A new age of funding: The rise of alternative investments and co-investing in Africa

Hot on the heels of the successful Africa Forum at the Hogan Lovells London office earlier this year, Hogan Lovells South Africa recently hosted its first Africa Forum in Johannesburg. The event was well attended, with delegates from Europe, Africa, the U.S., Asia and the Middle East. One of the sessions during the day focused on the rise of alternative investments in Africa.

In its simplest form, alternative investment is the investment of capital outside of the mainstream banking industry. If there was one key message from this session, it was the importance of partnerships in the wake of regulatory reform. In order for alternative investors to be successful in Africa, they need to collaborate, rather than compete with the traditional commercial banks and development finance institutions (to which we will refer collectively in this blog post as "banks").

Regulation

Arguably, one of the biggest changes to occur in the financial system since the global financial crisis is increased regulation. Capital and liquidity requirements as part of the Basel III directive have disincentivised banks from holding too many alternative “riskier” assets on their books and encouraged a deleveraging exercise by the banks, with many “riskier” assets being sold off. Despite this, investors still need these more flexible and short-term investments and funding, which provides an opportunity for alternative financiers to step in. 

But why is this? Well, not only are banks required to hold more Core Tier 1 capital against their risk weighted assets(RWAs) than before (from 2% to 7%), but now their RWAs will be calculated differently too, with sharp increases in RWAs from trading activities, that is the “riskier” investments, up 23% or more in some instances. If the earnings from such activities cannot be passed on to underlying clients then banks' capital strategies will naturally have to become more focused around lower risk assets that are less volatile and provide more stable returns for demanding shareholders. 

In any case, we can expect to see the more complex derivatives, trading and similar “riskier” business activities reduce in banks as the new rules come into place and take their toll on the profitability and returns of banks engaging in such transactions. This lack of liquidity in the respective markets caused by the absence of the banks will undoubtedly be filled by the alternative financiers, who are more nimble and can fulfill such demands more easily and under less scrutiny.  

Co-Investing

An alternative structure could take the form of co-investing, whereby banks form relationships alongside alternative investment companies to gain exposure to “riskier” asset types, but without having to directly hold the asset on their balance sheet.  The co-investing model provides an avenue for institutions that would like to be more actively involved in the perceived “riskier” deals, but do not want to fully in source investing in such asset class. The model offers several advantages relative to the traditional and direct investing models, for example co-investing is an efficient way to reduce the average cost of investing as the bank is not typically charged management or performance fees. Plus, the additional capacity provided by co-investing enables the bank to make larger transactions available to clients without having to invest in the fund directly and place an asset on its book that would be too large to cater for their usual transactions.

In contrast to direct investing, co-investing allows institutions to outsource the more difficult and complex investment tasks, for example sourcing, closing, and executing deals and managing and operating assets during the ownership phase, while capturing some of the upside in the form of lower fees and exposure to performance of “riskier” assets without such stringent capital constraints. Maintaining a passive minority stake also allows banks to avoid many of the internal and external political considerations associated with direct investments. However, the added costs of conducting diligence on an investment and managing the additional counterpart risk could mean that co-investing may only make sense when deploying large sums of capital. 

The Future

There is clearly pressure on banks to reduce costs and fees while also maintaining a healthy level of shareholder returns. The flexibility of the partnership and notable upside in the form of reduced fees, exposure to 'riskier' assets that clients demand to have and the improved returns/profitability from the full risk of such activities effectively sitting off balance sheet, all provide ample rationale for banks with an appetite for these types of investments to form more co-investing partnerships with alternative financiers going forward.

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