Development Capital Partners — The Changing Landscape in Africa

Fall 2014

Development Capital Partners (DCP) is a New York- based investment manager focused exclusively on African markets. The fund was co-founded by Paul Tierney, Matt Tierney ’02, Gordon McLaughlin ’11, and Matt Magenheim ’11.

Graham & Doddsville (G&D): Could you start by explaining how you became interested in investing?

Paul Tierney (PT): I got started in the investment business with no background in investments. I graduated from college having studied philosophy, and then went into the Peace Corps for two years. In the Peace Corps, I had in- tended to pursue a career in economic development. While there I observed that there were an awful lot of smart, well-intentioned people in the field of economic development, but collectively there were very few practical skills in the community. It was full of PhDs in Economics and Political Science but had very few people with training or experience, the sorts of things that make privatizations work, or that enabled cooperatives of small, poor farmers to make a living.

After leaving the Peace Corps, I won a Ford Foundation fellowship to go to graduate school. There were about ten other winners and all of the others went into programs in Political Science and Economics. I chose to go to Harvard Business School, which was a very suspect decision to the fellowship. Consequently, I had to take extra courses and find a mentor at the Kennedy School.

Through the program, I be- came very interested in entrepreneurship and investing. I started a PhD Program at Harvard, but never finished it be- cause I started working at an investment firm in New York. That’s about the time when I got more interested in investing.

Since I can remember, I have been interested in creative things: the creation of value, the creation of new entities, the creation of new businesses. At that time I made an important decision — instead of being an entrepreneur and building or starting a business, I would be a financial entrepreneur. I wanted to financially back and invest in lots of different businesses, participating in a whole portfolio of creative activities, rather than just taking a concentrated shot at one thing.

That interest continued to grow in the next few stages of my career. I went from doing that with the New York entity, to helping start a merchant bank in London, which in turn financed lots of entrepreneurial activities worldwide. Then, after spending one year in the federal government on a quixotic venture, I joined White Weld, an investment banking firm in New York. I was a jun- ior partner of that firm until we were acquired by Merrill Lynch, at which point I left to start my own firm with two other partners.

That firm was the originator of a whole variety of investment partnerships, which all tended to have something to do with corporate reorganizations, activist investing, mergers and acquisitions, risk arbitrage or event-driven marketable security purchases. There was a little bit of private investing, but for the most part it was a private investing approach to marketable securities.

It was pretty successful. In the late 90s, we decided to shut down the partnerships that we had with outside limited partners and I began a private office to invest my own capital together with friends and partners that I had known. I formulated an emerging market specialty investing my own and some friends’ capital outside of the United States — usually in conjunction with local partners or money managers in those countries. We spread from China to Russia, then Latin America. Then about five years ago, I started focusing on Africa.

Part of my reason for being interested in Africa was the fact that I had been Chairman of TechnoServe for a long time. TechnoServe is a not-for- profit organization that does economic development work in Africa, Latin America, and India. It started in Ghana and is now in 33 different countries, most of which are in Africa. I’ve had a long-standing involvement in Africa and an on- the-ground experience with it.

Due to my long involvement in the region and what I observed there, I thought Africa was the place that had the greatest opportunity and where I had the greatest personal interest. And so three years ago, the four of us began Development Capital Partners.

Gordon McLaughlin ’11 (GM): When I was in high school I worked part time in- stalling software systems in the homes of Radiologists so that they could view images from home at night as opposed to having to work “on call” at the hospital. I became so interest- ed in the software and hard- ware I was installing that I opened a brokerage account and invested a few hundred dollars in two of the companies that owned the technology. Eventually my consulting gigs dried up, but I ended up making more money on the companies I’d invested in. That experience really planted the seed of my interest in investing.

My first real professional role after college was working for an economic consulting firm providing valuation analysis on patents, trademarks and early stage technologies. But I always knew that ultimately I wanted to get into the investment industry and make decisions as a principal as opposed to as a service provider.

After a couple of years of consulting, I joined an investment manager in Chicago called Security Capital, which is part of JP Morgan. At Security Capital I was able to get formal training in the areas of investment research and security analysis. I also spent a couple of years in London leading an effort for Security Capital researching real estate companies across Europe and Asia. The international work allowed me to witness a lot of the things that were happening in emerging and frontier markets. Ultimately, I decided to go back to school to try to find an area in emerging and frontier markets to apply the security analysis skills that I had been developing. That’s how I ended up at Columbia Business School and in Paul’s class on investing and entrepreneurship in Africa. In Paul’s class, I was exposed to CEOs running highly profit- able companies across Africa. I was also able to study the in- vestment management industry in Africa and observed that the relative intensity of competition of investment management in Africa seemed less than in other geographies.

All of these observations about Africa were very appealing to me. By the time I hit my last semester at Columbia, I was quite keen on the opportunity. I started spending three days a week working with Paul and Matt Tierney identifying investments in Africa, and that led to my involvement in helping to form DCP.

Matt Tierney ’02 (MT): DCP was created to employ a similar investment strategy to what Paul, Gordon and I had been doing, but was organized as a new entity to bring in outside capital and be a standalone business. I knew I liked Gordon when I first met him and I found out he had run a personal stock portfolio since high school.

You’d asked how we got interested in investing. I grew up in a household where investing was talked about a lot. My brother, sister, and I would sit around the table on Sunday night at dinner, and Paul would be talking about a deal that was being done.

There are two things that got me to where I am with DCP. One, I have been interested in entrepreneurship and investing since a young age. Two, I have a passion for international affairs and emerging markets. I went to Georgetown, where I studied international relations with a concentration and focus on Latin America. After undergrad, I wanted to gain experience in emerging markets, so I worked for TechnoServe in Peru for a year. I ended up working with small businesses, primarily in the agricultural space, that TechnoServe was consulting with, both in Peru and across Central America.

During my second year at TechnoServe, I focused on Africa and conducted cost- benefit analysis of TechnoServe’s programs across the continent. I had been to Africa before, but that was the first time I spent a lot of time there professionally. I realized rather quickly that there’s only so much you can learn from an analysis standpoint at a non- profit, so I joined an analyst program at Credit Suisse in New York. I worked in the global corporate finance group for a few years, before going to Columbia Business School. I graduated in 2002 and joined Paul and a couple of other folks to help start a health care venture capital initiative called Aperture Venture Partners. I enjoyed doing venture capital deals, but after several years, I realized that health care was not something that I wanted to spend the rest of my life on, and I missed the emerging markets aspect of what I’d previously done.

Thus in 2008, Paul and I started talking more about what we could do in emerging markets, and began investing our own capital through various means, by taking direct or indirect positions across EM, in both public or private opportunities. Then we quickly became more and more interested in Africa after we saw a lot of the macroeconomic changes taking place, which eventually led to the formation of DCP.

Matt Magenheim ’11(MM): My passion for emerging market investing was developed early in my career. Six months into my first job, I was sent to Madagascar to work with the Malagasy government on an undersea cable project. After- wards, I spent 15 months in Mongolia setting up two businesses for a MENA (Middle East-North Africa) based investment group. I was hooked by the massive opportunities and challenges that these markets provide. It was difficult to land in a foreign environment with limited contacts and imperfect information, but it was stimulating, rewarding work. And during my time there, I quickly recognized that these markets would offer some of the most attractive financial returns.

My career path was somewhat backwards in that my financial analysis skills were mostly developed after Mongolia, during my time at Morgan Stanley and Columbia Business School. However, I believe my earlier jobs overseas provided much more valuable learning experiences. These jobs trained me to build contacts and find data and information in developing countries, a task which is much less straightforward there than it is in the US. For example, when I needed to find staff for our halal abattoir in Mongolia, I had to visit a funeral in a town with a large Kazakh population in order to speak with the local imam. He referred me to someone, who then referred me to someone else … and so on and so forth. Here it would have been an easier task.

While sophisticated financial analysis is an important part of what we do, the ability to get data and information to inform your assumptions and view of the business and management is a more important differentiator. Of course, you never want to take a framework or lens from one country or market and apply it blindly to another, but I believe there are skills beneficial for investing or doing business in imperfect, inefficient markets that can be transferred across geographies.

After Columbia Business School, I knew I wanted to focus on emerging markets investing. Given the nearly four years I had spent living and working in Central and South- east Asia, I was leaning to- wards Asia. However, as part of Paul’s class, I traveled to Ghana to work on a project with a mortgage company based in Accra. I added two weeks in East Africa to my trip and spent the time both on safari and meeting numerous medium and large companies in Tanzania and Kenya. I was impressed by the managers I met from a banana beer entrepreneur to the CEO of a major East African bank and the opportunities for growth they saw. I came home and immediately began to focus my job search on Africa-focused investment firms.

Following graduation, I joined Allan Gray, a Cape Town based asset manager that was attractive for the quality of the investment team and the firm’s value-oriented strategy. I worked there until I got a call from Paul about what the team was planning in DCP. The chance to work with these guys was too good an opportunity to pass up, and I was soon on a plane back to New York.

G&D: Your investment philosophy is probably a little different than some of the traditional value managers that we have featured over the years. Could you give us an overview?

PT: Well, we are similar to other value investors, but perhaps different than other investors in Africa, in that our primary focus is on a concentrated portfolio of publicly traded long positions. We normally have 20 to 25 positions.

Because we deal in markets with a lot of volatility, we have an initial two year lockup on the capital. It was my feeling that the fund structure would make it more difficult to raise capital, because people want to believe that there is daily liquidity even if it doesn’t always exist. We are allowed to have up to 20% of our partnership capital invested in non-quoted securities. We didn’t want to pass up special investment opportunities that we wouldn’t be able to cover, nor did we want to do them on the side with some carve-out where the general partner could do some things in the partnership and some things out. All four of us have extensive relationships all over Africa. If one of them happened to be a great chief executive officer running a company where all we could do is invest privately, I didn’t want to let that go by the board.

Our partnership was certainly not set up to allow the easiest raising of capital, but we didn’t want to compromise the structure of the fund in order to make it easier to market. We wanted to be able to make good, long-term investments with high rates of return and not have structural impediments get in the way.

GM: At the heart of it, we really formed the partnership to invest in the best companies and the best management teams at the best price that we could find. The philosophy is not terribly different from what you would find in the value investment community. When we decided to form the partnership, we said we just wanted the 10 to 20 best long- term investment ideas we could find in Africa.

G&D: Tell us a little about your investment process and the diligence you perform.

MT: There is certainly a lot of travel involved. There are similarities to the analytical process, which we do here in New York. The access to in- formation is getting better. There are publicly available documents that you can pull from Bloomberg. You can get them off websites, but that information is often limited. There are several companies which only give half year or annual results. Those are the types of companies where you have to actually go and gather more information. Aside from the analytics and the numbers, it’s really important to go and decide if management is good or not. That’s where our net- work comes into play, which is really helpful. It’s not just meeting the CEO; we look to understand mid-level management, the board’s corporate governance policies and other factors in finding strong, fortress like companies.

GM: I would add that another element of the diligence process that’s somewhat unique is accessing publicly available information. Information is theoretically available to all, but it sometimes takes extra work to access in Africa. Even for simple things like finding long histories of annual reports, sometimes you have to go knock on the broker’s door in order to find an actual hard copy from six years ago. Sometimes you can call someone sitting in Lagos and have it scanned to you in a 100 megabyte documents. These things can be frustrating at times, but we think they enhance the potential of a strategy like ours.

PT: You can’t have it both ways. You can’t have the benefits of being in an inefficient market with maybe a little lower level of competition and also have access to easily accessible information. This is probably a generational thing, but I’m amazed at how much information is available even if it’s somewhat difficult to obtain. Ten or fifteen years ago, you couldn’t do what we’re doing now.

MT: Even five years ago. There’s been a really big change in the level of interest in Africa, especially in the US. I think Europe definitely had more interest in Africa from an investment standpoint. About five years ago, I remember going to a conference and there were maybe twenty people in the room. It was a general conference about Sub-Saharan Africa. Two years ago, there was a conference across the street with two hundred people just on Kenya alone. There’s definitely a lot more interest, a lot more information available, but nowhere near what you get in developed countries.

GM: One other important component of our work is accessing people. Getting the first interaction with a management team can be a significant challenge. We often work through existing relationships to facilitate introductions to certain management in order to get a first meeting. Once we have the first meeting, it’s very easy for us to establish a rapport and the trust level required to develop an ongoing relationship. As the years go on and accessibility increases, it’s advantageous to have developed relationships earlier on than later.

G&D: Given the interest in Africa over the last few years, have you seen any changes in market efficiency or decreases in potential opportunities? Do you think that there’s still a long runway to finding mispriced securities?

PT: I think there’s still a long runway, but there’s also been more capital and more attention being paid to the region. The whole region from the Middle East down to South Africa is dynamic and the opportunity set changes on an ongoing basis. Periods of fear and optimism tend to get exaggerated. Egypt is one of the three largest capital markets, and Egypt has been very volatile over the last several years. This year, Egypt is the first or second best performing publicly-traded index on the continent. We shifted our attention to Egypt pretty early and have some great holdings there.

When the Arab Spring went through North Africa, one of the most misunderstood areas was Tunisia, which has proven to be a place where there’s been a lot of opportunity and not too much competition. As public offerings have taken place and markets have risen, there’s more competition there. It’s similar to elsewhere in the world when good companies start to show what they can do and capital markets are broadened, more and more money flows into them. The dynamism of the region creates a continuous stream of opportunities.

MT: Obviously there are 54 countries and they’re all quite different. There’s not too much correlation when you look across regions in Africa. Dislocation in one country from a macroeconomic standpoint oftentimes creates a lot of opportunity from a pricing standpoint. There’s typically something wrong somewhere in our universe. Asset prices may be rising in one area where you’ll also see IPOs, which we’ve seen taking place over the last year. At the same time, you can see pricing of great companies drop in another area that is experiencing a more volatile period. Falling prices often draw our attention.

GM: Some of the scariest markets to us exist when everything is perceived to be calm politically and the prices of assets get too high.

G&D: Outside of South Africa, what are the market cap sizes of these countries? What are the investable opportunities in places like Ghana, Ken- ya, Tanzania, Tunisia, et cetera?

MT: Our investable universe, including some opportunities that we see that aren’t listed in Africa, has a total market cap of about $1.4 trillion.

GM: If you break it up, though, it’s really about $130 billion of market cap in North Africa and then approximately another $150 billion in Sub-Sahara excluding South Africa. There is near $1 trillion in South Africa. The liquidity is also a more challenging element than over- all market cap. For example, if you exclude South Africa from the other exchanges in Africa, the approximate liquidity for all the markets is approximately equal to that of a single US stock like Home Depot.

PT: Another part of our strategy is to know a lot about Africa and then find ways of taking advantage of that knowledge — knowing about an opportunity despite the fact that the company might not be traded on an African exchange. It might be traded in London or Mumbai, but have growth potential and strategic focus in Africa; that’s part of our universe and that enlarges the pool a lot.

G&D: We imagine you must travel a lot. How much of your time is actually spent on the ground there and how do you approach it?

GM: In general terms, one or more of us is in Africa every month and each of us probably spend 25% or 33% of our time on the ground in Africa. Each trip is, on average, two to four countries, a lot of times in a region, because it’s easier to cover ground that way.

PT: We’ve never had a day in which we’ve sat down and said, you know, we have spent three weeks and nobody has gone to Africa.

MM: Though the flights can be painful sometimes, the face-to-face interactions are critical, especially when building new relationships. All investors typically meet with the same four or five individuals on their first visit to a new country. The key is getting beyond this first wave. It is great to have a network of key contacts that we can call from New York for quick feedback, but we are always looking for new perspectives. Meeting with suppliers, customers, former employees and mid-level management is invaluable to understanding a company, and these conversations can frequently only be done in person.

G&D: Are you at the point where you have some level of institutional knowledge of every country in the continent? Are there some areas where you’re still developing expertise in the companies that are available in those markets?

MT: North of South Africa, there are about 16 exchanges that we would consider, so we’re primarily focused on the countries where there’s a local exchange. Then there’s often times surrounding countries where a company is working in and so we’ll take a trip there. Ethiopia, in particular, is very interesting and we’ve spent a lot of time there. I wouldn’t say we’re experts in every country, but the ones where the companies are located we definitely have an institutional knowledge base, which is helpful.

PT: There are changes occurring and some government regulations and restrictions, which make countries more attractive at one point in time than another. The changes in Egypt are pretty obvious. Ethiopia, which Matt mentioned, is another big country and big opportunity, but it’s currently closed. It’s a tough place to do business and a tough place to acquire assets. The country still has a government controlled telecommunication system. That can’t continue into the future.

Tanzania had limits on foreign ownership, but they recently dropped the 60% maximum foreign ownership position. So you had situations where non- Tanzanian investors were negotiating with each other to buy stock that was available because both of them didn’t qualify as Tanzanians, and there are similar kinds of changes in Saudi Arabia now, so this makes certain countries and certain exchanges more interesting. Angola has no exchange, but has plans to set one up.

G&D: Some investors look into countries that have recently had poor economic performance. Do you have a similar framework for identifying new opportunities — is it more systematic? Or more organic as opportunities arises?

PT: We meet regularly. We have scheduled meetings and then we have a million unscheduled meetings. I would say we all have a nose or an interest in countries where the market has been smashed and things are very cheap, and skepticism about things that have gone up too quickly. Our choice of investments is all bottom up, but our instinct, or smell, increases when we see situations that are either too good or too bad and we look into them.

We also follow themes of investments that we like, so if we’ve observed a certain type of consumer products company or telecom or financial institution be successful in one country, we will look for more opportunities with similar profiles in neighboring countries.

G&D: Given that you invest in Africa, you have a limited investment universe. Natural resource and other commodity type companies have a large presence. Can you elaborate on the types of opportunities where you have been successful? What do you like and what do you look for in the companies that you typically invest in?

PT: We like transparent companies that have good corporate governance, audited statements and good and deep management teams, but in terms of industries, when we started, one of our priorities was looking at fast-growing consumer products companies. Guess what? It was a priority for everybody. As new, uninformed money entered the region, certain companies with a good franchise and all the other qualifications we always mention Nestle Nigeria as an example became the fashion of the day. It might be a good company, but is it a good enough company to purchase at 40 times earnings?

While we’re still interested in consumer products companies, it doesn’t constitute as big of a percentage of our portfolios as it used to. We’re also not generally commodities players. We try to buy into companies that provide a product or service that generates good cash flow.

GM: None of us have a deep background with commodity-based businesses. We see large opportunities in healthcare, retail, financial services, even industries that support infrastructural development like cement.

MT: As has been mentioned, we’re bottom-up, but from looking at natural resource companies, it’s pretty interesting to see any potential change that’s taking place that will affect the larger economy. There have been a lot of exploration and gas discoveries in East Africa over the last five years. We’ve looked at those companies and then tried to figure out what related indirect investments might do well as a result of that. As the economy grows, how is it going to affect the consumer? What industries are going to grow as a result? Many of them are the ones that Gordon mentioned.

GM: There are many industries where we believe latent demand exists, but where products and services aren’t reaching the population. For example, with retail, which is an industry that we like a lot, an estimated 90% of trade out- side of South Africa in Africa occurs in informal settings. Purchases of basic food, for example, don’t generally occur in an organized grocery store. Oftentimes these situations have evolved in other parts of the world and by studying historical trends, we inform our view of what might occur in Africa in the future.

G&D: How do you think about investing from a top down perspective? Are there countries that hold a greater appeal for you now that you may want to consider investing in? And, conversely, are there other countries that you want to avoid given macro factors and geopolitical stability?

PT: We unanimously agree on what companies we sell and what companies we buy, but I don’t know if we’d all unanimously agree on a macroeconomic profile of each country. One of the biggest risks in our portfolio is currency risk, and we often debate and make decisions on the currencies in Africa. For example, Ghana has been the worst performing market in Africa this year from a US dollar perspective, mainly due to currency depreciation.

We followed Ghana closely and have a lot of friends there. We have a lot of first-hand information, not inside information, but information on how the Ghanaian government makes decisions. We had a large concern regarding the currency and were lucky and smart enough to exit our investments in Ghana before the cedi started to unravel. On the other hand, we started to build positions in Tunisia and Egypt quite soon. Personally, I’m very worried about South Africa’s political and macro environment. However, there’s a big enough investment universe that I don’t think that a top down approach in South Africa is worth very much for us.

G&D: Can you speak to the process of managing currency risk? Do you take a view based on a macro assessment, or do you take a different approach?

PT: It’s very hard to hedge our currency risk. We try to have diversification in the portfolio with different currencies represented and manage our level of cash, but we don’t do any currency hedges.

GM: Generally speaking, when we are looking to make an investment, we consider the expected return on an investment in its local currency. Then we’ll also have a view of what we think the long-term drag from that currency will be. Ultimately, our consideration of currency risk manifests itself in the rate of return that we are requiring on investments that derive their income in a given currency or currencies. For example, we might make an investment in Botswana where we are expecting an 18% Botswana pula return over seven years, but we might require a 27% return for investments in companies that earn Ghanaian credits. As Paul mentioned, we also limit our overall exposure to various fiscal and political regimes depending on our views.

G&D: You alluded to the fact that you have close relationships with the management teams of many of the companies you invest in. When analyzing a business, how close do you typically need to get with the management team and understanding their strategy before you actually invest?

PT: Well, we try to meet and know every management team, but as far as the ones that we’re close enough to that we’d have regular dialogue with and would have come make presentations in the US, say at Columbia Business School, that would probably be around half of them.

GM: It’s a requirement that we understand their motivations, incentives and general ethos, but it’s not necessarily a requirement that we have an extremely special relationship with them.

PT: A couple of things that are different about publically traded marketable securities investing in Africa is access to people, because they must feel somewhat like purchasing agents that are besieged with neophytes who are coming in who want to talk to the company. Somebody sends in a junior guy to see whether they ought to have a fund in Africa and he calls the CEO and thinks he’s going to be treated like royalty. Well, these are very sophisticated people running key organizations in their countries, so they don’t have time to meet with everybody else. Finding ways to use their time efficiently, asking the right questions and winning their confidence is part of what we have to do.

The other thing is that sourcing stock is not so easy, because there’s not much liquidity in many of the markets. It’s nothing like calling a broker and placing an order with a limit. It’s often necessary to get some help. Some of these companies have chief executive officers who have had a meaningful personal family stake in their businesses for a long time. They might know that one of the family members who’s ill or wants to sell his stock, or some institution that backed him five years ago, who now has made 10 times his money, might want to sell. They can help you source stock, or brokers can because they want to work with you, or know that you’re for real if you indicate an interest.

G&D: How have you thought about potentially having an office in Africa? There are obviously pros and cons. Could you explain how you decided to be in New York?

PT: We’ve thought about it a million times. Currently we rely heavily on a network of relationships in each of the important countries, in places where if we want to use a friend’s office we can, and reciprocally when they come here, we’ll help them. With the relationships these guys have with all of the business and investment community there, I think we might even be at an advantage. It’s the sort of thing that Warren Buffett talks about by being in Omaha and having a better perspective than being in New York. We’re not as much in the rumor mill perhaps.

MM: After spending nearly five years as an expatriate in Asia and Africa, I appreciate the extremities of the highs and lows when living in the developing world. When battling the daily logistical and infrastructure challenges, it is sometimes difficult to keep perspective and detect the incremental improvement. New York also attracts more private and public sector leaders than most African capitals, especially during the UN General Assembly.

GM: We don’t think it would be an advantage to have an office in Kenya and be investing in Nigeria. It would be very difficult to fund and manage a local presence in all of the different countries we’re investing in right now. It was a tactical choice for us to have all key decision makers sitting next to each other. What we face is a constant stream of complex decisions that need to be made with limited emotion. There are always complicated situations that we need to get our heads around, so it’s really important that we sit next to each other and debate solutions and decisions.

G&D: Management is clearly important to you for investing. How often do you meet with management over time? Is this a process that will take you six months or more to get comfortable with a particular team, no matter how good the business fundamentals are?

PT: It can be. I would say that different types of companies require attention to different areas of management. Some companies require attention to mid-level and front line management. For example we were interested in a company in Kenya, Equity Bank, which is run by a guy named James Mwangi. We have known James for a long time. The question is not whether James is a smart guy. Helios Investment Partners owns 25% of the company. In this instance, the relevant question is also not whether the Helios team is a great team or that the directors that they have on the bank are great. Equity Bank has grown into an extremely large and fast growing company. The relevant question for us with regard to management is how deep the team is, and how deep the bench is where some of the riskier day to day parts of the business are being run. That can take a while to analyze and then the question is valuation, right?

Then there are some other companies for which it takes us a while to get to know key individuals. For example, there is a retail company in Botswana that is more of an up-and- coming, more entrepreneurial company. We have all visited the company several times. The head of the company has visited us here in New York. He is coming back again soon. We also want to know our other partners that are invested in the business including in this case the private equity firm that is invested in the company. That can take quite a long time.

Then there are some businesses, not many, that aren’t as management-sensitive. They are relatively easy to understand and might be a listed affiliate of a foreign company, such as Nestle Nigeria. You are pretty sure that the financials are clean, the management is at least competent and they might have licenses from the parent company.

MT: In fact, for subsidiaries of multinationals it is quite common for there to be a rotational program. You will get to know a CEO, but he or she may leave in a year or two. You can check the backgrounds on them, but they are usually at a certain level, which you could feel more comfortable with maybe faster.

GM: Management talent is scarce in Africa and exceptional management teams can do extraordinary things and create a lot of value. Investing the time to get to know them yields large dividends.

G&D: What is the valuation criteria that you focus on? What would be an interesting investment from a valuation standpoint? Is there a minimum hurdle that you view as appropriate for the fund structure that you have?

MT: Gordon touched upon the expected returns from a local currency perspective, which of course vary depending on where we are. But the fund is in USD. From a US dollar perspective, we’re looking for high rates of return given the riskiness of different markets that we’re in.

GM: We try to use as many tools as possible when considering valuation. We look at the fair value of a company based on forecasted models. We also look at historical ratios, peer analysis and the multiples that the company is trading on. Generally, when we invest, a five-to-seven year expected IRR is a critical point of discussion.

If you look back and say, “What’s been the average expected rate of return in your base case for all the investments that you’ve made?” The answer would be between 20% to 30% in local currencies. Selling tends to be much more difficult. We don’t simply sell if the expected IRR goes below mid-20s for example.

Generally, the heated discussions around selling a position from a valuation standpoint have occurred when expected IRRs drop below 10% in local currencies. Of course whenever we find something that we really love, we start kicking out the lower return ideas — it’s a constant competition of ideas.

Aside from simply valuation, one of the things that we really look for are businesses that are efficient with their capital. We are interested in deter- mining, at the unit economic level, what kind of return on its capital a company can earn. We are probably more interested in this than things like multiples, in many cases.

A big difference between companies in Africa and those in most other parts of the world is that debt costs are still extremely high for most of these companies. They really can’t finance growth projects with debt. For example, health care companies in Nigeria are paying around 20% interest on their debt. That’s an enormous burden on any company and it’s a death sentence for capital intensive or inefficient companies.

G&D: Can you speak about a recent success and take us through your process?

GM: Sure. There’s a listed company in Nigeria called Stanbic IBTC. It’s a listed affiliate of Standard Bank, which is a South African company. It’s really a financial services company with three lines of business. It make loans to individuals and small enterprises and provides financial related services to those groups of customers, it has an investment bank which serves large companies, and it has the dominant asset management franchise in Nigeria, which is the real reason we love the company.

In 2004, there was a major pension industry reform. Since that time, pension assets in Nigeria have grown at about 30% a year, every year, and we don’t see asset growth ending for a long period of time.

When compared to other banks in Nigeria, Stanbic looks relatively expensive on a price to book multiple, but the asset management business generates more than a 50% ROE. It’s not appropriate to apply bank book multiples to an asset management business.

Additionally Stanbic’s been investing heavily in people to grow its two banking divisions. We view these investments as a form of capex in people and infrastructure as the bank grows. But the expenditures flow through the company’s income statement and have dragged the profitability of those divisions as they are growing.

The historical result has been that analysts see a sub-20% ROE bank and a relatively high book multiple. We looked at it and saw a dominant, fast- growing, pension management business, with huge opportunities in other wealth management business lines. We also saw quite clearly that the company’s ROE was subdued by investments it was making in future growth.

It’s been a very good success for us as the fruits of the company’s investments started to materialize and investors and analysts perceptions of the business have changed. It’s one that we still like a lot. We still think that people are underestimating the overall potential of the asset management industry in Nigeria. Even after 10 years of 30% AUM growth, pension assets only represent around 5% of GDP. By contrast, Kenya’s are 18% of GDP, South Africa’s are 67%, and in the United States pension assets are over 100%. There’s a lot of room to grow in the Nigerian asset management industry. It could easily be a $150 to $250 billion industry in terms of assets and today it’s $30 billion.

G&D: What are some other investment ideas that you could share with us?

MT: One investment, which we’ve alluded to in the conversation, is Choppies. It’s a food retailer which is based in Botswana. It was started more than 20 years ago by an entrepreneur. The current CEO moved from India to Botswana about 20 years ago, and one of his first assignments upon arriving was to audit this particular business.

At that time, Choppies only had one or two stores and was nearly insolvent. Despite this, the CEO saw a big opportunity in retail and decided to join the business. He has since grown the company into the leading supermarket chain in Botswana. The CEO is essentially a founder and he owns a large piece of the company.

We started tracking Choppies about three years ago when it IPO’d on the local Botswana exchange. It was raising capital to expand into the northern section of South Africa, which it has done successfully. It’s interesting because there’s obviously a very mature market in South Africa compared to other parts of Sub-Saharan Africa. The CEO thought he could compete in the rural markets of South Africa against the larger format stores of, say, ShopRite or Massmart, which he’s successfully doing. Choppies typically has a smaller footprint store.

GM: The payback on a new Choppies store is typically one to three years with an ROIC of around 25% to 40% at the store level.

MT: So it’s pretty attractive. He should be breaking even in South Africa soon. Botswana’s quite profitable and he’s also expanded into Zimbabwe. Those countries are all in the same region and an important part of any food retailer is the distribution network, which he spent 15 to 20 years building up. A lot of goods come in from southern South Africa and feed right into his depots in northern South Africa that service the entire region, so he can still expand further into Zimbabwe as well as other surrounding areas of southern Africa.

GM: It also has a relatively small base of stores, so it should be easier to grow from a 100 stores to 1,000 stores than it would if you had 1,000 stores growing to 10,000. One of the reasons that the ROIC at the store level is so high is that he does not really have a credit card infrastructure, so his customers pay cash and he gets supplier terms. The stores are actually working capital positive to him. The growth essentially finances itself after a time. We really like that.

G&D: Are there other competitors that have come close to Choppies in Botswana?

GM: There is definitely competition in Botswana. There’s another local company called Sefalana, and South African retailers are also active in Botswana and other parts of southern Africa. South African retailers are much larger than Choppies and have tended to focus on putting up big box stores.

MT: One challenge for these bigger retailers in South Africa to expand to the rest of Africa is basically finding enough retail space, because there’s not that much commercially developed real estate.

GM: Development of new space is not trivial either. Some malls in Nigeria have taken more than seven years to build.

MT: We like the smaller footprint model that can go up almost anywhere, and he has various price points that serve different customers. We think that it’s the right model to expand across Africa, certainly southern Africa and potentially beyond.

G&D: What’s helped penetrate this food supermarket or retailing, generally speaking? You mentioned that lots of markets are very informal. What is the penetration of organized food retailers in the total market?

GM: Across the continent, it’s close to 10%. In Botswana and South Africa, it’s significantly higher because there’s been more development of formal retail. South Africa is closer to 60% formal.

MM: This story is also not unique to retail. With increased urbanization and growth in the middle income segment, we are seeing similar trajectories in ICT adoption, banking penetration, and consumption of many consumer goods. Since 2000, African mobile phone penetration has gone from less than 2% to more than 80%. The growth rates in other areas have not been as profound as that found in the telecommunications sector, but we know where the trends are heading. We just need to find the brands, distribution networks and most importantly management teams that are best positioned to leverage these opportunities.

G&D: For our readers that might be interested in becoming investors in frontier markets, what sort of advice would you give them?

MT: Well, investing in Africa is difficult. It’s amazing we got to where we are in creating this fund. We looked at every possible entry point and there’s a limited sphere of public equity funds, which are hard to access as an individual, and then there’s really only a handful of ETFs.

GM: If you are looking to start a career investing in Africa, there are probably more funds from South Africa that are looking for investment talent. Generally Africa and frontier funds are unlikely to come to campus, but that's where I'd be writing letters and making calls.

MM: Do your homework and be proactive. I was a bit naïve when I started my search for Africa funds. I remember being initially amazed that there were South African firms like Allan Gray with $40 billion of AUM. As capital markets and pension systems mature across Africa, you will find more large, indigenous funds in Nigeria, Egypt, Kenya and other markets. Have a local stock pick, preferably a write-up. It can set you apart from other applicants.

MT: There is definitely a lack of high quality talent across the continent from corporate to investment firms, so certainly people who are willing to go live there or travel extensively there could be successful.

GM: It's a strange dynamic because it's a small universe so there are a relatively limited number of spots that come up, but I guess there's also fewer people looking. On the other hand, there's also an extremely limited set of very experienced people, so I think it's a path worth pursuing, though I’m obviously biased. I guess we have to hustle a little bit, but it’s worth it.

G&D: Thank you very much to all of you for taking the time.