Mezzanine Financing: A Solution for the Mid-Market Funding Gap in Africa

LAGOS, Nigeria, Capital Markets in Africa: Mezzanine financing in developed markets such as Europe and the United States is typically used to fill a gap in the capital structure, providing additional leverage for primarily private equity funds. In emerging markets such as Africa, mezzanine financing is a key tool in addressing the current lack of funding that is especially obvious in the mid-market, where small and medium sized companies are looking to raise between $5- $20 million for expansion.

Mezzanine provides established African companies unable to access debt from local banks with a more cost effective and flexible financing solution, and also provides a less dilutive alternative to private equity for those entrepreneurs or family owned businesses looking to retain control of their business.

Africa’s mid-market funding gap
The lack of access to finance is one of the most prevalent challenges entrepreneurs and business owners face in Africa, particularly as credit to the private sector has failed to keep pace with the growth rates of most economies in Africa. With banks deleveraging after the financial crisis, credit flows from developed countries into Africa have shrunk, with cross border credit down 41 pct since the peak in Q4 2010. However over the same period the overall economies in selected African countries have grown 4.5 pct annually since 2010 despite this lack of credit, which for mezzanine providers presents a clear and significant opportunity.

Due to this lack of credit, African banks are now much more selective, preferring to focus their efforts and credit, on larger corporates and national champions. The perception exists among many local banks in Africa that smaller firms have insufficient assets or collateral, making them a riskier and therefore less desirable proposition. When banks do decide to lend to small and medium sized enterprises, the terms offered are often unsuitable, given the stage of the respective company’s development.

Banks fail (or are unable) to tailor debt-service schedules according to a given business plan, and tenors are often very short term, which is not the type of patient capital small and medium sized companies need to grow. There is typically a mismatch between the shape of the capital banks are willing to provide and the entrepreneur’s business plan. This lack of support from local banks for mid-market companies means the only option left for business owners is to turn to the private equity market to source growth capital. However, what we see is 1) entrepreneurs are unwilling to cede a significant minority interest or control to private equity fund due to succession reasons or the stage of their business, and 2) private equity dry powder allocated for Africa is much more targeted at larger companies/deals.

Since 2009 there has been approximately $19 billion of funds raised for private equity in Africa, with circa 40 pct raised in just the last two years. In 2014, excluding infrastructure funds, $1.9 billion was raised for Africa. However, three funds alone raised $1.5 billion or 77.1 pct. of total capital raised. The trend continued in 2015, a record year for fundraising, with $5.2 billion raised for Africa, with six funds accounting for $4 billion (77.4 pct of the total). A significant proportion of private equity raised for Africa is concentrated among a handful of GP’s. In order to reach the diversification typical in a private equity fund portfolio, typical single investment amounts for these larger funds would be in the range of $75 million, meaning those companies seeking financing of below $20 million fall well below their radar. This creates a clear mismatch between those who provide and those who seek capital.

The larger funds, which control the majority of available capital, are looking to fund the big deals as they seek to deploy their funds, in some instances between $700 million to $1 billion, over a 5 year investment period, despite the fact the majority of investment opportunities in Africa sit well below this deal threshold. Not only do mid-market businesses struggle to raise affordable, sustainable and long term bank debt, they also often don’t meet the minimum funding requirement for the majority of the private equity funds in the market.

What is mezzanine financing and how does it fill the funding gap?
Mezzanine financing is not pure debt and is not pure equity, but can be anything in between. The structure of a mezzanine deal will vary by transaction, and ultimately depends on the cash flow profile of the company, but there are common pillars that drive the composition of a mezzanine investment. The first is the contractual element, comprising both cash interest and PIK (“pay-in-kind”) interest, which accrues and is paid when the loan is repaid in full (a benefit of PIK interest is that it enables the company to efficiently defer payment of a portion of its interest, reducing the immediate financial burden on its cashflows allowing it to invest cash into growing its business). The second component of a mezzanine instrument, as we structure it, is the equity kicker which through a variety of mechanisms entitles the investor to acquire or have a right to an equity stake in the company at a fixed price for a fixed percentage that is agreed upfront.

The equity kicker ensures an alignment of interest between the entrepreneur and the investor as a portion of the investors flows come from the equity accretion in the company. Due to the contractual element of mezzanine which provides an annual yield that is growing due to compounding effect of the PIK interest, the equity stake the investor typically requires in companies is usually less than 15% i.e. a minority interest in the true sense of the word. At Syntaxis, we structure all of our deals so that our success is dependent on the upside from growth in the Company and not leverage or cost cutting. In terms of returns, a typical private equity investor will seek to achieve IRRs of 25 pct – 30 pct whereas mezzanine investors typically target returns in the high teens/low twenties.

Mezzanine financing can address this funding gap that is present in the mid-market from both the bank debt and equity market in Africa, by providing financing an alternative that is more cost effective and flexible than pure bank debt, by tailoring each investment to the company’s business plan and cashflows. Unlike a bank that only has downside, due to the associated minority equity interest in the company, there is an inherent alignment of interest with the entrepreneur/business owner. However unlike a private equity fund that might be looking to take a significant minority equity stake or control in the business, mezzanine investors only require a small minority interest due to their reduced return threshold. This is an attractive component of mezzanine financing for entrepreneurs or family owned businesses who look to retain control.

To conclude, over the last two years at Syntaxis we have seen over a $1 billion of mezzanine demand from our target countries in Africa, and are currently working on live deals totalling over $300 million, across Nigeria, South Africa, Ghana, Kenya and Ivory Coast. Going forward we believe that mezzanine in Africa will continue to develop as an attractive asset class as more managers aim to fill this funding gap.

Contributor’s Profile
Adesuwa Okunbo is the Co-head of Africa at the Syntaxis Capital and responsible for the firm’s investment activities in Africa including originating, structuring, executing, fundraising and post investment monitoring. Prior to joining Syntaxis, Adesuwa was in the EMEA Acquisition & Leveraged Finance team at J.P. Morgan. She was involved in $3.2 billion worth of transactions across different geographies and industries, including a $100 million refinancing and capex financing for a Nigerian oil field services company. Prior to joining the Leveraged Finance team, Adesuwa was in the Mergers and Acquisition team covering companies in the Diversified Industries & Consumer, Healthcare & Retail teams, working on transactions totalling just over $2 billion. Prior to J.P. Morgan, Adesuwa worked in Africa-focused private equity as an investment analyst at TLG capital and prior to TLG Capital, Adesuwa started her career in Lehman Brothers. Adesuwa holds a BSc in Economics from the University of Bristol.

This article was featured in the INTO AFRICA July edition, which focused on Private Equity in Africa and is titled Private Equity: Africa’s Trump Card.