SME financiers Grofin argue that debt is more suited as a financing mechanism for small and medium enterprises in sub-Saharan Africa as it meets entrepreneurs’ demands and allows an easier exit. Rachel Keeler takes a closer look at their business model.
Risk financiers in East Africa tend to agree on the portion of the lending market that holds the most potential for growth: “Within the USD50,000 to USD1m range is where most of the businesses that have restraints acquiring capital in Africa fall,” says Guido Boysen, CIO of Grofin Africa, a risk finance and development company operating across the continent. A host of new private equity funds popping up in the region focus their attention on the USD50,000 to USD2m deal range that they call “the missing middle” – too big for microfinance, too risky for commercial lending. SMEs are the agreed upon target, but that is largely where the agreement ends.
While private equity funds in Kenya like TBL Mirror Fund look for start-ups and fast growing companies to take a longer-term shareholder stake in, Grofin provides shorter-term self-liquidating loans and external business advice to a wide variety of small enterprises and established entrepreneurs. Grofin argues that its debt-based model is better suited than equity to meet the needs of the majority of African SMEs: “Local entrepreneurs need a specific type of advice and a specific type of finance. The typical entrepreneur [in Kenya ] doesn't want you to take a position in his company,” Boysen says.
Neither debt nor private equity function according to very traditional roles in emerging market finance, but is this statement a realistic assessment of the market?
- Risk mitigation: Private equity funds here focused on SMEs put a high premium on their management consulting roles to mitigate risk. TBL's private investors look for businesses to work with in their own fields of expertise. Business in Africa also relies in huge part on personal networks, so fund managers say they spend a lot of time getting to know the local market. Unlike other debt-based risk financiers in the region (such as Business Partners International), Grofin also applies a private equity-style business advisory approach to risk mitigation. But instead of taking a management role, the company looks at cash flow and viability, and charges higher interest rates (18.5% compared to the Kenyan base rate of 15%) in place of collateral. They also add a 5% business development fee to cover their costs of giving advice to the borrower. This approach, however, has made it hard to attract private investors. The bulk of Grofin's funding comes from government-backed development finance institutions (DFI), compared to private equity, which in Kenya has a mix of DFI and private money. So far, Grofin's model has proven relatively successful with a 5% default rate.
- Exits: What is more attractive to some investors in Grofin's self-liquidating model that requires no exit strategy in what many still view as an uncertain long-term market. “Private equity doesn't want to take a business from USD100,000 in revenue to 300,000, from four employees to 10 – it needs a business worth USD5m that someone will want to buy,” Boysen says, with the point that most of East Africa's SMEs are not structured to hit the million-dollar mark. Grofin Kenya 's General Manager Kenneth Onyando says the private equity model can expect unsustainable growth from an SME in the drive toward a viable exit: “There are only so many KenCalls” in the market with big potential.
- Equity fund managers say they look for appropriate exit strategies before investing, and draw on the local networks they cultivate to create multiple options: acquisitions and mergers, partnerships with industry friends, buyouts by foreign players, or the buy and build strategy – the advantage for equity is that the patience of its capital makes many avenues possible. Grofin's approach makes sense as a way to tap immediately apparent short-term prospects, but well-placed patient investment often pays off in Africa , too. Equity is less susceptible to monthly fluctuations and can capitalise on the region's long-term growth.
- Venture capital: Grofin's model is focused on cash flow, which is simply not suited to start-up companies. For the 15% of its portfolio that are new businesses, Grofin grants a one-year moratorium before loan repayments start. For established businesses, payments can start in as early as one month, with repayment terms for all of Grofin's clients averaging between three and four years. Private equity experts say many start-ups need three to four years before their cash flow cycles would allow them to repay debt, so venture capital is often a better option.
- Volume: Most financiers recognise the need for different kinds of financing for different kinds of business. Grofin's argument is that its model is designed to reach the most prevalent kind of risky SMEs in Africa . “Fund management is about volume,” Boysen says. He points out that one of East Africa 's largest private equity players, Aureos Capital, has moved away from venture capital and small deals, and that the even bigger Actis Capital is moving out of the market all together. To target the SME range, Grofin says the debt model is easier to scale up. The company has invested nearly USD9m in Kenya since 2005, with about USD17m also disbursed in Uganda , Tanzania and Rwanda . Its new USD130m Pan African Fund has another USD40m scheduled to go into East Africa over the next four years, which could increase if an extra USD30m in the works for the fund comes through.
Perspectives
The underlying assumption of Grofin's model is a static one, i.e. that the business landscape in sub-Saharan Africa will not evolve over time and SMEs will not grow to a size that is attractive for equity investors. Eline Blaauboer, investment director for the TBL Mirror Fund, which has a USD6m capital base for Kenya and is still fundraising, admits Grofin controls a larger share of the market today. She thinks understanding of the private equity model is still low in East Africa, but awareness is growing: “A lot of the companies I talk to are companies that find Grofin's interest rates too expensive,” Blaauboer says, adding that ultimately: “Africa will grow toward a more mature capital market where debt will be cheaper. Once that happens, Grofin's role with be diminished – their model is a temporary one. But there will always be a role for equity.”
Also read: Kenya: SME Private Equity Undeterred by Global Crisis
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