The Impact of Recent South African Credit Rating Downgrades in M&A Activity
The recent South African credit rating downgrades by ratings agencies S&P Global and Fitch will affect Mergers & Acquisitions (M&A) activity in South Africa. M&A activity and the health of the economy are intrinsically linked and regional economic difficulties present challenges for M&A deals. Most significant is the impact on investor confidence, especially the attitudes adopted in bank lending and capital markets.
After Brazil was similarly downgraded, the country saw a sharp rise in the cost of capital, especially private funding and risk-based investment. In addition, divestment also increased, especially from funds which required adequate investment grading, such as pension funds.
However, the South African Rand has shown to be far more resilient than most expected, and after a period of sell-offs and volatility, there is hope for a normalisation of the economic environment and a rally of business to restore investor confidence. This may create massive opportunities for acquisitions, and a shift in deal financing and buying patterns, to take advantage of the volatility.
In the short term, one can also expect M&A activity to be created by investors withdrawing from the South African market, as a result of the downgrades, whether voluntarily or as a result of complying with regulatory/policy requirements.
According to Baker McKenzie’s recent First Quarter 2017 Cross-Border M&A Index, Africa saw 14 outbound cross-border transactions worth USD 704 million and 29 inbound cross-border deals totalling USD 6.2 billion in the first three months of this year. The deal values have dropped in comparison to the last quarter of 2016, where there were 11 outbound cross-border deals in Africa, worth USD 4.6 billion and 22 inbound M&A transactions, worth USD 11.4 billion.
South Africa plays a major role as an investment hub for Africa (and in particular in the Southern African region), but it shares this role with other strong African economies, including Nigeria. Both South Africa and Nigeria are currently facing currency woes and the trickle-down effects of the Chinese slowdown. The downgrades in South Africa’s credit status are expected to have a negative impact on the perception of South Africa being an entry-point into the continent and as a destination for medium-to-low risk developing market investment. As almost half the continent’s M&A activity flows through South Africa, the downgrades will no doubt have a negative knock-on effect in Africa as well, unless South Africa's standing as a stable economy can be maintained.
However, Africa also has its own primary drivers, including a ballooning consumer market and rapid increase in middle class households in certain regional African economies. In addition, an increase in development in African telecoms industries and the opportunities for business this creates, as well as the opportunities presented by a rapidly developing financial services sector, are also key drivers of investment activity. Mining, as always, plays a crucial role as a driver for African M&A and the changing winds regarding global commodities will continue to influence African deal flow. It can be expected that private equity exits will probably drive the sell-side of M&A activity for the foreseeable future.
According to the Index, the current global drivers for M&A activity are listed as disruption and technological innovation, aftersales services, core competencies, and divestments and defence spending. As these factors affect the world's largest economies, especially the Americas, Europe and China, they will no doubt, either directly or indirectly, have an impact on M&A activity in Africa as well, which is largely influenced through the trajectory of foreign investors.
The Index shows that North America contributed the bulk of inbound investment into Africa, with investments valued at USD 4.1 billion. North American investment in Africa has traditionally been directed towards the exportation and establishment of global brands to satisfy the demand of a growing consumer market, as well as in the energy, oil & gas, healthcare and pharmaceutical sectors. Due to the opportunities the African economy presents in these sectors, this trend is likely to continue. Whether President Donald Trump’s policies will directly influence this is difficult to predict at this juncture.
The interest displayed by bidders targeting African investments should and could be higher than USD 6.2 billion for the first quarter of 2017. There are many untapped opportunities for attracting foreign direct investment, which the South African government has acknowledged. In the 2017 budget speech by the Minister of Finance, it was indicated that the relaxation of several foreign exchange controls and tax penalties may be implemented to allow for South Africa to be more agile regarding inflows and outflows of capital, whilst still protecting its currency reserves. The Middle East and the EU are specific areas where Africa could substantively increase its attractiveness as an investment destination. According to the report, bidders in the Middle East invested only USD 7 million in Africa in the first quarter of 2017 and investors from the EU spent USD 481 million in Africa in the same time frame.
The report shows that African outbound investment is mostly targeted at EU countries, with USD 625 million flowing from Africa to the EU in the first quarter of 2017.
South Africa, and Africa generally suffer the consequences of currencies with weaker buying power for outbound investment. However, due to historic ties/involvement, as well as synergies in certain sectors, and a certain sense of familiarity, Europe has in general been favoured by local-grown businesses looking to go global. If anything, Brexit may have a positive impact on the trade relationship between Britain and South Africa as Britain may become more focused on finding trade relationships outside of Europe.
The Index also shows that the consumer sector was most active by value globally (142 deals worth USD 113.3bn) while the technology sector was most active by volume (182 deals worth USD 14.9bn).
This is true for Africa as well, where the growing telecoms infrastructure and access to internet services are broadening access to technology. Telecommunications, technology and energy corporates are increasingly targeting Africa. Increases in local demand for innovative technological services and solutions have also seen global technology companies like Uber thrive in some African countries. The growing financial services sector has also seen domestic banks make significant investments in technology. Consumer growth is also at an all-time high, with an increase in demand for foreign brands and products. This has also lead to increased retail development and shopping centre development in the property sector, which is backing the increase in the consumer market.
It seems that despite political and regulatory uncertainty, Africa remains rich with M&A investment possibilities. As a result, many jurisdictions in Africa have been introducing investment friendly legislation and regulations to attract foreign interest.