When faced with the daunting task of having to raise capital to finance its growth, a business has two options to consider – debt which is effectively, borrowed money, or equity, representing owners’ contributions.
As the “residual claimants”, the economic agent with the sole remaining claim on the net cashflows of the business, equity investors should expect to benefit not only from the potential upside in the business but also, carry the risk of loss. Hence, basic corporate finance principles dictate that the foundation of any capital structure be composed of equity. In its simplest form, equity has no fixed repayment date or guaranteed return. It is a patient form of capital, as compared with debt, permitting the business to invest for growth without the pressure of imminent debt service. It carries more risk than debt, but may yield a significantly greater return in the long run. And yet, Ghana’s financial landscape is dominated by debt.
How did we get here?
Given the large number of lending institutions in the economy, such as banks, micro-finance and savings & loan companies, Ghana’s predicament is understandable. Ironically, however, there seems to be dearth of lending opportunities with appropriate risk-reward trade-offs, especially within the banking sector. This is particularly manifest in the commonality of the banks’ loan portfolios, and their penchant for aggressively pursuing a limited subset of clients. As a result, several businesses that require equity financing, an indisputable conclusion that will follow a thorough and candid assessment of their credit worthiness, have instead been offered bank financing.
An alarming trend persists where new businesses settle on bank financing as the foundation of their capital structures, instead of equity. With distinctively weak capital foundations, the vast majority of these businesses are unlikely to be able to contribute meaningfully or sustainably to economic growth. Their ability to withstand shocks through different economic cycles will be very limited.
In making loans to businesses that have limited equity in their capital structure, lenders indirectly and unwittingly, step into the shoes of shareholders, effectively taking on equity risk for debt returns. Despite this additional risk however, these lenders do not benefit from the upside in the company’s performance. In fact, the exposure to equity risk further places the deposits of such banks in a perilous position. Sadly, neither these lenders nor their depositors earn additional returns for the exposure to equity risk. It is from this perspective that the Bank of Ghana is exploring an increase in the minimum regulatory capital levels for banks, to ensure appropriate equity buffers to safeguard depositors’ monies.
Let’s be creative and not prescriptive
The blame for the pitiful state of our equity markets lies not entirely with the banks. Indeed, the crowding out effect from excessive Government borrowing, and its deleterious impact on interest rates, provides easy opportunities for yield-seeking investors to achieve attractive fixed income returns while avoiding the risks associated with equity investments.
Furthermore, viable alternatives for raising equity capital in Ghana, whether through the public markets or privately are exceedingly limited. The mood of excitement that greeted the establishment of the Ghana Stock Exchange (GSE) in 1990 has long fizzled out. Aside from the high standards for financial reporting and corporate governance that are required of public companies, the prospect of being held accountable by shareholders in such a public manner can be intimidating for some privately-held businesses. Becoming a publicly-listed business is not for everyone.
Trading commenced on the GSE with 11 listed companies, and after 27 years of its existence, the main market can boast of only 36 corporates. A parallel market operated by the GSE, the Ghana Alternative Market (GAX) that focuses on small and medium-sized businesses, has equally struggled to gain traction. Notably, a lack of liquidity, driven by factors such as the limited number of listed companies, the limited “free float”, which represents the proportion of shares in a company in the hands of public investors and not held by insiders, the low numbers of retail investors, and the significant and long-term holdings by the state pension fund (SSNIT), further constrains the markets’ potential for development.
At the same time, it has been disconcerting to see a crescendo of pressure being brought to bear on multinational companies operating in critical sectors of the economy such as financial services, manufacturing, mining and telecommunications to mandatorily list on the exchange as a catalyst to further develop the market. The argument frequently adduced by proponents of this policy is to afford Ghanaians an opportunity to participate in the ownership of these companies. This is wrong – a stock exchange is not a wealth distribution platform – it is primarily a market to facilitate the issuance and trading of securities, such as equities. In any free market regime, the decision to trade on a market, or to issue and list the shares in a privately-held business on a stock exchange, should remain voluntary. Concerns regarding low Ghanaian participation in critical sectors of the economy are best addressed through local content policies, good examples of which exist in the oil & gas and mining sectors, to name a couple.
Relevant and broad-minded Government policies will achieve much
Efforts to date by Government to improve the availability of private equity financing through venture capital and private equity funds need to be recognized and applauded. However, much more has to be done in this direction. The majority of the funds within the local private equity sector became active after the establishment of the Venture Capital Trust Fund (VCTF) Act 680 (2004) and the Internal Revenue (Amendment) Act (2006). These provided favorable tax incentives such as exemptions from capital gains and corporate tax, for firms domiciled in Ghana that invest in private equity and venture capital funds. Although the recently introduced Income Tax Act 896, 2015 eliminates some of these incentives, significant incentives still remain for local firms that invest in private equity and venture capital funds. Despite these incentives, however, relatively few private equity and venture capital funds have succeed in developing portfolios of repute to date. On the contrary, there are currently 33 commercial banks, 77 savings & loans companies, 141 rural and community banks and 564 microfinance institutions in active operations. This state of affairs underscores the need for a rethinking of our policy priorities with respect to capital.
An opportunity exists to nudge institutional investors, and to a limited extent, retail investors to make more private equity investments to fill the financing gap. More generous tax and regulatory-based incentives, combined with matching grants, should provide the required draw. The goal of these policies will be to significantly increase the amount of equity investments in privately-held businesses that meet specific criteria. As has been the case for the few venture capital and private equity funds that have been set up, institutions that are likely to take advantage of these incentives include investment banks, insurance companies, asset managers and pension funds. What all these institutions have in common are large pools of money available for long term investments which would generate appreciable investment returns and provide retirement income to their clients.
Too much money chasing debt products
Pension reform has translated into a pile of approximately GHS 6 billion in investible funds that has largely been parked into government debt and fixed income instruments issued by banks. This asset pile is growing at a healthy clip – estimated at approximately 60% per annum – and represents a readily accessible source of funding for private equity. While other African countries such as Nigeria, Kenya, South Africa and Botswana allow pension funds to allocate between 5% and 10% of their assets under management to private equity and venture capital investments, current investment guidelines in Ghana do not. If Ghana should follow suit, and amend its asset allocation guidelines accordingly, this will represent a momentous step in ultimately addressing the scarcity of external equity financing in the SME sector. Doing so will undoubtedly unlock long-term patient capital for investment. Likewise, additional tax incentives over what currently persists in our existing tax code would certainly bolster the interest and participation of local fund managers – regulated firms that provide investment advice and assist clients to invest their money.
The policy goal of any tax and regulatory incentive scheme to encourage the private equity and venture capital industry should accordingly seek to increase the volume of private equity investments in emergent and SME companies. The use of tax credits, both on the “front end” when equity investments are made and on the “back end” through a capital gain exemption that reduces tax on the gain realized on successful investments, are approaches that have proven successful in a number of jurisdictions. Other more aggressive incentives could include an outright exemption from withholding taxes on income distributions such as dividends to shareholders, or from corporate, income or value-added taxes (VAT). Incentives can also be delivered – either to investors or to the companies in which they invest – directly through a matching grant program.
Looking ahead
As the number of private equity and venture capital funds increases and the ease with which businesses are able to access equity capital improves, the merits of a stock exchange as an avenue to raise capital or to facilitate the trading of equities becomes even more notable. In this regard, the stock exchange serves as a conduit for private investors to monetise a portion or all of their holdings, while enabling the company to swap any exiting investors with new public investors. Over time, a critical mass of businesses with external private investors will develop, serving as a healthy pipeline for future stock market listings. Additionally, the stock exchange would channel much needed capital to sectors of the economy that require financing and provide private investors with an accessible exit for their investments. Finally, a robust economy with prudent fiscal and monetary policies that boost private sector growth and reduce economic uncertainty would also support the stock market.
