By Paul Trites, director, investments, Sango Capital
“Africa? I’m not sure we have the appetite for that kind of risk.” – US/European/Asian CIO/portfolio manager.
As an African private equity manager raising money from global investors, we’ve heard variations of the above statement many times over the years. It’s a point of view that often doesn’t permit for any serious engagement on the topic of making an allocation to Africa, because of the widely held view that Africa, a relatively unfamiliar territory to many global asset managers, carries existential risks. These risks can seem so difficult to assess and quantify that they make it simple to remove an entire continent, with more than a sixth of the world’s population, from serious investing consideration.
However, as we survey today’s global investing opportunity set, we’ve noticed something interesting. Many of the risks which we have heard cited as excuses for avoiding investment in Africa are today becoming just as serious, if not more so, across the world’s advanced economies. There has been a shift in the global risk landscape, and Africa’s place within it. We believe that shift is significant, and justifies a reassessment by any serious global capital allocator of the decision to include African assets in a portfolio, and in what size.
In Africa, the political stories that get ink are the ones that have to do with dysfunction. A few thematic areas that get a lot of attention include:
- Dictatorships: Africa has countries with regimes which have stayed in power through ruthless repression of personal and press freedoms. Think of Teodoro Mbasogo and his 43 years (and counting) as president of Equatorial Guinea; Paul Biya’s 40 years in charge of Cameroon; or Yoweri Museveni’s 38 years at Uganda’s helm. The level of government interference in such economies can be so high as to impair their investability, one of many reasons why a high degree of selectivity continues to be required when assessing which African countries are suitable investment destinations.
- Juntas: Africa has had bad historical experience with the generals taking charge, though on a per-country basis, Africa has been slightly less prone to coups than Latin America. 2021 was a uniquely bad year for coups in Africa, with military takeovers in Chad, Guinea, Mali and Sudan. In 2022, there was one more, in Burkina Faso. It’s worth noting that none of these countries have been magnets for inbound investment, so while these political events have been events of concern to individual companies with investment in (for example) the resources space, to diversified investors in Africa, they have been non-events. It remains to be seen whether the spike in coups in 2021 was the product of pandemic-weakened administrations falling victim to a one-off wave of opportunistic power grabs. The longer-term trend has been positive, as indicated by the chart below.
- Broken democracies: Where democracies exist and voting is permitted, the stories from Africa have been about, first and foremost, subversion of free and fair voting results. Voters are intimidated, votes are bought, and the counting of votes is manipulated through the control of electoral bodies. Political losers cry foul in many cases, bringing supreme court lawsuits and street protests in their wake.
“You see?” says the portfolio manager. “There may be some improvements here and there, but overall, political risk in Africa is off the charts. How am I supposed to price any of that? My investment committee is a lot more comfortable with stable, investor-friendly jurisdictions, where you know what the policy framework is going to be for the next decade. Places like the US, UK, Europe, China…”
Political risk in the US, UK, Europe, China
US: The chaos following the 2020 federal election in the US, reaching its apex with the storming of the US Capitol on January 6, 2021, underlined the fact that no matter the country, political risk is never zero. American electoral institutions have come under unprecedented scrutiny as it has become clear that certification of votes at the state and even county level can influence who occupies the White House. Gallup and the Pew Research Center, among others, have highlighted how low American faith has become in the political system and public institutions, and the threats to due process have become more serious. As industrial policy becomes more expansive in the economy, political risk matters to investors. An investor seeking to position a portfolio to take advantage of the green-transition priorities in 2022’s Inflation Reduction Act needs to take a view with respect to what future administrations with radically different priorities may choose to do with various tax credits, rebates and subsidies.
UK: Brexit … the Kwasi Kwarteng budget sending the gilt market upside-down … Liz Truss defenestrated after six weeks in office. When it comes to political dysfunction, the Conservative government has been tough to beat. We will see if Sir Keir Starmer, the Labour PM in waiting, will usher in a more stable era in British politics.
Europe: Over the past decade, in general, the political environment in Europe has shifted from cordial parrying between centrist parties to strident calls to action from the political extremes of both left and right. Politicians and opinions previously seen as part of the political fringe are now getting serious mainstream media attention (Marine Le Pen), and even assuming power (Giorgia Meloni). So far, the political consensus is holding for support of Ukraine in its war against Russia, but cracks in the united front are bound to appear as the conflict drags on through a second year, particularly given different national approaches to natural gas price subsidies, arms sales to Ukraine, and assessment of the risks of further escalation in the Ukraine-Russia war. The bad-tempered debates over fiscal austerity in the Eurozone crisis of the early 2010s may come to seem quaint by comparison.
China: As Xi Jinping as grown into the strongest Chinese leader since Mao, the CCP appears to have no appetite for change at the top for the foreseeable future. President Xi has surrounded himself with pliant figures who are willing to implement his favoured policies. A long-term bet on Chinese technology firms needs to carry with it an assessment of the risk that the government may once again crack down on the sector, as happened in 2021. An investment in the banking or real estate sectors needs to include a view on how the People’s Bank of China will deal with the stock of bad real estate loans currently clogging its banking system. We are already witnessing capital flight by western investors from the region, with an impact on both public and private markets.
The world’s oases of political stability are built upon shifting sands.
“I see what you’re saying,” says the portfolio manager. “But put politics aside. What about the financials? Inflation and interest rates are just too high in African countries, and I can’t get comfortable on currency risk.”
Inflation, currency, and interest rate risks
In Africa, high inflation has been part of the business operating environment for many years. Consumers and businesses are familiar with the challenges (and occasionally the opportunities) presented by inflationary conditions. This experience was brought to bear as inflation spiked in 2022, though over a longer time frame, the level of inflation across sub-Saharan Africa has moderated significantly, as evidenced by the chart below:
Meanwhile, in the US, consumers and businesses are grappling with price increases that haven’t been seen in more than four decades, putting senior business executives in an environment they haven’t seen in their entire careers.
The risk of rising prices is now largely similar across the world. The difference is that in Africa, inflation is a familiar fixture of the landscape, while in the US and Europe, it’s a shock that has put many businesses into uncharted territory. If price pressures do not abate as quickly as markets anticipate, the wage demands of frustrated American and European workers will squeeze the profit margins of those businesses that can’t pass cost increases through to their customers.
In the decade-plus bull market for the US dollar, many African currencies have faced significant valuation pressure against the dollar, impairing dollar-denominated returns on African assets.
However, in 2022, with US interest rates pushing higher into positive territory after years of hovering just above zero, many advanced economy currencies also saw valuation pressure as capital flowed into US dollars.
As can be seen in the chart above, many African currencies held up reasonably well in value against the US dollar, particularly compared to advanced economy currencies, like the British pound and the Japanese yen.
The arrival of severe currency risk on the shores of other advanced economies was a shock to the system in 2022 and should cause asset allocators to rethink the level of currency risk in markets previously perceived as relatively protected against it.
High interest rates are a fact of life in African markets. The high cost of debt financing has led to key differences in how a private-equity-owned company is financed and run in Africa, relative to what has been the case over the past several years with near-zero interest rates in advanced economy markets.
As interest rates have moved higher across advanced economies, private equity investors in those markets are encountering the challenges that higher interest rates pose to the value-creation playbook that worked so well in a zero-interest-rate environment. No longer will more debt make a model work for a slow-growing business. With higher rates making it more challenging to accelerate profit growth through M&A or greenfield expansion, value creation will be driven by the growth of the core underlying business.
For Africa, high interest rates and constrained access to financing are business as usual. For advanced economies, high interest rates are an unwelcome shock that render many value-creation strategies from the last decade impractical or impossible.
Another important change in the landscape is the re-emergence of interest rate risk. With rates so low for so long, one of the most elemental risks in modern finance – the impact of a sudden increase in interest rates – may have been calculated but was not considered as a serious threat by many executives in advanced economies. The failure of Silicon Valley Bank was a bracing reminder that even US treasuries carry risk if their duration is greater than zero.
Before 2022, the world’s advanced economies did not have much to worry about in terms of military risk. For the most part, the US, Europe, and advanced Asian economies enjoyed a state of peace. Military spending was near post-WWII lows as a percentage of GDP in most wealthy countries, freeing up government spending capacity for social spending, including the extraordinary fiscal measures undertaken by governments to support citizens impacted by COVID-19.
When Western readers saw news of military conflict, a fair amount of attention was given to Africa. The civil war in Ethiopia, ongoing insurgencies across the Sahel and Horn of Africa, and continuing conflict in the Great Lakes region occupied much of the limited media space devoted to Africa by global media outlets. The effects of these conflicts were felt intensely on a local basis, but none of them promised to escalate into a continent-wide conflagration. Across many African economies, these were stories coming from remote parts of their country or neighbouring countries and did not pose any day-to-day concern or business disruption.
With its invasion of Ukraine in March 2022, the perception of military risk has changed not only in that country but across all of Europe and its non-European NATO allies. As the largest shooting war in Europe since WWII has escalated and extended, government thinking around military spending has changed. Since the invasion, an aggregate of over $200 billion of new military spending has been committed by the members of the European Union. If Ukraine falls, it’s difficult to imagine that Putin’s appetite for conquest will be satisfied. And if Russia were to invade a NATO member, putting the pact’s Article 5 mutual defence guarantee to the test, the prospect of a much broader war in Europe looms. The fact that such a war would include a non-zero chance of the use of tactical nuclear weapons is a prospect that now merits serious discussion when ten years ago it would have seemed the product of a wildly overactive imagination.
The impact of this change in risk is significant. A large capital investment now carries with it an entirely new set of risks to be quantified and managed. If a company is building an LNG regasification plant in Germany, for example, how much will it now cost to insure against the targeting of such infrastructure in an act of war, either physical or virtual? The shadow of war is disrupting the regular course of business, while government resources are diverted to strengthening military capabilities (itself a perverse kind of self-insurance at the national level).
But the elevation of military risk does not stop at Europe’s shores.
After decades of diplomatic doublespeak about Taiwan, in which it has existed in a netherworld between renegade provincehood and nationhood, Xi Jinping has made statements indicating that he intends to bring Taiwan back into China’s possession during his time in power. Even if invasion is not being seriously contemplated, the army has been told to be ready to take Taiwan by force as soon as 2027. And despite many rounds of inconclusive sabre-rattling in the past, the world is now taking these threats very seriously.
Taiwan matters, and not just because of the political wishes of its people and the historical precedent that would be set if its many allies chose to renege on their explicit and implied commitments to come to its aid if invaded. Taiwan currently manufactures more than 60% of the world’s semiconductors and more than 90% of the most advanced ones.
Given the fresh experience of supply chain snarl-ups during the COVID-19 pandemic, we know well how critical the reliable supply of chips is not only for computers and smartphones but for vehicles and everyday household appliances. With microchips as a critical element in a broad economic conflict between the US and China, the interruption, in the short- and long-term, of Taiwanese chip supply by a Chinese invasion could be extremely damaging in economic terms.
Another standoff, with unpredictable but potentially catastrophic military risks. It is difficult to see a smooth path to a new formula of strategic ambiguity over Taiwan. A much starker question looms: Is Taiwan an integral part of China, or isn’t it? And that question will likely not be adjudicated without conflict.
A spring-of-1914 feeling may be in the air. It’s clear that for years, the seriousness of China and Russia with respect to their grievances has been systematically underestimated. An investor not giving weight to the possibility of broader military conflict, pulling in NATO and its allies, is making a bet on a peaceful world and the financial returns that flow from that state of nature. Changes in facts on the ground could happen very rapidly, with severe impacts on asset prices.
Would Africa be completely untouched by these potential broad military conflicts? Certainly not. The resulting spikes in commodity prices would certainly affect Africa, as was observed in African countries importing oil and wheat in the months following the start of the Ukraine-Russia war. But by being outside the theatres of potential conflict and not being forced to expend resources to support military allies, Africa would suffer less than Europe, Asia, and the US.
From a diversification perspective, having assets in a region that promises to be lightly touched by the impact of extraordinarily negative (and inflationary) events is exactly the safe port in a storm that a global asset manager should find attractive.
Leaving aside military risk, there are a set of issues that businesses in Africa face every day, disrupting smooth operations. The questions come up in diligence processes:
- How can you run a factory if your power supply is unreliable, and if fuel shortages make it difficult to keep backup generators running?
- How can you run a business involving imports and exports when customs inspections and other red tape may create unpredictable delays?
- How can a business operate without participating in corrupt business practices?
“How do you even do business in this region?” asks the portfolio manager.
The answers differ, depending on the company and the region, but thematically, they’re the same.
Business adjusts to the conditions it faces. And after decades of dealing with the issues of business friction, African management teams are well accustomed to getting on with things – investing in solar power, inventorying fuel, building relationships with reliable intermediaries, and finding ways around corruption.
And slowly, these frictions are improving in African business. Up to its final edition in 2020, the World Bank’s Doing Business report had shown remarkable progress through the 2010s in the ease of doing business in African countries relative to other regions, particularly in four key areas: protecting minority investors, trading across borders, enforcing contracts, and resolving insolvency. More progress lies ahead.
Business friction in the US, Europe, and Asia
The COVID-19 pandemic laid bare (in terms of shelves in stores, quite literally) the extent to which global supply chains had been taken for granted. Lockdowns of factories and disruptions in shipping schedules, coupled with overnight changes in consumer behaviour, led to a world where the weekly shopping run put a new fear into consumers’ minds: What will they be out of this week?
Something as simple as a business trip became an exercise in frustration, given the differing regimes with respect to COVID-19 vaccination and testing. Many office workers went home, and now not all of them are willing to come back.
Spikes in gas and power prices disrupted business and consumer life in Europe in 2022 and may do so again in 2023. German manufacturers of chemicals found that without a reliable supply of Russian gas after the invasion of Ukraine, processes needed to be reconfigured, and some production put entirely on hold.
Business friction, and all its attendant frustrations, are on the rise in the world’s advanced economies.
The risk of natural disasters and disease
Natural disaster risk
Africa has historically had a difficult experience with droughts and floods. Water is one of the continent’s greatest challenges, and in times of scarcity, the human toll can be significant. The impact is not only felt in human health outcomes but economic output. The impact of drought on agricultural output can have a material impact on economic growth, particularly in countries that have a significant part of the population working in agriculture.
Thanks to climate change, the impact of adverse physical disasters is becoming more frequent and severe in advanced economies. In 2022, the US had 18 separate natural disasters involving financial losses of $1 billion or more each. The only years that had more such events were 2020 (22) and 2021 (20). As global temperatures continue to increase, the risk of natural disasters will be increasingly significant in advanced economies, drawing those countries unhappily closer with Africa in this respect.
In Africa, the experience of disease has been severe, prolonged, and disruptive to economic growth. The lives and time lost to AIDS, malaria, tuberculosis, trypanosomiasis, and Ebola are significant. Lives lost comprise an incalculable burden, and just the time spent suffering and recovering from illness means lost time from school and work, impairing long-term workforce productivity.
COVID-19 turned the perception of disease risk upside-down. The disease had a far greater impact in terms of serious illness and death in advanced economies, with the countries of Africa being touched more lightly thanks to youthful populations, quick public health responses, public adherence to safety measures, and favourable climate conditions.
This was fortunate, as African governments did not have sufficient fiscal space to provide benefits allowing people to spend significant amounts of time at home without enduring financial hardship. African countries, in general, saw less severe drops in economic growth from COVID-19 than advanced economies.
“Hmm. It might be time to revisit some of our assumptions about the risks of investing in Africa relative to the rest of the world,” a portfolio manager might say.
We agree. There is a broad range of risks that we believe needs to be reassessed because, in many cases, what may historically have seemed to be higher risks in Africa have either closed the gap with respect to advanced economies (inflation risk, interest rate risk, currency risk, political risk, natural disaster risk, business friction) or may even be lower-risk than advanced economies (military risk, disease/pandemic risk).
With a lower risk differential relative to advanced economies and continuing low return correlation, we think there has been a step-change improvement in the attractiveness of African assets as part of a global portfolio. As asset allocation decisions are made in 2023 and beyond, responsible stewards of capital should think seriously about revisiting and recalibrating their assumptions with respect to the risk and return of African assets to better position their portfolios to weather future crises.