Investors Encouraged to Invest in Private Equity
The hands-on approach
The recent changes to regulation 28 of the Pensions Fund Act encourage investors to extend their investments from conventional vehicles such as bonds and listed equity to hedge funds and private equity.
Up to now the main investors in private equity funds have been development finance institutions such as the Industrial Development Corp and the International Finance Corp. Only the very large pension funds, such as the Government Employees Pension Fund, have been substantial investors in private equity. Even wealthy investors - other than the general partners of private equity funds - rarely invest.
Two-thirds of the US$800m (R7bn) Ethos Fund VI had to be raised overseas, as local fundraising remains a long drawn-out exercise.
At the recent annual private equity conference the focus was on making SA's R120bn private equity industry attractive to foreigners.
According to the Emerging Markets Private Equity Association, the share of global fundraising attributable to emerging markets has increased from 4% in 2004 to 15% last year.
And the prospective rewards justify this. No less than 57% of investors in private equity in sub-Saharan Africa expect annual returns of at least 16%. In contrast, returns from developed-world market bonds are barely 2%.
There is plenty of competition, however, with Brazil, the rest of Latin America and China the most attractive regions for global private equity investors.
Few products were revealed at the conference that make private equity accessible to smaller domestic investors. An exception is Old Mutual, which is launching the third of its private equity multimanager funds. The product won't be competing with R50/month investments such as Fundisa unit trusts, but with a minimum investment of R100000 it can play a role in the investment line-up of the well-off and smaller pension funds.
Paul Boynton, head of alternative investments at Old Mutual Investment Group SA (Omigsa), says the two predecessor funds have both outperformed the all share index. Old Mutual's Fund 1, started in 2006, which was split between Ethos Fund V and Brait Fund IV, has returned an annualised 25,9% since inception. Fund 2, started in 2007, is more widely spread, with Old Mutual's own direct investments as well as investments in funds run by Capitalworks, Actis, Brait, Ethos and Lereko Metier. It has given a return of 18,5% over the past three years.
Fund 2 held businesses as diverse as Libstar, a private label food manufacturer, and cement producer Pronto. Another investment was South Point, which redevelops inner-city properties. The best-known investment is Consol Glass.
Private equity investors avoid high-risk areas such as deep-level mining and regulated industries such as banking.
Boynton says the new R600m fund, which should be available by May, has taken holdings in all the leading new private equity funds. It has invested in the new Ethos fund and the current Actis fund, and hopes to invest in the funds that are still being put together by Capitalworks and Medu Capital.
Boynton says the new multimanager fund will focus on the commercial private equity funds, as opposed to impact funds such as Old Mutual's own housing and education funds.
"But inevitably the vanilla private equity funds will be under even greater pressure to screen their prospective portfolio companies on an environmental, social and governance basis."
It might not be possible to repeat the returns achieved before the global financial crisis - there isn't the same access to cheap and plentiful finance anymore. Funds that started in 2007 and 2008 have provided an annualised internal rate of return of 7,8%, compared with 36,9% for funds started from 2000 to 2004.
Ethos CEO AndrÃ© Roux told the conference that the industry needed to look at other ways of adding value, apart from financial engineering.
As private equity firms follow an active ownership model, they have numerous opportunities to improve portfolio company operations.
Andrei Vorobyov, a partner at Bain & Co, says the returns of top-quartile US private equity firms have fallen from more than 50% 25 years ago to less than 20%, and the trend in Europe is similar. He says it has become much harder to buy companies at a bargain price, as there is an efficient and competitive sales process even in middle-market transactions.
"The only controllable way to earn differentiated returns is to add value to portfolio companies," he says.
About 70% of private equity firms believe they offer superior operational expertise, yet only 40% of investors are satisfied with the portfolio management skills of their fund managers.
Vorobyov says it is never too early for private firms to intervene in their portfolio companies - Bain & Co stats show that those who intervene in the first year will make a total return of 3,6 times the deal price during the time that they hold the company. But those who intervene later will make a total return of 2,4 times the price.
"After purchase it is best to skip the honeymoon and get straight down to business," he says.
He advocates a collaborative model of portfolio activism. "There will always be tension, particularly if the entrepreneur who started the business is still around.
"Private equity firms can bring a full Rolodex of advisers to help the business. In some cases firms will have industrialists on the payroll who have had direct experience of running a manufacturing operation. It is often easier for managers of the underlying companies to talk to them than to the financial whiz kids who make up the bulk of private equity managers."
The huge international private equity firms such as Blackstone and KKR have specialists drawn from every industry, some of whom might be parachuted into the portfolio companies for several years.
Vorobyov says it is not practical for SA firms to have such a wide group of specialists, "but it might be necessary to second a partner full-time right after purchase to ensure that the acquisitions bed down".