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With its economy still growing and stable banking sector, South Africa is proving to be a resilient environment for deals and exits.
Private equity is back on the rise in South Africa. In 2011, total private equity investment activity was up 32 percent year-on-year, according to KPMG, while early indications are that it will increase again in 2012. And it's easy to see why: the country's economy continues to grow, has a stable and well-capitalised banking system, and is well-positioned to act as a gateway to other fast growing economies in emerging markets of sub-Saharan Africa.
South Africa has not been immune to the effects of the financial crisis. Nor is it immune to the ongoing financial crisis in the Eurozone; South Africa’s manufacturing sector, which accounts for almost a fifth of GDP, depends on the Eurozone as one of its biggest customers. But it continues to enjoy a fruitful export relationship with the growing economies of India and China – and unlike most countries in the developed world, it is benefiting from a growing middle class, as income levels rise among the country's black population.
South Africa's GDP growth is expected to be in the range of 2.5 - 3 percent in 2012 and possibly higher still in 2013 (depending on events in Europe and China). So there is no shortage of opportunity for savvy investors – particularly if they have an ability to originate opportunities in growth sectors.
From good to great
"Some sectors are growing at a much faster rate," explains Ngalaah Chuphi, a partner at South African firm Ethos Private Equity, which has completed three new deals and two exits in the last year. "Household consumption expenditure, for example, is rising at circa 5 percent [per annum]. We're seeing a transformation as more black people come into the mainstream of the economy. So we try to find sectors that will benefit from that." Chuphi cites the example of Tiger Automotive, a tyre retailer that Ethos bought in 2008, which is tapping into the rapid growth in the number of cars in South Africa.
Other sectors also offer attractive prospects, says Chuphi: notably education and healthcare, where the private sector is playing an ever greater role, and infrastructure, in which the government continues to invest heavily. Then there's energy and commodities, where South Africa is trying to position itself as a gateway to the rest of the continent.
The role South Africa is playing as a gateway through which companies can access growth in the rest of the Continent is a recurring theme for many of the sectors in which Ethos operates. "More and more of our companies are exploiting growth across the borders of South Africa," Chuphi says. “A key part of our strategy for investments is to capture growth not only in our home market but also growth across our borders.” (Ethos also has a mandate to invest a small portion of its fund on a direct basis elsewhere in sub-Saharan Africa).
There's also a steady stream of deal flow in the market. South African corporations continue to sell off non-core assets; family businesses are still accessing private equity to solve founder succession and corporatisation challenges; and there are still public companies in need of patient capital to fund periods of strategic change in an ownership environment that prioritises cash flow and long term returns.
According to Chuphi, Ethos is “very proactive” in its deal sourcing; the firm's last three deals have all been uncontested. But equally, it does not shy away from auction processes– or from complex public-to-privates – if the price is right. “We've been around for 27 years – and because of our reputation in the market with sellers and management teams, we do get invited to the dance when somebody is thinking about selling." The Ethos view is simple, says Chuphi: "We pay fair prices for good businesses that we can take from good to great."
Operational value creation is crucial to this. Approximately half of the returns of Ethos’ last fund were attributable to EBITDA growth, and it continues to evolve its capability in this area. It has recently appointed an operating partner, who is involved from the earliest stages of a deal in setting a value creation road map with the executive management team.
Might this entail new management, too? "Our model is to back strong management teams who are doing a good job and give them the opportunity to do even better," explains Chuphi. "So it's mostly about bolstering management teams rather than finding replacements – introducing additional capacity and capability at different phases of the company's growth. This might include someone to oversee a new product line or geographical expansion, for instance.”
One of the main strengths of South Africa as a deal environment is the relative health and stability of its banks. "There is no stress in our banking sector – the banks here are very much open for business," says Chuphi. In addition, over the past few years the local market for high yielding debt instruments has increased considerably.
A good illustration of this is the fact that Ethos has recently been able to perform three positive recapitalisations of existing portfolio companies, where they tapped the local capital markets for local currency -denominated high-yield bonds. "We've done this before, but it's ratcheting up in scale and becoming really viable as a funding option," says Chuphi. "We like the flexibility the bonds give us from a covenant standpoint. If there's excess cash in the business, it can either be repaid to investors or it can be used to grow the business." Indeed, the breadth of financing options in South Africa is far greater than in other emerging markets like Brazil, Turkey or India, he suggests.
There has been one big change with the banks, however, with regulation making it ever more difficult and expensive for them to commit capital to private equity, most are withdrawing from direct equity investment activity altogether.
The withdrawal of banks from the sector has had a positive impact for the remaining players and therefore entry multiples, Chuphi suggests. "I'd say the competitive landscape is much more balanced now –there's a better balance between supply and demand of private equity capital. And this is reflected in deal pricing in South Africa where entry EBITDA multiples are at a significant discount to those being paid in other emerging markets."
Although a number of the banks and some local players have withdrawn from the market, Ethos is seeing some new entrants in the fray, including some global players. These funds typically have a pan African focus – but since South Africa is by far the biggest market in the region, they are likely to compete with South African focused GPs like Ethos, particularly on the larger deals. "South Africa is such an important market that you can't ignore it; any deals of scale are more than likely to be here than elsewhere in the region." explains Chuphi.
This does have an upside, however, as he points out: for firms like Ethos that are currently trying to fundraise in a difficult environment (it's hoping to close its sixth fund towards the end of this year), the interest of global players provides hesitant LPs with a ringing endorsement of the region's prospects as an investment destination. Given South Africa's strong fundamentals, it's an investment destination that certainly shouldn’t be overlooked.