Conduits of Capital

• The development of an onshore financial centre is
not merely a matter of legality but largely a function of
cultural changes. Investors must feel confident in the
region with respect to political stability and regulatory
risks.
• Whereas the location decisions of PE firms have
significant impacts on the local economies, it appears
domiciliation offers considerably more modest benefits.
We therefore suggest that it is more important for most
African nations to focus on the development of PE
activity in the region (i.e., local HQs and offices) than
on establishing an onshore financial centre for PE fund
domiciliation.
2. THE IMPORTANCE
OF PRIVATE EQUITY IN
FRONTIER MARKETS
Enterprises in frontier markets face many challenges,
including inadequate infrastructure, scarce management
skills, competition from the informal sector, and corruption.
Beyond these factors, recent data from the World Bank
Enterprise Surveys suggest that 23.4% of firms in Sub-
Saharan Africa (SSA) identified “access to finance” as the
biggest obstacle to their establishment—the largest of all
obstacles identified. 1
Private equity is a critical form of risk capital—i.e., money
contributed to high risk investments that have exceptional
growth potential but also run the possibility of complete
default—in frontier markets. On the firm level, PE offers
financially constrained firms a viable alternative to traditional
debt financing, which is often unattainable. On the country
level, PE investment can help create demonstration effects
that can propel an economy forward, beyond the direct
impact of the given investment. PE teams provide advice to
the entrepreneurs in their portfolios, which builds domestic
business capacity on a broad level. We discuss these
benefits in more detail below.
2.1. Firm-level Benefits of Private
Equity Participation
Risk capital in the form of PE can alleviate financial barriers
to growth for SSA firms for which bank loans are extremely
difficult to obtain. Bank financing in frontier markets is
impeded by the difficulty of finding reliable information on
both the entrepreneur and the business. The impact of such
information gaps is substantial.
In a study of the transition economies of Central and
Eastern Europe, James Barth, et al. found that small- and
medium-sized enterprises (SMEs) with external auditors
had improved the verifiability of their financial statement
and thus could better access credit from large creditors
that specialised in “hard information” lending. 2 In SSA, the
World Bank Enterprise Surveys suggest that roughly half of
firms do not have an annual financial statement reviewed
by external auditors, 3 which often makes banks unwilling
to lend.
Another challenge to SMEs seeking finance is the poor
quality of the judicial system, which complicates property
claims. In light of the information asymmetries and judicial
system issues, lenders de-risk investments with collateral
requirements. Heywood Fleisig, et al. pointed out, however,
that in low income countries there is a typically a mismatch
between the type of assets that firms have—namely,
moveable assets such as the goods they produce and
manufacturing machinery—and those that lenders typically
accept as collateral (i.e., new motor vehicles or urban real
estate). 4 In fact, research suggests that 78% of the capital
stock of a business enterprise in the developing world is
movable assets, while only 22% is immovable property—
that is, the collateral that the banks want is exactly the type
that the SMEs lack. 5
As a result, researchers using data from the Enterprise
Surveys found that 22% of firms in SSA are “Fully Credit
Constrained,” as they had obtained no external loans (of
any form) during the previous fiscal year because either their
loan applications were rejected or no loans were sought
despite a need for capital. 6 Risk capital (i.e., PE, typically
in the form of venture capital or growth capital) can provide
the financing critical to growth and economic development.
In addition to capital, research (though mostly on US and
European companies) indicates that PE can add substantial
value to firms with respect to governance (e.g., improving
management practices, reducing earnings management,
etc.) and professionalization (e.g., recruiting, CEO choice,
etc.). 7
Conduits of Capital – Onshore Financial Centres and Their Relevance to African Private Equity
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