The majority of the financing in sub-Saharan Africa for acquisitions and management buyouts comes from a hybrid of short-term debt from local banks and equity participation, generally from private equity.
It’s known as mezzanine finance — a household term in Europe and the U.S. but in the African context, less known and more loosely applied.
Local laws and regulations limit mezzanine finance to unsecured senior or subordinated debt — debt that takes priority over other unsecured debt — possibly with convertible optionality.
The risk level intrinsic to some of the sub-Saharan deals can push mezzanine interest rates up to between 20 percent and 30 percent. Yet mezzanine finance presents a vital opportunity and resource to the sub-Saharan Africa financial market.
A cash infusion is the most basic and straightforward benefit of mezzanine finance. It provides a strategic source of funding for acquisitions and management buyouts. This type of funding is also central to acquisitions made by a growing number of leveraged buyout players in the sub-Saharan Africa space as well as previously locked-out participants in the private equity space such as black economic empowerment investors in South Africa.
Avoiding equity dilution is always a top concern for entrepreneurs and family business owners. Both types of owners have significant business interests tied to financial investment, sweat equity and personal attachment with a business. And both parties generally want to avoid any significant dilution of their equity in the business.
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Direct investors, by contrast, want a controlling stake in the business in which they invest and will, for that reason, request a majority stake in the business and seats on the board.
Mezzanine finance is an avenue for entrepreneurs and family business owners to avoid a considerable dilution of their equity, a reduction in their control of the business and the general conflicts or issues that arise with incorporating new — and generally more active — investors.
Mezzanine finance provides another level of funding for companies that have reached the limit on bank borrowing capacity. This discussion is also partly tied to the equity dilution conversation. If the company is willing to assume more debt to avoid equity dilution, then mezzanine finance is a vital option.
Mezzanine finance can play a role across various sectors. This characteristic cannot be understated in the sub-Saharan Africa region where bank borrowing is limited across all sectors.
In retail and consumer sectors, and any other traditional leveraged-buyout sector, mezzanine finance efficiently slides into the capital structure and provides both business owners and direct investors a space in which to manage equity and control concerns on both sides.
For example, some direct investors provide their own mezzanine finance to their deals with a convertible option. The convertible option gives the investor a way to have a piece of the upside but alleviates investor concern of control on the front end.
Mezzanine finance is now also a vital part of greenfield or brownfield infrastructure, especially power projects. Operators view mezzanine finance as a quick way to extend the life of their projects before direct investors get fully excited and involved.
This extra source of debt is also central to the general funding of these infrastructure projects as equity providers are hesitant to provide more than a third of the financing of the entire project (with a preference for less equity) and therefore seek to make debt a significant portion of the funding.
The challenge nevertheless for infrastructure projects is around the limit to mezzanine finance and overall debt borrowing. Considering the size of the projects – many push beyond $500 million – mezzanine finance as an industry may be lacking capacity. The relatively smaller sub-Saharan African cohort of mezzanine financiers lack the financial backing to support the appetite of borrowers.
Can European and American voters find a niche in the sub-Saharan Africa mezzanine finance space? This may be the central question going forward in an industry short of available cash to lend. The industry requires more investment and more players to support projects and boost competition on deal terms for companies.
Very few players that invest in sub-Saharan Africa manage funds north of $100 million. For example, Vantage is a major player with Mezzanine Fund III (approaching $250-to-$270 million) with 60 percent targeting sub-Saharan Africa, excluding South Africa.
Another big investor is the $670-million Emerging Africa Infrastructure Fund (EAIF), managed by Investec Asset Management. It is unique in its structure as a public-private partnership anchored by the governments of the Netherlands, Sweden, Switzerland, and the U.K.
The Emerging Africa Infrastructure Fund invests in infrastructure projects with both long-term debt and mezzanine finance which boost its structuring options in negotiating with companies. A great portion of this fund can go to sub-Saharan Africa excluding South Africa. This is good news to sub-Saharan African companies yet these Vantage and EAIF funds are part of the small group of funds with considerable capital dedicated outside South Africa and Nigeria.
The industry needs to mature and will do so. The sub-Saharan Africa market does not necessarily draw distinct lines between mezzanine finance, second lien, and payment in kind notes as well as other forms of debt financing.
The differing rights and obligations to companies and their investors under all those debt financing structures in Africa are also nebulous and therefore hard to uniformly and explicitly categorize as done in Europe and the U.S.
That said, the evolving nature of the market and the opportunity to define terms is a positive for the experienced investor willing to take risk. It’s only scary if the unknown and undefined worry you. I recommend avoiding many other aspects of sub-Saharan Africa investing if that is the concern.
Kurt Davis Jr. is an investment banker with private equity experience in emerging economies focusing on the natural resources and energy sectors. He earned a law degree in tax and commercial law at the University of Virginia’s School of Law and a master’s of business administration in finance, entrepreneurship and operations from the University of Chicago. He can be reached at email@example.com.