Investing in African SMEs – a New Approach to Private Equity

The role of the development finance institution is under debate. As the countries they serve increasingly become "engines of global growth" (as coined by former World Bank president Robert Zoellick), with the capacity, resources and entrepreneurial talent to make their own economic destinies, so the emphasis on including the local market private sector in development finance projects has increased.

This is not to say that the requirement for development finance has decreased – poverty in Africa is still a serious issue, with the last Africa Progress Report stating that almost half of the continent's population earns less than $1.25 a day – but merely that the focus for its input has shifted.

The UK's development finance institution, CDC, has recently announced its intention to focus its new investment strategy on building businesses and creating jobs in Africa and in South Asia. Once again, supporting the local private sector is the focus.

That is a necessary strategy. With a population set to double by 2050, yet no clear sign of where the jobs to support this demographic growth will come from, Africa is facing the risk of stalled economic development and widespread civil unrest unless swift action is taken.

SMEs are the driving force of a country's GDP, wealth and government tax revenues, which in turn fund public services and infrastructural reform critical for socio-economic growth. In fact, every $1 invested in an SME generates an additional $10 in the local community. SMEs are also the primary source of new job creation. In high-income countries, small businesses provide 60 percent of employment opportunities compared to less than 20 percent in developing countries. There is a huge opportunity – and acute need – for this percentage to grow.

Private equity investment, with its appetite for greater risk than the banks combined with its management expertise, is a sound solution for enabling private sector development in Africa. It is one vehicle that CDC and its peers can appropriate to target job creation via SME growth. However, SME investing in Africa is notoriously difficult, due in part to a lack of investment track record, and depth of resources and experience among many African SME private equity funds.

The traditional model for private equity does not work for African SMEs because precisely in the part of the market where fund managers need additional resources to support portfolio companies, fee levels can only accommodate small teams with limited experience. If African SME private equity funds do succeed in overcoming the many challenges to developing experience and a track record, historically they have then tended to raise larger funds and focus on larger transactions, so their expertise is lost to the SME sector.

What is required is the development of a new model for private equity investment, with the structure, skills and experience to successfully invest in SMEs on a pan-African and long-term basis. By combining African professionals who understand their local markets and can provide close support to portfolio companies, with highly experienced international private equity veterans who commit their time and expertise on a pro-bono basis, on-the-ground teams can be bolstered with high-level private equity professionals whose management fees they could never afford. This unique blend of knowledge and expertise is the only way we believe SME private equity investment in Africa can be successful and sustainable in the long-term.

Recognition of the evolving global economic landscape combined with innovative solutions to support African SME and private sector growth are essential to ensure that the demographic dividend is catered for with new and sustainable jobs. With the right support – from the DFIs, from private equity managers, from the local governments and from the African private sector itself – economic growth in Africa will continue.

Simon Merchant is CEO of Jacana Partners, a pan-African private equity company investing in SMEs.

Investing in African SMEs – a New Approach to Private Equity

Simon Merchant submits that investing in African SMEs requires a new private equity model.