Private Equity's Retail Tilt
It is the best-performing asset class available, but it has largely been a no-go zone for private investors. Now some moves are being made to open up private equity. We figure out what you need to know to take advantage of superior returns.
Last month private equity firm Ethos sold its majority stake in sports and outdoor goods group Holdsport, through the retailers’ listing on the JSE, Ethos banked a compound annual return in the order of 25% on its five-year holding of Holdsport, which had been one of nine holdings in the R5,5bn Ethos Fund V.
As is typical within the private equity industry, which in SA boasts assets under management of about R100bn, Holdsport enjoyed a fixed period of strategic and active input from a significant shareholder, whose investment managers had their personal savings at stake.
These industry traits are partly why private equity consistently outperforms listed equity globally and rates among the best-performing asset classes over time. Until recently, though, only those with serious financial clout – pension funds, life funds, foundations, large family trusts and the like – have had access to these returns. Retail investors have been largely shut out. Slowly, the divide is narrowing: a handful of local investment houses have experimented with retail offerings in the private equity sphere and, though some have failed on the quiet, a few now present innovative and appealing products tailored to the well-to-do and seasoned retail investor.
So, what’s all the fuss about? What your financial adviser might not be telling you is that reputable South African private equity funds have outperformed listed equity benchmarks by 500 to 750 basis points over time. RisCura Fundamentals’ latest assessment of industry performance, done in partnership with the Southern African Venture Capital and Private Equity Association (SAVCA), shows that private equity has delivered a compound annual return of 21,4% over the past 10 years. The measure is a pooled internal rate of return, net of all fees and expenses. The total return on the JSE all share index (Alsi) over this period was 17,5%. On a five-year basis private equity returned 19,8% against the Alsi’s 12%; the equivalent returns for the two asset classes over three years are 10,2% and 4,6%. Launched to the market earlier this year, RisCura’s is the first comprehensive measure of private equity performance in SA, and follows globally accepted methodology. Rory Ord, head of RisCura Fundamentals, says the quarterly publication of industry performance may help open the industry further to the retail market. “Enhanced information flow is consistent with the industry trend of improved transparency. With the data in hand, there is better understanding of what private equity can deliver and potential investors can compare performances with other asset classes.”
Is private equity one of the investment world’s best-kept secrets, then, from a retail perspective, anyway?
Thierry Dalais, executive chairman of private equity group Metier, shrugs off any reference to the industry’s reputation for secrecy, saying its methodology is as old as the hills. “It’s a privately negotiated investment in equity or equity-related securities, where the manager holds anything from a significant minority to a controlling position in a business, pursuing an investment strategy that he believes in.”
He argues that this equity exposure creates accountability that might be absent from a board of directors whose members have no active ownership. “In private equity, the strong alignment of interests ensures that we actively do those things which will make the investment more efficient, while taking our responsibilities seriously.”
Anthonie de Beer, a partner at Ethos, also emphasises the value of this active involvement, arguing that the right investment strategy and an experienced private equity fund manager are what underpins outperformance relative to listed equity. “Some investors have had off-putting experiences after investing with private equity fund managers who don’t necessarily have a solid strategy or who make short-term decisions. It’s important to be very specific about your strategy and to be focused on building value over a five- to seven-year period.”
Depending on industry conditions and the nature of the business, the private equity firm may encourage measures that steer turnover higher, be it through product expansion or a move into new regions; it may seek add-on acquisitions; impose disciplined cost-management or sell non-core assets, de Beer says. “In order to be able to defend one’s outperformance relative to listed equity, one has to be consistent in driving this value creation – year in, year out.” Along with consistency, fund managers need the discipline of patience and commitment to careful research. Mark Gevers, head of Old Mutual Private Equity (OMPE), points out that his team typically devotes six to twelve months to analysing a target company and its sector before pursuing a deal. “If you consider that we’ve done just over 20 deals over the past seven years, you’ll appreciate that these are very considered decisions – ours is patient capital.”
Earl van Zyl, who heads up private equity at Momentum Investments’ subsidiary FRAIM, explains that the information advantage derived from careful research is especially valuable in the unlisted space, where market efficiency definitely does not exist. “The financial performance and prospects of private equity owned companies are not publicly known and the private equity manager often can buy at lower multiples. Part of the value to be had, then, is on account of the information asymmetry between insiders and outsiders.”
Another factor that plays a role in boosting return on equity is the use of debt – through deals described as leveraged buyouts. “There is some debate regarding the sustainability of financial engineering in the private equity industry, and there is the argument that one shouldn’t build an investment thesis on the basis that one can get leverage,” Van Zyl says. He adds that few firms in SA have relied heavily on leverage as an investment strategy.
All in all, good reason to expect some decent performance from the private equity asset class. With the added benefit of diversification, there is a strong rationale to include it in one’s portfolio. So, why aren’t more Individual investors venturing there? Well, the very characteristics that make private equity irresistible from a returns point of view render it quite unappealing to Joe Investor.
For starters, with their target market firmly set in the direction of big-pocketed institutional investors, it’s not unusual for private equity firms to set a minimum investment amount of around $10m. On the argument that your private equity exposure ought to be in the region of 5% - 10% of your total portfolio, on top of which you’d have to spread your private equity allocation across a number of fund managers to avoid risk concentration, you’d have to be in the very high echelons of the high-net-worth category to make this work.
Then there’s the liquidity mismatch, as Citadel chairman Jan van Niekerk calls it. “Individual investors usually are accustomed to having access to their capital within days, weeks or months; there’s no such convenience with private equity, where the lock-in can be in the region of 10 – 12 years.” Once invested, the only way out is by selling to a third party, “at a price of their making”. Since such a secondary market is underdeveloped in SA, the penalties for exiting early, by way of steep discounts, are that much heftier.
The typical private equity fee structure can be unpalatable. Once the fund manager has access to the investor’s capital, a management fee of around 2% is levied on the committed amount – regardless of whether these funds have been disbursed through acquisitions. This initial phase in which the fund manager selects target companies for the fund can take up to five years. But Van Zyl explains that this is integral to creating the right incentive structure, so that managers are not tempted into hasty deal-making. Additionally, the profit share from the winding up of a private equity fund is weighted generously in favour of the manager: the convention is that one fifth of the excess returns from the fund – that is, returns higher than the so-called hurdle rate - go to the manager. Typically the hurdle rate is in the order of 8% to 10%. With huge sums at stake - and with investors having to make capital commitments to the fund manager well before any underlying investments are made – detailed due diligence of the manager is essential. Referring to the local institutional market, Dalais argues that SA is still building expertise in the area of manager evaluation. By implication the dilemma of disconcertment is considerably greater for the retail investor who may not have this expertise.
A fund-of-fund structure, through which a manager builds a portfolio of investments into private equity funds, removes much of the rigmarole of a due diligence and gives the investor diversified access to the asset class. It may come at the cost of an extra layer of fees, though. Vunani Private Equity, Sanlam Private Equity, OMPE and Momentum all offer fund-of-fund structures in the local market; the first two are open only to institutional investors.
Speaking from experience in assessing potential private equity fund managers, Citadel’s Van Niekerk says his team looks at what strategy the fund manager follows and whether the organisation has the appropriate skills set; what incentive structures are in place and whether the manager has his own money invested alongside the investor’s. Also important are the manager’s track record and whether the other investors in the fund could bring some strategic advantage in helping to boost returns in the underlying investments.
|SA PRIVATE EQUITY IN PERSPECTIVE|
|Dec 2010||Dec 2009|
|Funds under management||R97,6bn||R105,4bn|
|Third-party funds raised||R11,1bn||R3.8bn|
|Proportion of total funds raised in SA||42.4%||50.3%|
|Funds returned to investors||R17,3bn||R2,0bn|
|Soure: KPMG, SAVCA|
Having investigated private equity as an offering for Citadel’s retail client base, Van Niekerk says the lack of liquidity is too big an obstacle for a pure exposure to the asset class, even though he is “very excited” about its returns performance. What his team has designed instead is a fund-of-funds that invests in a mix of private equity and hedge funds, which is one way of overcoming the illiquidity problem without introducing cash drag. At the other end of the spectrum, Douglas Investments has partnered with Metier in bringing pure-play private equity to its high-net worth retail base. The Conexus unitised portfolio has an estimated market value of nearly R125m and invests directly in underlying businesses, in contrast with the fund-of-funds structure which typically is considered suitable for retail investors. Dalais explains that this particular client base understands the illiquidity risk; moreover, the investment adviser is able to assess clients’ overall financial allocation and judge whether they can afford the private equity exposure.
A handful of SA’s bigger institutions, including Momentum, have entered this market, too. Its private equity fund-of-funds welcomes wealthy individual investors. “Compared with the average private equity fund, we are far more accessible to the retail market. The minimum investment value is R1m, although this is negotiable and is set as a way to filter sophisticated investors into the fund,” Van Zyl says.
Momentum’s fund has a market value of just over R400m, has returned over R700m to investors since closing in 2004 and boasts an annual return of 28,3% since inception (after adjusting for fees, but before tax).
Meanwhile, OMPE has what could be labeled one of the most innovative retail products on the market. In May 2006 it closed its first private equity multimanager retail fund, which was followed by another in 2007. In October 2009 it launched a pure secondary private equity fund – effectively, a buy-in to existing private equity assets. The first fund has delivered annualised returns of 30,5% since inception (after adjusting for fees, but before tax).
A number of factors differentiate these funds from their peers. The minimum investment is set at a low R100 000, while investors may withdraw capital in advance of the so-called investment realisation – the point where the underlying assets are sold. The cost for such quarterly liquidity withdrawals varies across the funds, from 5% to 7% of the then market value.
Gevers describes the liquidity facility as a way of giving clients peace of mind. “Very few investors have made use of the liquidity option. More than anything else, this is possibly just a convenient emotional backstop for investors.”
Offering a liquidity underpin to the private equity investor is a luxury that might be limited to large institutions with hefty balance sheets; in Old Mutual’s case, the private equity product is life-wrapped, meaning the asset is matched to the horizon of a life or endowment product, and additionally benefits from tax rebates associated with life products.
The investment house is committed to the retail market. “The wider the gospel is spread, the better. Our motivation is to create a market for private equity to those investors who otherwise would not have access to institutionally orientated third-party private equity funds; we hope these investors will continue to be followers of the asset class.”
For investors who simply want to avoid the inconvenience related to illiquidity, penalties and minimum investment amounts, there is always the indirect route to private equity, which would be through listed vehicles that invest in unlisted assets. A long list of possibilities might appeal here, including Brait, Brimstone, Bidvest, Purple Capital, PSG, RECM & Calibre, Reinet and Remgro.
But the purists argue that exposure to unlisted assets through listed securities is not an entry to private equity in the strict sense of the term. The major distinction says SAVCA executive officer JP Fourie, is that there is a definite end point in the private equity investment model, which entails a recycling of investments. “It is a transitional business model with an exit mentality.”
Many of the listed investment vehicles are strategic long-term investors rather than financial buyers, with the additional feature being that they use their own balance sheets to fund acquisitions. Asked about the likelihood that the private equity gospel will indeed be spread to the retail market, Fourie argues that, “as the asset class matures and understanding of it increases, we will see more retail interest. Most of it will be done through a fund-of-fund structure, though, because of the administrative burden related to managing large numbers of relatively small clients.”
Momentum’s Van Zyl emphasizes that private equity remains a tough sell in the retail market because of the illiquidity constraint. “This will never be something to open up for R5000 a month with the option to exit at any time. It will always be a product for the top end of the market.”
On the broader prospectus for private equity, Van Zyl says he expects returns to ease as returns from other asset classes come off. “Private equity is not an absolute-returns game, though; its performance is measured relative to listed equity – and this relative outperformance ought to remain the same.”
De Beer agrees. “The top-quartile private equity funds globally should always outperform public markets by greater than 300 basis points. If they don’t, the investor has to question the strategy and quality of the private equity fund manager.”
For retail investors with the means – and the stomach – it’s time to opt in.