External investors looking for merger and acquisition deals in East Africa are facing challenges when conducting due diligence and valuing potential targets due to low-quality financial data, potentially costing the region valuable foreign direct investment inflows.

Advisory firm Deloitte says in a macroeconomic outlook publication that underdeveloped target companies — in terms of revenue and profitability—are also forcing investors into a narrow band of sectors such as energy, fast-moving consumer goods and financial services, and leaving other small businesses facing a capital drought.

Private equity, venture capital funds and development finance institutions (DFIs) have over the years expressed concerns about asset quality and valuation of local businesses, pointing out the possibility of overpaying for low-quality investments.

When conducting due diligence on potential acquisition targets or merger partners, companies analyse historical performance and also evaluate the operating environment to project future performance.

Failure to do proper analysis can, therefore, leave a buyer staring at considerable losses should the financial projections of the acquired asset fail to match actual performance.

“Key challenges experienced in due diligence comprise tight deadlines, inadequacy in the skills in the finance function and low quality of financial information. Inadequate due diligence presents the risk of mis-assessment of the going concern of the target, resulting in an uninformed merger or acquisition,” said Deloitte in its East Africa Macroeconomic Outlook report.

“Most investors looking to deploy capital in the East African region have (also) expressed concerns about the quality of assets, the reasonableness of their valuation asking prices and the fairness of market pricing.”

Challenges have also been seen on deals cutting across more than one jurisdiction, Deloitte added, due to lack of a harmonised regulatory framework around mergers and acquisitions in the East Africa Community (EAC).

“Although the East African region through the economic bloc EAC has been trying to implement a harmonised approach to regulation of M&A through the EAC competition regulations of 2010, the countries have yet to fully implement the regulation. This poses a challenge, particularly to cross-border deals,” said Deloitte.

Given that a majority of the deals in the region are executed from Nairobi, which is the financial hub of East Africa, the barometer is a reflection of the business environment in Kenya.

A survey done by advisory firm I&M Burbidge Capital showed that in the first eight months of this year, Kenya accounted for three-quarters or 68 of the 91 corporate deals so far recorded in the region this year, ahead of Uganda’s 15 deals, Tanzania’s five and Rwanda’s three.

From the 91 deals, 39 were venture capital investments, which eclipsed the 31 private equity and Development Finance Institution (DFI) investments and 15 merger and acquisition deals in the period.

In terms of sectors, ICT and telecommunications have dominated with a total of 33 deals this year, followed by financial services at 18.

Logistics, healthcare and energy have six deals each, while there are five apiece for manufacturing and agribusiness.

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