The untapped private equity potential

The untapped private equity potential
Samuel NUNOO &Esther Afoley LARYEA

Small and Medium Enterprises, popularly referred to as SMEs, are one of the primary means through which countries can achieve their economic growth objectives. Besides the unique growth opportunities SMEs present as prolific job creation tools, they also serve as innovation hubs across several industries. In Europe, SMEs have been identified as the drivers of past economic growth and are still considered key to unlocking future economic growth. Although SMEs play a significant role in economic activities in developing countries, their potential remains untapped. In the case of Africa, SMEs contribute to over 50% of employment and GDP, but the continent continues to face alarming rates of poverty and unemployment.

In Ghana, SMEs account for approximately 92% of businesses and contribute to 70% of GDP. This reveals the economic weight of SMEs in the Ghanaian economy, their crucial role in employment generation, and their potential as a means of alleviating poverty. Although important, the mere presence of SMEs does not guarantee economic growth; it is their ability to scale up to medium and large firms that lead to the expansion of industries and economic growth.   As a nation, we have struggled to scale SMEs and consequently lost out on economic opportunities.


Efforts of government

Acknowledging the role of SMEs, the government of Ghana has introduced several initiatives and institutions targeted at supporting the progress of SMEs. One such institution is the Ghana Enterprise Agency (GEA), formerly the National Board for Small Scale Industries (NBSSI). The GEA exists to create an enabling environment for SMEs, facilitate access to credit and provide substantial and high-quality business development services to SMEs. The government has been able to use the GEA in carrying out its initiatives, including the GHS 600 million COVID-19 stimulus package the GEA made available to over 200,000 businesses in 2020.

Despite the government’s efforts, factors constraining the ability of SMEs in Ghana to scale efficiently continue to persist. These factors include lack of access to appropriate technologies, lack of management skills and training, and, most importantly, lack of access to finance – the most crucial element to survival and scaling of SMEs. With most SMEs formed as sole proprietorships, the owners are solely responsible for the firm’s financing requirements which are often too huge to bear and do not result in a sustainable approach to financing.

Debt Financing

The first step for most owners in raising capital for their businesses is to reach out to family and friends for contributions and loans. Traditionally, the next option would be loans from banks; however, SMEs are unable to obtain these loans as they are perceived as having high default risk. The few fortunate SMEs that are able to access loans are charged very high interest rates. SMEs unable to raise capital through loans from banks often look to Microfinance institutions. Microfinance institutions have succeeded in providing financial products and services in the form of microloans, savings accounts, micro-leasing services, micro-insurance services, and money transfer services to assist impoverished business owners in establishing or growing their businesses. Therefore, it is not surprising that many SMEs attribute their success to microfinance institutions.

The Potential of Private Equity 

Despite the immense contribution of microfinance institutions to the SME sector, there remains a considerable financing gap. Filling this gap will see SMEs scale their operations to serve larger markets and become the cornerstone of employment creation and economic growth. A potent source of financing to propel the growth of SMEs that has remained largely untapped is private equity (PE). Private equity is a growth-oriented source of finance that ensures that entrepreneurs have the capital available to take on long-term investments that establish profitable business models and create innovative solutions to consumer needs. Short-term financing instruments, such as bank loans and microcredit facilities are not suitable for taking on long-term investments that sustain innovative programs and achieve consistent long-term growth.

The private equity industry has been in existence for quite some time and is still a thriving industry. In recent years, the influx of European investors and fund managers looking to diversify their portfolios while capitalizing on exciting opportunities outside their home markets has seen the industry experiencing some growth and vibrancy. The expansion of the industry resulting from the influx of investors into the African private equity market is partly due to the realization by investors that investments in emerging markets yield higher returns over that of matured markets.

Gains from Private Equity

Research examining private equity’s impact on firms has shown that PE firms have a higher return on equity than listed firms. Also, having a small board size and involving the founder of the PE firm in management decisions tends to impact PE firm’s efficiency and profitability positively. A closer look at SMEs vis- à -vis other sources reveals that family-run SMEs generally remain more reluctant to adopt innovative strategies. One would expect the involvement of bank loans to motivate investments into R&D, but that is not the case. Private equity rather encourages more investments into R&D in family-run SMEs far more than bank loan financing. The implication is that PE firms conduct value-generating activities that lead to the business’s long-term growth.

To understand how PE firms introduce value-generating activities into the firms, we delve deeper into the operations of private equity firms. PE investments typically occur in three phases: the investment selection phase, the managing and monitoring phase, and the investment exit phase. During the investment phase, private equity firms screen potential firms to select a firm they want to invest in. The managing and monitoring phase, require PE firms to actively monitor and manage their portfolio to safeguard their investments. After successfully managing and growing their portfolio firm, private equity firms exit from their investment in the portfolio firm either through an Initial Public Offering (IPO), a merger, or an acquisition.

The management and monitoring phase is undoubtedly the most crucial stage in the investment process for private equity firms. To successfully navigate the management and monitoring stage and ensure that the portfolio firm grows efficiently, private equity firms adopt management control mechanisms, including taking a seat on the portfolio firm’s board of directors, engaging in the hiring process, and actively managing the firm’s operations to ensure they are involved in crucial decisions affecting them. Since private equity professionals have experience in funding and growing businesses, they can develop strategies to put their portfolio firms on a path of sustainable growth and profitability. In addition to being actively involved in the firm’s management, PE firms leverage their reputation and performance in hiring experienced professionals to manage various facets of their portfolio firms. PE firms may also be directly involved in the operations of the company. In doing so, the portfolio firm can develop a sustainable and profitable business model, increase the odds of their growth, and the certainty of a return on investment for the firm, industry, and economy.

For these gains to actualize, there must be a level of trust between equity investors and entrepreneurs to avoid conflicts and ensure an alignment of interests between both parties. Entrepreneurs must be confident in the ability of the private equity firm to provide resources and expertise to help them grow their firm. Also, entrepreneurs must be willing to give off a part of their control to private equity investors to enable PE investors institute management control mechanisms that benefit the firm. In turn, PE investors must act according to the terms and conditions of the investment.

Recommendations to Government

Ghana currently ranks 91st on the 2018 IESE Venture Capital and Private Equity Country Attractiveness Index, a relatively low rank compared to other African countries such as Nigeria and Morocco, ranked 72nd and 61st, respectively. Ghana’s position on the index proves that, although the government has made commendable efforts, more needs to be done to foster PE investments in Ghana. The Government of Ghana must look to create an enabling environment for both SMEs and investors to ensure the growth of the private equity industry.

To do this, the government must create a robust SME ecosystem by working with other private business development agencies to support SMEs. Working with business development agencies provides SMEs with the necessary tools and knowledge to fine-tune their core operations. Doing this will lead to viable business ideas worth investing in. Also, working with business development agencies creates a robust SME ecosystem where SMEs can gain access to knowledge and skills to operate effectively. A strong SME ecosystem increases the attractiveness of Ghanaian SMEs to international investors.

Another major cause for the low level of PE investments in Ghana is the underdevelopment of the capital markets. With the low level of activity of the Ghana Stock Exchange, private equity firms are skeptical of their ability to exit their investments to make a profit. With this, the government must look to revitalize the capital markets to increase investors’ confidence in the capital markets.

The authors are with Ashesi University

Leave a Reply