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Analysis > Analysis and Strategy

PRIVATE EQUITY: The Principal Agent Problem

Pieter de Wet, Head of Research, Novare Equity Partners
July 22, 2015, midnight

Word count: 1457

The potential for exceptional returns via the private equity route remains very high, but also poses some significant challenges, says Pieter de Wet, Head of Research at Novare Equity Partners

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The potential for exceptional returns via the private equity route remains very high, but also poses some significant challenges, says Pieter de Wet, Head of Research at Novare Equity Partners

Since the start of the millennium, the African investment case has become stronger with each passing year. Demand for its resources from especially the Asian burgeoning markets coupled with positive demographics and relative political stability resulted in some of the strongest GDP growth rates globally.

Given thin liquidity and small bourses, many investors acknowledging this growth and looking for a vehicle to partake in it decided to go the private equity route. Although the potential for exceptional returns via this route remains very high it does also poses some significant challenges.

Principal Agent Problem Theory

Research by Michael Jensen and William Meckling during the 1970’s lead to the formation of the so-called Principal Agent Problem Theory. In short, it refers to when one party, the Agent can make decision on behalf of another party called the Principal. The potential problem arises when the Agent acts in his own best interests when making the decision instead of in the Principal’s. This problem’s potential impact reach considerable dimensions when it is seen in the context of private equity investing in Sub-Saharan Africa.

When making a capital allocation decision into any jurisdiction, the manager or owner of the capital, in this instance the private equity manager needs to be aware of all the potential barriers to success. The operating environment will usually be much different than the one from which the capital is flowing and many failures has been due to a disregard for the importance of said differences. The bigger this difference the greater the potential for a principal-agent dilemma, since the agent or representative in the invested country operates in such a different environment. Ease of access as well as communication further compounds the problem.

Since 2001 the World Bank publishes its Ease of Doing Business Index on an annual basis. Various factors, such as “getting credit”, “starting a business” or “trading across borders” are ranked per country with an overall ranking assigned to each of the 189 countries based upon these factors. Whilst the methodology differs per factor or so-called sub-index, what is abundantly clear every year is how most African countries routinely end up at the bottom of the indices.

If, for example, one wants to start a company in Canada, the World Bank states that the whole process will consist of one procedure taking five days. Compare this to Chad where the same process takes 62 days and consists of nine different steps. Chad’s ranking in 2014’s sub-index was 185th whilst Canada ranked second just behind New Zeeland.

In the private equity space, several of these factors are of extreme importance when deciding upon an investment into a country. “Protecting minority investors” is a good example. It is heartening to note that most of the bigger African investment destinations do not score too badly. Nigeria at 62 and Ghana at 56 is still below Eastern European countries such as Poland or South America’s Brazil in this sub-index, although it is the other Latin American countries such as Venezuela and Guatemala that are resident at the bottom of the list. Unfortunately with a factor such as “enforcing contracts” we again find our bigger players such as Nigeria, Mozambique and Angola at the bottom end.

Information Asymmetry and ESG

A basis of the Principal Agent problem is information asymmetry. This occurs when one party has more information with regards to a situation or a transaction than the other. In this instance, the Agent usually has better information than the Principal, due to his closer proximity to the actual transaction or event. Should this lead to a situation where the Principal loses value relative to the Agent, the loss in value is referred to as Agency Costs.

A good example in the context of Africa is the social or environmental consequences of investments. If for example a project management team develops a property on behalf of investors into a Private Equity Fund in Cameroon, the project manager will be the Agent, whilst the investors are the principal. Should the development cause undue pollution, it will potentially be in the Agent’s short term financial best interest to try and cover up this to other related parties including the Principal. Rectifying it will be costly and will affect the performance fees of the Agent. Should this come to light at a later stage, the Principal will be the party most affected, in terms of reputation as well as financially. Due to information asymmetry, he was not aware of the original issue but he has to bear the agency costs.

It was due to examples such as these that initiatives like ESG, or Environmental, Social and Good Governance guidelines and policies became such a popular tool. Especially in the African context, investors are now demanding these policies to be in place as well as regularly monitored and updated. It assists in aligning the interests of the Agent and the Principal due to greater clarity with regards to how investments should be implemented and subsequently operated.

Unfortunately, ESG is just one of the fields where progress has been made to reduce Principal Agent problems. The difficult operating environment still allows for a much greater scope of misalignment than in other jurisdictions. It is for this reason that many traditional private equity models and methodologies are adapted on the African continent.

Real Estate development model

For simplicity we can continue with the Real Estate development model. Due to relatively shallow local pools of capital in most African countries outside of South Africa, many major real estate developments are financed via private equity funds. Traditionally the role of the private equity manager would have been that of a pure capital allocator. Said manager would raise the funds, source the deals and then outsource the actual development function and its underlying tasks and responsibilities to various contractors. As a rule these contractors supposedly has the necessary experience and local knowledge to act as capable Agents to their Principals.

In order to be successful in this potentially lucrative market though, traditional private equity strategies have to be adapted to be in line with local market conditions and norms - Pieter de WetUnfortunately due to the environment as well as different incentive models, the risk the Principal faces with regards to potential agency costs reaches rather high levels. If one sit in the airport lounge of any major Sub-Saharan city, chances are there will be a group of real estate developers sharing the lounge with you, exchanging very colourful anecdotes around this theme. Some of the leading PE managers has accordingly started adapting their model.

Adapting to market conditions

One example of how their models has been adapted, was the integration of the process’ value chain by the Principals. Setting up in-house team members in the countries where they operate, in order to have a firmer grasp on the projects and managing the development function with these teams has shown to very effective countermeasure against the Principal Agent issue. Owing to an alignment of interest and a lessening of asymmetric information due to clearer communication lines, costs can be managed much more effectively.

There has been some investors who cautioned against this approach by stating the potential for conflict of interest escalates when this route is taken. By operating these in-house teams as cost centers instead of profit centers with regards to their allocated tasks this conflict of interest argument becomes void though.

Historically, the high cost of living for expats has made managers shy away from employing such a strategy. Mercer publishes an annual cost of living index for expats, and African cities are routinely in the top quartile. Angola’s Luanda has been in the number one position for a few years, whilst major cities such as Lagos in Nigeria are not far behind. If one tally the agency costs with the direct savings generated from greater efficiencies and cost savings, the greater costs of living for team members which are usually carried by the manager is not nearly as big an issue anymore.

Although massive developmental progress has been made during the last decade and a half across the continent, as has been noted the operating environment remains one of the World’s most difficult. In order to be successful in this potentially lucrative market though, traditional private equity strategies have to be adapted to be in line with local market conditions and norms. Managers employing the most innovative and efficient strategies will be able to deliver the returns the Principals seek whilst at the same time reducing the potential risk to manageable levels. For the rest, the road forward could be more difficult than needs to be.

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