Armed and Ready
Private equity investors are armed with a fresh arsenal of new cash after a successful round of fundraising. They are now on the hunt for new investment opportunities in SA and the rest of Africa.
The last private equity buying spree led to a wave of major deals. Big names like Edcon, Consol Glass, Alexander Forbes and Primedia disappeared from the JSE during the last bull run that ended in 2008, thanks to private equity buyers. With the market again at record levels and firms sitting with cash, could we again see big delistings and large premiums paid to shareholders/
There are two reasons to think not. First, slow economic growth in SA limits the growth scenario for companies, although fund managers and analysts say they are still finding decent opportunities for promising investments locally. Second, the growth scenario in countries to the north of our border are much more attractive. The result is that private equity is interested in using SA as a gateway to the continent, be it in partnership with, or competition to, the local players.
Putting a brake on the pace of investments into Africa, however, is the risk associated with lack of infrastructure and uncertainty regarding the rule of law.
Erika van de Merwe, CE of the SA Venture Capital & Private Equity Association, says she is expecting deal flow on both sides of the story; many private equity funds have closed to investments and are looking to deploy their cash, while others have matured in terms of their investment time horizons and will be returning money to investors.
In their search for viable businesses, she says most funds are agnostic and will look at any industry, although the mining sector is generally being avoided. “Many see themselves as value investors and invest wherever they see opportunity.”
Rory Ord, head of Riscura Fundamentals, which provides consulting and advisory services to a range of investment organisations including private equity firms, has notice a trend towards investing in private healthcare, private education and other niche service areas. While “not a major theme yet”, such businesses are being favoured both in SA and to the north.
However, he says the majority of deals are still happening in the mainstreams sectors; consumer and industrial manufacturing companies. “Private equity firms are saying they are finding many opportunities. So the Africa growth story is finding traction in the private equity market in Africa”.
Access to the retail sector itself and secondary industries that retail growth brings, however, is proving more troublesome. In Africa there is little established, formal retail space. “We know that people have disposable income and need access to products, but it is difficult to meet that need,” Ord says.
Stephen Brown, a director at RMB Corvest, an on-balance sheet private equity firm- meaning it funds investment from its own finances – says the biggest problem in Africa is that structures are not well established, particularly for senior debt and due diligence studies.
“The above structures are not as efficient as in SA; therefore closing deals takes much longer in the rest of Africa.”
Ethos CEO Andre Roux says SA’s strength in such areas is what makes it attractive both to his firm – which is at the early stage of its investment cycle, having invested 10%-12% of the R7bn raised – and to foreign investors. “We have a mandate to invest 20% of our fund in the rest of Africa. Our challenge in that context is trying to find deals with scale and transactions in which we can obtain a controlling position. So we are specific in what we’re looking for in Africa but at the same time, 20% for us is about the right level: we remain comfortable with investing the other 80% in SA.”
While saying that “might sound strange” in the context of SA’s modest growth relative to Africa, he adds: “What we find attractive about SA is that, similar to Europe, it has huge institutional and infrastructure advantage that the rest of Africa cannot provide. These include the rule of law, a culture of entrepreneurial management and liquid asset markets that you can get into and out of.” Such factors are extremely valuable to private equity investors as they reduce risk and introduce certainty to the investment proposition.
Brown say Africa, generally is becoming more competitive. “There is lots of money chasing the growth story. So price:equity ratios are high as sellers push up their asking prices because of the high demand. “We are struggling to find medium-sized companies [with annual profits higher than US$4m]. There are lots of small entrepreneurial businesses and then very big ones – in the pharmaceutical, telecoms and infrastructure sectors.” But he identifies a distinct gap in the mid-size market in which Corvest specialises.
One area that Corvest is interested in is the fast-moving consumer goods sector. “It’s probably the sector with the most deals available in our target market for private equity.” But services in this segment are not as developed as in SA, “so we have to asses those issues”.
Roux says SA’s more advanced business environment also serves to attract foreign companies. “It’s interesting that we are still finding strong evidence of foreign companies wanting to use SA as a springboard into the rest of Africa,” he says, pointing to the Walmart-Massmart deal and Japanese company Kansai Paints’ initial merger with Plascon. Kansia Plason has since started its geographic expansion, having recently bought Astra Industries in Zimbabwe from Finance Trust of Zimbabwe.
“We believe you can still make very sensible returns out of South African investments because of the institutional and infrastructure advantages. Those cannot be underestimated.”
The merger and acquisition (M&A) market in SA, he says, is certainly not depressed. “There’s a reasonable market out there with a number of private equity deals just announced.” High profile ones include the bid by Chile’s CFR Pharmaceuticals for SA’s Adcock Ingram and Actis’ purchase of Paycorp from Transaction Capital, in which Ethos has a stake. “So the M&A market is not buoyant but it is reasonable. My sense of it is there’s a strong correlation between SA’s M&A activity and the developed world. If there is an economic recovery globally, things will pick up in SA.”
A good adage, Roux says, is that investment returns can never be linked to geography; it has to be to something much deeper. And high GDP growth does not necessarily translate into high investment returns.
In terms of assessing a business for investment, Ethos looks as sectors linked to the growing middle class, in SA and in wider Africa. “A growing middle class is a prevalent theme that is evident in the market and it won’t go away for a long time because of population demographics. So if you can get into spaces that can take advantage of that, it is an area of preferred activity for us. But there are always pockets of excellence in other sectors – particularly in services.”
He emphasises that the market is not in the doldrums. “Yes there could be more buoyancy in the market but there are definitely reasonable opportunities about.”
Brown says SA’s low economic growth combined with the JSE being at record levels is having an effect on the market in SA, both in terms of RMB Corvest’s existing portfolio and new deals.
He describes the local environment as being highly competitive with import costs rising because of the weaker rand, while the labour market is stressed both by socioeconomic tensions and inflationary pressures on incomes. Europe’s slow growth is also curtailing SA’s exports. All these factors suppress profits in existing businesses.
From a new deals perspective, Brown says they are more difficult with the JSE at record levels “because the seller has heightened expectations and raises his asking price when he sees the high valuations on the JSE”.
However, he says deal flow is being boosted because in difficult times, companies tend to sell non-core assets or loss-making divisions.
When investing in Africa, “it is ideal to partner with a local investor [as a co-investor] who knows the business environment of that country.” Such a partner picks up on local issues, has established relationships, knows which are the good and bad companies, understands the local politics and taxation and also makes for a good sounding board for decision-making.
Because RMB Corvest finances its own deals, there is no fixed term to its investments as it does not have to return money to outside investors. This gives it the freedom to enter and exit investment s when it deems appropriate, and it can hold onto an investment for long period should circumstances so warrant.
Its investment criteria include a good track record with historical earnings and existing, positive cash flows. Company management is an extremely important factor. “We want to back the right management,” Brown says. “Management is the most difficult to conduct due diligence exercises on. In fact, most business failures are due to management ability and not market forces.”
He says if a company is making profit and has a good track record that is indicative that management is good at running the business.
Despite the difficulties being experienced in the South African market, Brown is upbeat on the future. “We do see opportunities in these difficult times and we are looking for companies.”
He is also expecting more opportunities to flow through for private equity on the back of a second round of black economic empowerment (BEE) transactions. These will be driven by liquidity issues, in which the original BEE partner exits a company and another BEE entity buys in, so that the company does not lose its BEE status. “Lots of BEE partners have created value but they lack liquidity. We fund other BEE entities to buy their shareholding and we think we will see a lot more of that.” He expects this trend to accelerate should SA’s GDP growth rate improve.
The private equity market can be described as bubbling along nicely without any big bang headline grabbers, although those may yet come. In terms of investing in a promising business and guiding it on its growth path, they fulfil a critical role in the wider economy.