Held on 14th August 2021 – virtually
Thank you for having me today. I am so happy to be here and to contribute to the important dialogue about Venture Capital and Private Equity in Tanzania. We are going to look at the regulatory, policy, and legal environment for PE investments, and in looking at these areas, we will see what needs to change in order to build a conducive environment for PE and VC investments in Tanzania.
Currently, most investments for the East Africa region mainly go to Kenya, for several reasons namely the conducive environment that Kenya has managed to develop over time from an investment vehicle structuring perspective meaning the company law amendments over the years as well as the taxation reforms that allow for taxation at a much later growth stage sometimes up to only 3 years after investment operation.
In Tanzania, the reality is that local investments in equity are largely confined to the very beginning of the company formation journey in which a principal shareholder takes the lead and invites friends or acquaintances. Second stage external equity is still very much a preserve of foreign owned equity firms. In Tanzania, there are several challenges around raising equity financing by Tanzania owned firms or High Net worth Individuals in Tanzania for several reasons:
- Lack of knowledge of equity financing
- Being used to investing in “traditional” asset classes like real estate
- Little developed culture around investing
From a policy perspective, when it comes to SME funding and financing, we mainly have outdated policies:
Currently, the various policies and institutions that support the development of equity finance for SMEs are outdated. We have the following:
- SME Development Policy of 2003 identifies access to various financial products, including short and long term debt and equity as one of the key means of improving the performance and competitiveness of the SME sector.
- The National Trade Policy stipulates that for trade to be effective, there is a need for enhancement of short and long term access to finance for SMEs. The long term finance in this case includes equity.
- Other policy frameworks that emphasize issues related to access to finance for SMEs are the National Microfinance Policy (URT, 2000)
- The National Economic Empowerment Policy (URT, 2004),
- The Financial Inclusion Framework and
- The National Financial Education Framework.
These policies are largely outdated and need to be reviewed and I believe there is an effort being made to adopt a new SME Policy that would subsequently lead to SME Legislation and regulations. However, this is only a small part of the story.
Let us look at the Funds structure aspect and the Investment aspect
The venture capital model relies on expensive investment analysts and fund managers, which necessitates investment thresholds that are too high for virtually all small and medium enterprises in Tanzania. Traditional equity funders also expect a certain level of governance and managerial capacities in the investor, and a readiness to share business information and ownership with other investors. These attributes are not as developed in markets such as Tanzania. The challenges here are on the one hand finding professionals who are able to understand and manage PE / VC funds in Tanzania. The expertise is scarce and would have to be imported from abroad which increases the expenses since we would be dealing with expatriates. Another challenge is corporate governance culture and practice in a lot of companies in Tanzania is very weak. Coupled with the fact that most companies in Tanzania are private family businesses, corporate governance is even more loosely applied. Finally, the ability to share information accurately is challenging considering the practice of having several different account books for example that tell different stories depending on who is being addressed (bank, investor, tax authority).
Also for Private Equity funds, currently the Capital Markets and Security Authority (CMSA) provides for the traditional collective investment schemes that are not quite in sync with the Private equity investment model. Typically the General Partner – Private Equity Fund structure is a see-through legal vehicle in the form of limited liability partnership however, these are not provided for in the current capital markets laws and company laws in Tanzania. So ideally we would want to change this if we want to attract more Funds to park their private capital and house their funds in Tanzania.
Currently, collective investment schemes (CIS) are the only mode of investment that can be used for PE funds in Tanzania. A CIS is managed by a fund manager without a legal vehicle structure. A CIS does not have a separate legal personality and it is not registered at BRELA. It is essentially a contractual arrangement between the investors and the fund manager which is “alive” once the contract is executed. So this is not exactly ideal as it poses questions on liability for example or even from an accounting structure perspective, it is very difficult to do since different actors in PE have different rights to earnings.
From a tax perspective, we would need to see quite a few changes so as to have a conducive environment for PE and VC investments. Investees have the option of using debt, equity, or a combination of both. Typically, as a way of extended due diligence on the target investee company – the financing is structured as a mezzanine debt-equity financing with a convertible option of the debt to equity at a future date. But where there is debt including convertible debt, there is withholding tax on interest (5%) from the first repayment. The interest is tax-deductible, compensating partially for the withholding tax. However, we have seen with the revenue authorities that where a loan agreement has preferential terms related to the interest rate, for example, the authorities have reserved the right to amend the interest rate if they deem that this is too low for example. This type of interference in commercial arrangements between private parties is a disincentive to have these types of structures and transactions in Tanzania. On the questions of dividends, these attract a capital gains tax of 10%. Given that most PE and VC investments are carried out by foreign investors, repatriation of profits for foreign investors attracts another 5% withholding tax. In any case, the case for limiting equity ownership is so strong that marginally higher tax implications would not justify maintaining a lower debt/equity ratio. But also, you are paying 30% income tax from the get-go, before you have even started making any income you already pay an assessment on taxes that you will pay based on income that is projected only. Although the law changed so as to afford a grace period of 6 months to taxpayers before they have to register and pay for income tax, we see that the Tanzania Tax Revenue Authority is not implementing this. If we look at Kenya, Kenya has really become competitive in that sense because there is a grace period of 3 years before a company starts paying the 30% income tax. But also Kenya offers a Limited Liability Partnership structure under its companies act whereby the pool or fund would not attract any taxes because of the partnership nature of the structure.
Finally, other panelists have discussed the Fair Competition Commission (FCC) rules and legislation which are not ideal in Tanzania. Notification is a must as soon as there is an acquisition of shares where the combined asset of the company is Tshs 3.5 billion (approx. USD 1.6 million). These attracts fees that vary on a sliding scale and range between TZS25 million to TZS100 million, based on the combined total annual turnover of the last audited accounts of the merging entities. So if we think about it, USD 1.6 million is a small amount of investment for the added bureaucratic layer that one must go through in notifying and paying the notification fees. The threshold was much lower before (Tshs 800 million which is equivalent to about USD 350,000) so we welcome the change, but I think we can do better and increase the threshold even more. Another challenge with the FCC though is how long it takes to get approvals. A deal can take 6 months to go through and be approved which is such a long time in the business and investment world. What we have been seeing is when we advise clients on mergers and acquisitions in Tanzania, some opt for the loan structure meaning to just give the financing in the form of a loan since this attracts less strenuous compliance requirements and only necessitates going through the Central Bank of Tanzania for registration and not approval per se.
Some of the key challenges that I have seen in the equity financing space in Tanzania facing both Tanzanian investors and investors is low awareness of the company law and the high reliance on informal arrangements. Investments are being made without having the requisite protections, including agreements, title to the company shares (share certificate), informed valuation, use of legal and finance expertise, etc. All these are contributing to conflicts and maybe hurting the credibility of equity investments. Investee companies complain of unfair terms however the truth of the matter is that nobody forces anyone to sign unfavorable terms. Often investee companies are desperate to receive funds and do not care about the terms and conditions until it is too late!
But other than the laws, regulations, and policies in Tanzania that we have examined and concluded that are unfavorable to the PE and VC investment climate in Tanzania, we need to look also at the Tanzanian companies that are potentially investee companies. The problem also lies there and we see this a lot in the investment structuring stage where the investor and investees are in the due diligence process and contracting. The challenges here are i) Low awareness of standard terms to private equity investing among SMEs ii) slowness and reluctance in delivering needed information; iii) The problem of valuation of businesses, particularly due to lack of reliable historical financial information, meaningful financial projections; limited financial skills and industry data for valuations; iv) Challenges of obtaining sufficient information from the potential investee companies,
Due diligence in Tanzania is time-consuming because of the lack of adequate records and/or documented procedures. We can expect an improvement in this area since the law now requires a company to file its audited financial statements each year with the registrar of companies failure of which they will not be able to get any updated records at the company registrar of the company and will not be able to transact. This is helping as there is a culture being developed of at least keeping financial records which is key for any company that expects to have investors invest in their company.