Deepening our financial sector requires greater access to private pools of equity capital
When faced with the daunting task of having to raise capital to finance its growth, a business has two options to consider – debt which is effectively, borrowed money, or equity, representing owners’ contributions. As the "residual claimants", the economic agent with the sole remaining claim on the net cashflows of the business, equity investors should expect to benefit not only from the potential upside in the business but also, carry the risk of loss. Hence, basic corporate finance principles dictate that the foundation of any capital structure be composed of equity. In its simplest form, equity has no fixed repayment date or guaranteed return. It is a patient form of capital, as compared with debt, permitting the business to invest for growth without the pressure of imminent debt service. It carries more risk than debt, but may yield a significantly greater return in the long run. And yet, Ghana’s financial landscape is dominated by debt.
How did we get here?
Given the large number of lending institutions in the economy, such as banks, micro-finance and savings & loan companies, Ghana's predicament is understandable. Ironically, however, there seems to be dearth of lending opportunities with appropriate risk-reward trade-offs, especially within the banking sector. This is particularly manifest in the commonality of the banks' loan portfolios, and their penchant for aggressively pursuing a limited subset of clients. As a result, several businesses that require equity financing, an indisputable conclusion that will follow a thorough and candid assessment of their credit worthiness, have instead been offered bank financing. An alarming trend persists where new businesses settle on bank financing as the foundation of their capital structures, instead of equity. With distinctively weak capital foundations, the vast majority of these businesses are unlikely to be able to contribute meaningfully or sustainably to economic growth. Their ability to withstand shocks through different economic cycles will be very limited.
In making loans to businesses that have limited equity in their capital structure, lenders indirectly and unwittingly, step into the shoes of shareholders, effectively taking on equity risk for debt returns. Despite this additional risk however, these lenders do not benefit from the upside in the company's performance. In fact, the exposure to equity risk further places the deposits of such banks in a perilous position. Sadly, neither these lenders nor their depositors earn additional returns for the exposure to equity risk. It is from this perspective that the Bank of Ghana is exploring an increase in the minimum regulatory capital levels for banks, to ensure appropriate equity buffers to safeguard depositors’ monies.
Let’s be creative and not prescriptive
The blame for the pitiful state of our equity markets lies not entirely with the banks. Indeed, the crowding out effect from excessive Government borrowing, and its deleterious impact on interest rates, provides easy opportunities for yield-seeking investors to achieve attractive fixed income returns while avoiding the risks associated with equity investments.
Furthermore, viable alternatives for raising equity capital in Ghana, whether through the public markets or privately, are exceedingly limited. The mood of excitement that greeted the establishment of the Ghana Stock Exchange (GSE) in 1990 has long fizzled out. Aside from the high standards for financial reporting and corporate governance that are required of public companies, the prospect of being held accountable by shareholders in such a public manner can be intimidating for some privately-held businesses. Becoming a publicly-listed business is not for everyone. After 27 years of its existence, only 35 corporates, predominantly medium and large-sized in nature, have ventured onto the GSE. In addition, a lack of liquidity, driven by factors such as the limited number of listed companies, the limited “free float”, which represents the proportion of shares in a company in the hands of public investors and not held by insiders, the low numbers of retail investors, and the significant and long-term holdings by the state pension fund (SSNIT), further constrains the market's potential for development.
At the same time, it has been disconcerting to see a crescendo of pressure being brought to bear on multinational companies operating in critical sectors of the economy such as financial services, manufacturing, mining and telecommunications to mandatorily list on the exchange as a catalyst to further develop the market. The argument frequently adduced by proponents of this policy is to afford Ghanaians an opportunity to participate in the ownership of these companies. This is wrong - a stock exchange is not a wealth distribution platform - it is primarily a market to facilitate the issuance and trading of securities, such as equities. In any free market regime, the decision to trade on a market, or to issue and list the shares in a privately-held business on a stock exchange, should remain voluntary. Concerns regarding low Ghanaian participation in critical sectors of the economy are best addressed through local content policies, good examples of which exist in the oil & gas and mining sectors, to name a couple.
Relevant and broad-minded Government policies will achieve much
Admittedly, there has been some effort by Government to improve the availability of private equity financing through venture capital and private equity funds. But much more needs to be done. The majority of the funds within the local private equity sector only became active after the establishment of the Venture Capital Trust Fund (VCTF) Act 680 (2004) and the Internal Revenue (Amendment) Act (2006). These provided favorable tax incentives such as exemptions from capital gains and corporate tax, for firms domiciled in Ghana that invest in private equity and venture capital funds. To date, relatively few private equity and venture capital funds have succeed in developing portfolios of repute. On the contrary, however, there are currently 33 commercial banks, 77 savings & loans companies, 141 rural and community banks and 564 microfinance institutions in active operations. This, quite frankly, points to the need for a rethinking of our policy priorities with respect to capital.
An opportunity exists to nudge institutional investors, and to a limited extent, retail investors to make more private equity investments to fill the financing gap. More generous tax and regulatory-based incentives, combined with matching grants, should provide the required draw. The goal of these policies will be to significantly increase the amount of equity investments in privately-held businesses that meet specific criteria. As has been the case for the few venture capital and private equity funds that have been set up, institutions that are likely to take advantage of these incentives include investment banks, insurance companies, asset managers and pension funds. What all these institutions have in common is that they typically have large sums of money that they seek to invest for long periods, in order to generate appreciable investment returns and provide retirement income to their clients.
Too much money chasing debt products
The policy goal of the tax and regulatory incentive scheme should be to increase dramatically, the volume of private equity investments in emergent companies. Additional incentives over what currently persists in our tax code would certainly bolster the interest and participation of local fund managers - regulated firms that provide investment advice and assist clients to invest their money. Research suggests that foreign-owned fund managers currently have four times as much in private equity assets as do Ghanaian-owned fund managers, given their broader access to long-term capital. This anomaly can easily be corrected by tweaking the guidelines that govern the investments of local pension assets.
Pension reform has translated into a pile of GHS 6 billion that has largely been parked into government debt and fixed income instruments issued by banks. This asset pile is growing at a healthy clip – 60% per annum – and represents a readily accessible source of funding for private equity. The current investment guidelines governing the investment of pension funds do not allow for private equity exposure. Amending this will unlock long-term patient capital for investment, boosting the supply of funds. The use of tax credits, both on the “front end” when equity investments are made and on the “back end” through a capital gain exemption that reduces tax on the gain realized on successful investments, are approaches that have proven successful in a number of jurisdictions. Other more aggressive incentives could include an outright exemption from withholding taxes on income distributions such as dividends to shareholders, or from corporate, income or value-added taxes (VAT). Incentives can also be delivered – either to investors or to the companies in which they invest - directly through a matching grant program.
As the number of private equity and venture capital funds increases and the ease with which businesses are able to access equity capital improves, the merits of a stock exchange as an avenue to raise capital or to facilitate the trading of equities becomes even more notable. In this regard, the stock exchange serves as a conduit for private investors to monetise a portion or all of their holdings, while enabling the company to swap any exiting investors with new public investors. Over time, a critical mass of businesses with private investors will develop, serving as a healthy pipeline for future stock market listings. Additionally, the stock exchange would channel much needed capital to sectors of the economy that require financing and provide private investors with an accessible exit for their investments. And finally, but quite obviously, a robust economy with prudent fiscal and monetary policies that boost private sector growth and reduce economic uncertainty would also support the stock market.