SA Private Equity Is Definitely On The Mend
The smart money says SA s Private equity industry will be out of intensive care by the end of the year and the smartest guys in the room believe it will be stronger as it recovers from the flu it contracted during the global credit crunch.
”Private equity should end up in a better space relative to the market because managers will end up actively managing their portfolio to a greater extent “says Old Mutual head of private equity Mark Gevers.” If anything, this period will differentiate good managers, who need to be awake and astute, from the bad. ”He says he says if he were a betting man “I’d say the market is likely to recover to some degree of normalcy by last quarter of this year." The exact timing of the recovery is still debatable. Says RMB Corvest executive Mike Donaldson: “We have seen earnings improve to some extent but haven’t really seen the big uptick yet we believe that by end of 2010 we’ll see some light at the end of the tunnel. There are many factors that could derail any recovery: a wild swing the exchange rate could play havoc with SA private equity as could any drop in appetite for resources from China and India.
A survey by KPMG early this year conducted at the SAVCA unquote Private Equity congress in Cape Town, highlighted this optimism. More than two- thirds of people surveyed – 64% said they believed the SA economy had either already turned for the better or would within six months. More than 55% believed that SA would start to see the mega deals – worth R3bn or more – before the end of 2011. But while the optimism was there are clearly still obstacles that need to be overcome. The biggest issue facing private equity, according to 40% KPMG’s survey, was the uncertain performance of their portfolio companies, which created “uncertain exit opportunities”. Another 25% believed that “uncertain commitments” from investors was another big issue, while 20% highlighted the “non-availability of debt” to complete deals.
But the reassuring part is that the trajectory is upward. “The pulse of the Southern African private equity industry is certainly strong,” says SAVCA executive director JP Fourie. “It is clear that the role of the industry, as a long-term provider of risk capital, is more important now than ever before (and) the congress left us in no doubt that the investment case for Southern Africa could not be stronger.”
Stuart Mackenzie, partner at Ethos Private Equity, says what will aid the recovery is the fact that banks are starting to open up their funding taps again. “But of course, local banks are limited in terms of how big a cheque they’re willing to write,” he says.
Though banks tapped the European high-yield bond market to finance the Edcon, Alexander Forbes and Consol deals this market has effectively shut down for private equity deals.
Says Ethos partner Bill Ashmore: “The first problem is that private equity firms need a global investment bank to underwrite a high-yielded bond issue and the appetite to underwrite is limited at this time. Secondly, investors will not invest in the bond unless there is a currency hedge to protect the issuer from rand depreciation, but that hedge costs so much more that it used to,” he says. So if you’re paying 8% to hedge currency risk, and you need to borrow at about 10%, then this ratchets up the growth you’ll need on the investment to make enough of a return to satisfy investors in the fund.
Ashmore says the upshot is that deals have been limited to below R3bn, with the terms of the lending also a lot tighter than before. “This is why during the last year you have seen so many private equity firms now focusing on their existing investments – making sure they perform better – and doing follow-on investments,” he says.
Says Mackenzie: “It is important to recognize that leverage did remain available in SA throughout the crisis for the right assets and Ethos was able to conclude the R3bn Idwala transaction in December 2008 – in the eye of the storm and at pre-crisis leverage levels.”
Actis partner John van Wyk says the different price expectations of buyers and sellers are a hurdle. “Share prices have already recovered to some extent, so you’re not seeing potential deals at really cheap values. The debt is also more expensive now, and (large amounts) may be difficult to find.”
John Gnodde of Brait says that with all these unknown factors, private equity firms are best advised to return to the basic principles of their profession. “Getting finance last year was tough, but you have to keep your eye on the ball and look at what you can expect form a business perspective, not a financing perspective. If there is sufficient growth and a solid business plan for the company, the finance will look after itself,” he says. Of course, pricing is important too. Buy a company at too expensive a multiple, and this will eat into your returns over the course of the entire investment. “The thing is, you have to dig around to find the right opportunities, looking at where you’ll get the most benefit over a five-year investment,” says Gnodde.
Importantly, there are still acquisition opportunities for astute private equity managers. “In general, the SA market is fully priced, but there are a handful of attractively priced opportunities, provided you know where to look,” says Gevers.
In expectation of new acquisition opportunities, a number of private equity firms – including Brait and Ethos – plan to raise funds in the next year. Ethos’s Mackenzie says the plan is to raise US$750m for its new Fund VI – pretty much what it raised for its Fund V. “We know it’ll take longer than it took to raise the cash for Fund V, but the biggest issue is that there are not enough exits happening, which is holding back investors,” he says.
If anything 2008/2009 represented an interregnum for private equity, treading water while waiting for things to improve. Practically, this meant private equity owners who planned to exit their investments last year missed the deadline – preferring to wait to sell out until the market improved and they could get bigger a price tag.
But, as Mackenzie says, “we’re happy to wait it out, we’re not in a hurry to realize anything”.
Gnodde says Brait remains confident it will be able to attract new investors to its new fund. For Brait Fund IV, about half of Brait’s investors were from the US, and a quarter each from SA and Europe. Until now, investors in all the funds have been paid back returns northwards of 30% / year – and this will probably be a swing factor in luring them back, especially in a world with uncertain growth prospects.
Actis raised a $2,95bn fund just before the crisis, and this isn’t fully spent yet. “It will be interesting to see how well current private equity fundraisings go because this will give you a sense of how the fundraising has recovered, and the appetite for risk,” says Van Wyk. But assuming that the recession has changed the rules of the game hiking up the price for debt substantially – what will the new world of private equity look like?
Mackenzie says that in any future scenario the ability to leverage investments will be dramatically reduced, but assets will be obtained in competitive fair processes, which will be good for prices. “Things have changed, but we’re already seeing a strong deal pipeline – both from private institutions and public (like those listed on the JSE). I’m sure we’ll get back to the sort of multiples we saw in 2005 anytime soon, but private equity is a durable ownership model, so we’ll see it come back,” he says.
Which sectors will be the most attractive for private equity firms in a new post-recession environment? Most of the private equity houses focus more on “themes” in the wider society, where they see the potential for biggest profit. And for most, there are a couple of common themes, including that of “an emerging consumer” and the infrastructure boom.
Says Van Wyk: “It’s really still a consumer story in Africa, so that’s why you see many investments in banks, for example, like Actis’s purchase of Diamond Bank in Nigeria and CIB in Egypt.” The competitive landscape for SA private equity was also radically altered by the recession. Whereas the likes of the banks, lead by ABSA Capital, made all the noise in 2007 and 2008, trumpeting large deals, this has changed.
New banking rules – specifically tightening Basel regulations to require for their private equity investments – will make private equity far less enticing to the banks. Metier CEO Paul Botha believes that the financial crisis will spur more private equity firms into merging. “New regulations are set to come into force – which we welcome – but the smaller firms won’t be able to comply with all the rules, so we’ll see far more consolidation,” he says. As for the bank-owned private equity companies, he says the new Basel rules mean that “bank equity capital allocations have become expensive”.
Another change is that the big foreign private equity firms that flooded SA in 2005 looking for opportunities have retreated. “I don’t think they’ve gone for good, but they’re focusing on their home markets and waiting till the high-yield bond markets recover,” says Mackenzie.
Van Wyk says he has seen signs in recent weeks that the large international players have recovered some of their appetite for SA. “We have seen the international firms sniffing around again,” he says. Despite concerns about how SA stock seems overvalued – the JSE is again valued at more than 17 times historical earnings – there is certainly still interest in SA companies. Talk is that the likes of Bain, the Carlyle Group and TPG (Texas Pacific Group) are still mulling over some SA deals – and one of them is sure to take the bait sooner or later. In recent weeks, rumors have gained ground that Wal-Mart is back in SA and seeking to do a deal to buy and SA retailer like Shoprite or Massmart.
Though nobody will comment on that speculation, the mere possibility of such an interest highlights both the attraction of the SA market and that the private equity market is well on the way to recovery.