Private Equity: A Value Add Infrastructure Investor, the largest Asset Class in Africa

LAGOS, Nigeria, Capital Markets in Africa: Sub-Saharan Africa’s economies have shown impressive growth since the global financial crisis, outperforming the global average by 200 basis points. A critical underpin to this growth has been the flow of foreign capital from private sources into the continent’s leading economies. In no other sector is this as prevalent as infrastructure. Infrastructure development in Africa has lagged behind population growth over the past fifty years, and governments have begun to turn to the private sector to catch up.

Private equity fund managers, who primarily manage the capital of institutional investors, have been at the forefront of this acceleration in infrastructure development. Institutional investors have good reasons for investing in this asset class in Africa and have found particularly good opportunities to do so. In 2015, more capital (28%) was channeled into African infrastructure than any other sectors by private equity fund managers.

The boom in Africa’s mobile telecommunications sector is one opportunity which has caught the attention of PE funds. The private investment deployed in the rollout of mobile phone towers over the last two decades allowed African countries to leapfrog over traditional landline telecommunications. Private equity fund managers have backed many of the businesses instrumental in doing this and continue to provide the capital necessary to grow the networks and connect populations.

Private capital has also been deployed in the development of other types of infrastructure, previously the domain of governments and state-owned utilities. Substantial progress has been made in the energy sector, where privatization of transmission and distribution infrastructure has driven efficiency and increased access to electricity. The procurement of electricity from the private sector is enabling the much needed expansion of generation capacity. Cote d’Ivoire, Nigeria, and Uganda have led the way on power sector privatization and the procurement of renewable energy in South Africa provides a model for the rest of the world. In both cases, private equity fund managers have seized the opportunities.

Uganda’s national electricity distributor was privatized in 2005 and has been in the care of private equity since then. Poorly maintained infrastructure has been replaced, technical losses and theft have been reduced and collections markedly increased.

Lereko Metier Sustainable Capital Fund has focused on the energy generation opportunity in South Africa. Bokpoort, a 50MW concentrated solar power project provides a case study. Metier provided early stage capital to mature the development of the project towards bankability and later the Fund contributed equity to the capital structure to construct the project. Bokpoort commissioned successfully in early 2016 and is the world’s first plant of its type with over nine hours of thermal storage and the ability to produce base load power. South Africa’s competitive procurement process is driving down the cost of energy and providing tangible solutions to the country’s electricity crisis and the movement away from environmentally damaging fossil fuels.

What do Private Equity fund managers like about infrastructure? 
While infrastructure development is undoubtedly a catalyst for economic growth and the doorway to further investment opportunities, it is not only the positive developmental impact that encourages private equity fund managers to pursue these transactions. They offer specific benefits which attract investors including stable cash flows, a variety of risk/return profiles and scale.

Stable cash flows are supported by an off-take agreement with a utility, government or both. Investors in energy projects will further secure their cash flows by insisting that these agreements be entered into on a take-or-pay basis, at a fixed or escalating tariff and backed by a sovereign state. While this by no means ensures consistent and predictable distributions, it forms the basis upon which other risk mitigants can be built into projects to provide a yield-type exposure for investors.

In the developed world, low-risk infrastructure assets often generate very low yields. This is true in part because much of the infrastructure is well established and assets tend to be in their operating phase resulting in lower operational and default risk. In sub-Saharan Africa, private equity fund managers have not been precluded from accessing investments with a range of risk/return profiles. Investors can gain exposure to projects either at an early stage of development, alongside senior debt in greenfield projects, or in brownfield projects with an operating track record.

Furthermore, more traditional private equity “value investing” is an option as infrastructure businesses offer equity in their companies to private investors in order to fund their development and expansion. Risk and return also vary substantially between jurisdiction and across technologies. The strength of off-taker balance sheets and sovereign credit risk rating are key indicators for private investors when assessing the risks of an investment. These factors are considered alongside security issues, the rule of law, construction complexity and the expected quality of cash flows emanating from a particular project. Private equity fund managers able to weigh these risks, put in place strong protections and with the vision to build where people have the greatest demand for infrastructure services provide exceptional long duration returns to their investors.

Finally, it is the scale of investments which is often considered a feature of this asset class. Many private equity fund managers are being tested to find good investment opportunities for the large sums of capital committed to sub-Saharan Africa. Recently it has been in infrastructure where these fund managers have found a home for their largest investments. As the backbone of economic growth, it is foreseeable that this trend strengthens as governments mimic the early movers in mobilising private capital to drive development.

What value-add do private equity fund managers offer as shareholders? 
The best private equity fund managers are renowned for their active investment style and value-add. In certain cases infrastructure developers will look to these managers to fill a funding gap during the construction of a project, the savvy ones invite private equity fund managers into a partnership as they recognise the value they will bring.

The first way in which infrastructure developers benefit from partnerships with private equity fund managers or including private equity funds as shareholders in their businesses is through the new project opportunities they bring. The important role played by infrastructure financiers (both on equity and debt) ensures that private equity fund managers are tapped into networks of entrepreneurs, regulators and service providers. Being at the intersection of this nexus allows private equity fund managers to gain insight into market trends and exposure to a wide range of projects. The best ones are able to quickly assess early stage opportunities and feed a developer’s pipeline with high potential projects.

Managers add further value through their ability to access capital of differing profiles. The majority of investors in private equity funds are institutional investors looking to diversify their portfolio. These institutional investors will allocate different pools of capital to equity, mezzanine debt and senior debt (and in the case of Development Finance Institutions to grant funding as well).

Strong relationships with these institutional investors as well as the reputation of the private equity fund manager allow private equity-funded projects greater access to these complementary forms of capital. In particular, senior debt providers are comforted by the knowledge that a rigorous due diligence process is being undertaken alongside their own.

Strong financial partners are also valued by infrastructure players during the financial structuring of project financed infrastructure. Optimisation of the capital structure, refinancing of debt facilities post-construction and the arranging of preferential rates on guarantees and other facilities are some of the ways in which a strong financial partner can support their more technical counterparts.

Many private equity funds in the infrastructure space include Development Finance Institutions in their pool of investors. Private equity funds of this profile have a strong focus on environmental and social governance and provide material input and guidance on these important aspects of infrastructure projects.

Perhaps the most undervalued aspect of partnering with a private equity fund manager is the opportunity to benefit from a mutual exit. The length of an infrastructure contract typically exceeds the investment time horizon of a private equity fund and as a result, private equity investors will typically sell their ownership in a project which still has a long tail of secured cash flows attached to it. As the risk profile pre- and post-construction in infrastructure projects changes significantly, an investor with a lower risk appetite is more appropriate during the operating period. This sort of investor will typically accept a lower yield on their investment, allowing a seller to enhance returns through an early exit. Fund manager’s expertise in the sale of assets, networks amongst buyers and the opportunity to exit a project as part of a diversified portfolio all provide immense benefit to partners upon a mutual exit.

While some publicly traded businesses may allow investors to gain exposure to certain features of the infrastructure asset class, they do not allow investors to cherry pick those secure cash flows most likely to yield a strong risk weighted return. As macroeconomic headwinds and unprecedented uncertainty dominate the global investment climate, well-managed infrastructure investments in emerging economies are more relevant than ever to institutional investors. It may well be the key to unlocking the potential of the African continent.

Contributors Profile 
Mike Heyink is a deal executive at Metier where he is part of the fund management team of the Lereko Metier Sustainable Capital Fund (LMSC). LMSC is an African resource efficiency fund, invested in seven utility-scale renewable energy projects. Previously Mike worked in strategy consulting for the Monitor Group, where he advised multinational clients in a range of sectors including infrastructure, energy, property development, agriculture, and telecommunications.

This article was featured in the INTO AFRICA August edition, with focuses on Infrastructure Finance in Africa.