Africa: Market conditions prompt a waiting game

In 2011, Africa appeared to be riding the wave of the much-vaunted shift in global financial power in favour of emerging markets. Over the past year, African policymakers have admonished eurozone officials for failing to put their fiscal house in order and Portugal has courted Angolan lenders to ramp up investment in the country’s troubled privatization scheme. In the summer of 2011 South Africa took the unprecedented step of issuing a travel warning to its citizens visiting the UK as urban riots and looting raged, an ironic reversal of old stereotypes: conflict-ridden Africa versus the calm waters of Europe. Against the backdrop of Africa’s relative resilience to the global headwinds, European leaders increasingly tout trade, rather than aid, as the principal factor governing their relations with the continent.

Adding a sense of momentum to this pitch – and mindful of the surge in Chinese investment in Africa in recent years to $160 billion in 2011, up 28% year on year – private-sector representatives, including Barclays chief executive Bob Diamond, flanked UK prime minister David Cameron during his trip to South Africa in July.

Politically correct platitudes about the moral case for investing in Africa no longer dominate discussions about financial opportunities on the continent. African bulls can point to statistics that indicate its lucrative potential for inbound investment and how much of the continent has largely banished the demons of conflict and economic mismanagement. Debt relief, strong commodity prices, capital flows as well as improved macroeconomic policies powered regional growth years before the Lehman crash. Global monetary imbalances and the breakneck pace of financial globalization pre-Lehman conspired to drive down yields on conventional asset classes in the developed world and, to a lesser extent, in the mainstream emerging markets, boosting the popularity of high-returning frontier markets in Africa.

Six of the 10 fastest-growing economies in the world between 2001 and 2010 were in Africa, according to the Economist Intelligence Unit. Foreign direct investment rose five-fold between 2001 and 2010, hitting $55 billion in 2011, according to the UN.

Economists have also repriced Africa’s domestic consumption prospects, undermining negative stereotypes of consumers’ purchasing power. For example, a report by consultants McKinsey published in June 2010 indicated that the number of families in Africa with an annual income of more than $20,000 now exceeded that in India. McKinsey reckons that the number of consumers earning more than $1,000 a year will rise by 221 million within just five years. In a stark illustration of how Africa’s economy has been reappraised, Ghana’s statistical office in November 2010 indicated that the economy was 75% larger than previously calculated, giving the West African nation middle-income status. US retailer Walmart’s $2.4 billion acquisition last year of South Africa’s Massmart highlights foreign investor confidence in Africa’s consumption prospects.

The bull run is by no means over. Africa is on course for a multi-decade structural boom as it capitalizes on its resource wealth and cashes in on its young population and growing middle class, Standard Chartered reckons, forecasting 7% annual growth on average to 2030, propelled by robust resource demand and domestic consumption.

Amin Manekia, head of Africa banking at Citigroup, says: "This is clearly a market that is growing relatively quickly, expanding to $2.6 trillion by 2020, based on a consensus forecast of 4.5% to 6%." Standard Chartered thinks the continent will experience an Asia-like bull run in investment at 30% of GDP by 2020. Relatively diversified economies in east Africa – Ethiopia, Mozambique, Tanzania and Uganda – have notched up impressive growth rates of above 5% since 2000.

Hopes are highest in Nigeria, sub-Saharan Africa’s economic powerhouse after South Africa. Nigeria’s GDP rose from $46 billion in 2000 to $247 billion in 2011, according to IMF estimates, while the economy is expected to add the equivalent of another Vietnam or Bangladesh to its GDP between 2011 and 2016.

Renaissance Capital is even more bullish, betting on nominal GDP growth of 15% to 25% by 2015/16, creating a $460 billion economy. Political instability and the backlash against fiscal reforms, such as the clampdown on fuel subsidies in January, highlight the many downside risks to these expansive forecasts. However, growth opportunities abound even if Nigeria’s structural economic bull run fails to meet such high expectations. Only 8% of Nigeria’s middle class own a washing machine, for example, a statistic that exposes the level of pent-up demand for loans, both secured and unsecured, to fund consumer and household needs.

In sum, although a woeful number of conflicts still blight the continent – from the continuing Zimbabwe crisis to last year’s conflict in Côte d’Ivoire – the risk/reward calculation for investing in Africa has clearly shifted in the continent’s favour.

The theory of how Africa’s economic promise should reap financial dividends presents an unambiguously bullish picture. It centres on the core investment thesis buttressing emerging markets globally: convergence theory. In short, poorer countries should experience higher growth rates because of their catch-up potential. Adding capital at modest levels in poorer countries should produce higher returns and higher growth rates than adding extra stock in already capital-intensive rich countries, says Yvonne Mhango, sub-Saharan Africa economist at Renaissance Capital.

After Africa’s economic promise turned to dust between the 1970s and the late-1990s – driven by conflict, weak rule of law, high inflation and low investment – this theory should come true, thanks to beefier macroeconomic policies and a fundamental shift in foreign investor sentiment.

Although the relationship between economic growth and financial market expansion is far from linear, from a supply-side perspective Africa’s debt and equity market growth should be driven by powerful structural forces. Pent-up demand for capital is likely among corporates hungry for growth in the context of Africa’s likely economic diversification away from light manufacturing – textiles and family-financed small and medium-sized enterprises (SMEs) – amid urbanization.

David Munro, head of corporate and investment banking for Africa at Standard Bank, says: "African governments are crafting enabling legislation to ensure that the local population can reap the fruits of their economy’s resource wealth; that is opening up opportunities for capital formation and pent-up demand for equity financing."

Last year, there was some evidence of this convergence theory coming to life. Zambeef, a fully integrated African agribusiness with operations in southern and west Africa, became the first Zambian company to list on London’s Alternative Investment Market (AIM) last June, raising $55 million in total in conjunction with a domestic rights issue.

In a baby step towards the creation of a capital market, Bank of Kigali, Rwanda’s largest lender by assets, raised a sum equivalent to $62.8 million in the country’s second-ever IPO, with foreign investors accounting for 40% of demand.

The outlook for deal flow in the coming years is encouraging. Craig Reisser, director of M&A for the CEEMEA region at Citigroup, says: "Africa is increasingly a magnet for capital. You have seen deals launched and priced with attractive premiums and strong demand – this trend should continue."

He adds: "We continue to see a lot of interest in the resources sectors. But other sectors are expanding and increasing activity as well", citing the fast-moving consumer goods, banking and power and infrastructure sectors.

Sovereign capital-raising in external markets also shows how the region’s access to international finance is gradually diversifying away from traditional bank lending and foreign direct investment, expanding the pool of assets for foreign portfolio managers.

Last year, Namibia, Senegal and Nigeria launched competitively priced $500 million benchmark bonds with 10-year maturities. This year, while peripheral European sovereign bond yields have climbed to precipitously high levels, yields on Nigeria’s BB minus-rated 2021 benchmark tumbled to a record low of 5.29% in April, underscoring the diverging fortunes between the eurozone and commodity-rich emerging markets.

China Investment Corporation, with Standard Chartered acting as adviser, acquired a 25% stake in leading South African conglomerate Shanduka Group for almost R2 billion ($255 million) last year, highlighting the growth of Sino-African investment ties outside the resources industry – and the role for banks to intermediate cross-border flows.

Finally, in a development that underscores how investors are seeking to marry their newfound enthusiasm for Africa with direct exposure to the continent’s growth story, the private equity market has witnessed impressive growth over the past year.

Helios Investment Partners closed a record-breaking $900 million fund, driven by strong demand from private-sector investors, while US private equity firm Carlyle Group launched its first Africa-focused fund, heralding Africa’s ascent into the mainstream.

Against this backdrop, it is no surprise that market consensus is betting on a boom in African banking. Africa’s domestic $107 billion financial services industry will be worth $517 billion in 2020, growing 15% annually thanks to a boom in retail banking, a report by Bain & Company forecast last February. The consultancy predicts that banking growth will outperform economic expansion in the coming years as financial intermediation greets pent-up demand. The $107 billion industry is dominated by corporate banking and retail banking, according to Bain.

"Once markets get more and more developed, the need for advisory services, structured financing and investment banking products will increase," Manekia at Citigroup says.

Over the past year, global banks have seemingly woken up to this potential. "International bulge-bracket banks are increasingly interested in Africa and are now seeking to establish a presence," says Munro at Standard Bank.

Stephen Priestley, Standard Chartered’s co-head of Africa wholesale banking, tells Euromoney: "We are definitely witnessing more competition between global banks operating in Africa – it’s good for Africa and for attaining its long-term objective to attract capital."

In November, JPMorgan began offering rand clearing services in South Africa. The bank is awaiting regulatory approval to offer naira-denominated commercial banking products and services and is establishing representative offices in Kenya and Ghana, a precursor to offering local-currency-denominated services, John Coutler, senior company officer for sub-Saharan Africa at JPMorgan, says: "We have plans to expand our commercial and corporate banking services across the world. Africa is part of these expansion efforts, since 80 of our top 100 multinational clients are doing business in sub-Saharan Africa." Credit Suisse set up a wholly owned subsidiary in South Africa in January, following the termination of its joint venture with Standard Bank. And in a practical and symbolic move, Barclays shifted its Africa headquarters from Dubai to London, while HSBC has set up in Nairobi. Renaissance Capital has tapped senior bankers across Africa – despite outlining plans to downsize the group’s workforce elsewhere by 10% last year. "We are still in the building mode but we have so far built a fully integrated business with a strong cash equities capability as well as investment banking and advisory services," John Hyman, co-head of investment banking and finance at Renaissance Capital, says.

In recent years, Africa’s economic outperformance has reaped only modest dividends for investment banks. According to Dealogic, investment banks generated revenue of $323 million in Africa in 2011, compared with $330 million in 2010 and $803 million in 2007. Last year’s revenue constituted just 0.46% of total global investment banking revenue of $69.6 billion. Even in the bull run of 2007, African revenue made up just 0.9% of investment banking revenue globally, according to Dealogic.

"Because the market is more emerging, more fragmented and the pie is smaller than other emerging markets, there are challenges in generating sufficient deal flow in Africa," concedes Coulter at JPMorgan. He adds: "Equity capital markets in sub-Saharan African experienced a flood of IPO deals in 2007; since then there has been a drought. Over the medium to long term, we would expect it to average out."

While local pan-African banks – such as Togo-based Ecobank and Morocco’s Attijariwafa – and domestic lenders are focusing on deepening their retail and corporate banking presence, global banks are still taking modest steps to build up their investment banking franchises. They are concentrating on servicing large local and multinational businesses through cost-effective expansion efforts in corporate and transaction banking – while flirting with investment banking. As one senior bank executive at a US bank puts it: "The creation of monoline investment banking services requires creating a large-scale banking infrastructure that might make such business less profitable."

At the heart of the issue is that the complexities of capitalizing on Africa’s economic promise are all too often overlooked whenever financiers wax lyrical about the region’s growth rates. Global macro fund manager and bank executives agree that while the rationale for investment in Africa has arguably never been more compelling, the statistics paint a more dispiriting picture of secondary market trading and the supply of investable products more generally.

Net portfolio equity flows to sub-Saharan Africa fell by 50% from $8 billion in 2010 to $3.9 billion in 2011, amid the global volatility, even as sub-Saharan Africa’s economy grew by 4.9%, according to the World Bank. "It has been a bit of a puzzle that a hiccup in Athens still manages to create a tremor in Lagos. There has been a real dichotomy between the performance of the real economy and local financial markets," says Renaissance’s Hyman.

After outperforming between 2003 and mid-2008, frontier markets in Africa have underperformed developed bourses ever since, slamming the brakes on primary market issuance. As a result, the global crisis has undermined two conventional frontier-market investment pitches: the higher returns on offer, and their purported non-correlation with the developed world.

Africa’s inability to attract large amounts of equity capital in publicly listed markets – and thus the lack of incentive for global banks to strengthen their cash equities franchise ex-South Africa, for example – is not attributable to unattractive valuations (many Nigerian banks are trading below book value, for example) or poor economic growth. It’s a problem of illiquidity.

In 2010, the IMF painted a dispiriting picture that rings true today. "The small size [of African bourses] and lack of liquidity deters foreign investors: the exposure of foreign institutional investors is typically negligible until a market reaches about $50 billion in size or $10 billion in shares traded annually."

On this basis, only South Africa fits these criteria. Elsewhere on the continent, market liquidity is typically less than 10% of the value of shares traded each year.

"Such low business volumes make it difficult to support a local market with its own trading system, market analysis, and brokers," the IMF noted. The total market capitalization of all companies listed on African stock exchanges was $1.28 trillion at the end of 2011, of which over $1 trillion was on the South African benchmark bourse, the Johannesburg Stock Exchange. Most of the markets have fewer than 100 domestic companies listed. As a result, there are only a handful of Africa-focused investment products for US or European-focused mutual funds, for example.

In Nigeria, foreign portfolio investors and banks face hurdles in getting exposure to its consumption prospects. None of the main telecom players is listed, for example. Meanwhile, corporate governance and price concerns have reduced the appeal of the traditional bellwethers for household demand such as food and beverage companies or industrial conglomerates. There are few pure-play agricultural stocks even though the sector employs 70% of the labour force. "Like many African markets, the Nigerian equity market does not reflect the country’s economy," Mhango at Renaissance says.

One way to boost public equity markets is to consolidate illiquid bourses through linking exchanges, dual listings or by creating regional stock markets. Talks have taken place between African securities regulators on regional integration efforts since the 1990s, but have hit a wall given reform inertia and national pride.

There is also a lack of supply of fixed-income products. Investors in local government debt can barely diversify their credit risk since local Nigerian debt, at around $64 billion, makes up the bulk of sub-Saharan Africa’s investable local-currency-denominated debt stock outside South Africa, with Ghana’s debt stock worth only $6 billion, for example, says Samir Gadio, African markets strategist at Standard Bank.

Against this backdrop, a joint survey conducted by Invest AD and the Economist Intelligence Unit last year, which polled 158 asset managers, highlighted the problem of Africa’s shortage of investable assets in public markets and secondary market illiquidity, factors that have slammed the brakes on the expansion of Africa’s capital markets. Over half of those polled said their investment mandates prohibited them from materially increasing their exposures given liquidity concerns. Citing institutional constraints in listed equity and debt markets, such as security and efficiency of settlements, the availability of market data and the ability to conduct cross-border transactions more generally, the respondents said direct investment opportunities – private equity and infrastructure – are likely to be the most popular asset classes for foreign investors in Africa in three years’ time, followed by commodities, equities, real estate, fixed income and currencies. In sum, structurally, African economies boast strong growth potential, attractive demographics and ever-growing ties with growth markets, principally China. However, the macro-financial cycle is at its early stages; global portfolio managers and global investment banks have little incentive to increase their exposure, given the limited supply of investable assets in public markets.

"Dedicated investors are constructive towards Africa, but larger investors are rarely overweight since there is a lack of debt or equity opportunities, and global investment banking businesses are still highly reluctant to put the infrastructure and boots on the ground," says Hyman.

Africa will increase its share of global GDP from 2% to a still-modest 5% by 2030, according to Standard Chartered. But first-mover advantage will prove crucial, as Munro at Standard Bank explains. "Even though Africa-derived revenues, for all intents and purposes, are irrelevant for now, from the perspective of global banks, there is an expectation that Africa’s promise will pay off within the next five to 10 years," he says. "And you have to be in the market on the ground to capitalize on those prospective opportunities."

Timing the market – rather than country risk – seems to be the greatest challenge for international financiers with budding African operations.