins and tighten contractual terms.
The valuation environment also has changed in terms of venture businesses, including faster-growing and more innovative financial companies – “fintechs” – in Africa. Valuations of fintechs’ equity peaked in 2021 and early 2022, and now have been corrected for the most part. When considering investments in these growth-stage businesses, we believe that GPs need to be keenly aware of “downstream” capital risk, i.e. the extent to which further capital raises will be required for a business to reach long-term economic resilience.
For all types of funds, the quality of due diligence is of critical importance in today’s more challenging macroeconomic conditions. GPs can no longer rely on the hope of the “Fastest Billion,” “Africa Rising” or other secular growth themes driving performance. This focus on due diligence generally should include both the due diligence by the investment team and that of third parties with relevant technical expertise.
A deeper focus from GPs on environmental, social and governance (ESG) factors should provide greater resilience of the asset class in terms of both LP appetite as well as the sustainability of the underlying investments. Meanwhile, specialist funds must consider issues specific to their sector. For example, client protection principles (CPPs) are an important factor for Verdant Capital Hybrid Fund when evaluating a financial institution. These factors, traditionally seen as “softer,” are now more mainstream because of the growing recognition of the capacity of such issues to impact long-term commercial returns. An example of this in our fund: avoiding “aggressive” lending models in favor of a strong focus on client protection principles should pay dividends in terms of the investee’s long-term credit portfolio performance.
Today’s more difficult macro-economic environment is synchronised with what we see, overall, as a more challenging fund-raising environment. The returns on private equity in Africa over the last decade have been weaker than projected, and numerous funds have failed to deliver sufficient exits during their fund lives. Some larger funds have left the market, and others have changed their strategies. Meanwhile, a new generation of funds has entered the market, with many of these adopting more focused mandates; and mezzanine and private credit strategies have grown disproportionately. The downside risk mitigation of mezzanine and private credit strategies is arguably a crucial advantage in today’s more volatile environment. For example, these strategies mitigate risks around exits, which have caused challenges for many equity managers. Furthermore, mezzanine and private credit strategies address some of the information asymmetries and principal-agent issues in comparison to some other strategies, e.g. minority growth equity. While lower equity and M&A valuations may mitigate the risks faced by – and improve the prospective returns of – equity funds, Verdant Capital believes that private credit and mezzanine strategies continue to offer a better risk-reward trade-off in the current environment.
This article has been sponsored by Verdant Capital and does not necessarily reflect the views of Africa Capital Digest