Treading Water-and Bent On Staying Afloat
If the latter part of the past decade had a turbulent wave of private equity investment shake-up of SA’s corporate landscape, then 2009 was a return to calmer waters. Rather like a dip in the Mediterranean, there were pretty much no waves whatsoever last year. The good part is that no one drowned amid a global undercurrent as vicious as any experienced in the history of SA private equity.
The annual survey of SA private equity activity by KPMG bears out this prognosis. The value of private equity funds under management slipped 2,7% from R109,4bn, while R5,5bn was raised during the year (compared to R10,6bn in 2008). Where you saw the real drop in appetite was in the number of handshakes. Last year, deals worth only R6,9bn were concluded, down sharply from the R18,9bn of 2008, or the R26,1bn of 2007, which notably included Bain’s purchase of Edcon.
Warren Watkins, KPMG’s head of private equity markets, says the figures illustrate how the industry trod water last year. “What we saw was a holding pattern. There were few investments, a lack of fundraising, and people simply watching the market for any signs of a return to normality,” he says.
JP Fourie, executive head of the SA Venture Capital & Private Equity Association (Savca), agrees with Watkins. “Lead times just blew out,” he says. “The trend we saw is that it took longer to do deals, longer to raise funds, more time to raise debt, and the mega deals that we saw in 2007 were off the table.”
A report by Savca and Evalueserv illustrated that this wasn’t just a SA scenario. Overall, global fundraising in 2009 fell off a cliff: only US$246bn was raising internationally – less than half the $636bn of the year before. “Fundraising conditions were extremely challenging in 2009, with a large number of investors restraining from making new investments,” says Evalueserv. “The fourth quarter of 2009 represented a low point, with only $35bn raised by 75 funds – the lowest quarterly total since the third quarter of 2003.” As a result, says Old Mutual head of private equity Mark Gevers, confidence among funds dropped sharply in SA last year. “There was a lot of uncertainty on every score: around the amount of credit available, the risk attached to investments, and a lack of visibility and trust in the numbers coming out of the market,” he says.
In the earlier part of this decade, credit was abundant and banks were willing to provide finance for deals based on up to seven times the earnings of the target company. Now, in a post-recession environment, banks (which are now slowly coming back to the market) are only considering funding deals based on twice, or three times earnings.
Brait Private Equity CEO John Gnodde says SA firms had the ability to mitigate the impact of the recession by developing plans before the storm hit. “The impact of the credit crunch hit SA about nine months after the rest of the world. So looking at what was happening in Europe and the US helped us prepare for this.” He says that when it became clear that the local industry was going to suffer almost as intensely as its US peers, “pre-emptive action had to be taken.” We said, listen guys, we know this is coming down the track, so we have to focus on our portfolio companies. We have to keep investors up to speed, and keep a close eye on the companies. So this is what we did for the past 18 months,” he says. But the problem was that neither private equity companies nor banks had any idea where the earnings levels of companies would be two years down the line. As a result, says Fourie, private equity firms went “back to basics” – applying the principles of sound investment practices to ride out the storm. “We saw far more follow-on investments and a slowing down of growth in portfolio companies. There were also few disposals, as private equity funds chose to hang on to their assets, rather than sell them at bargain basement prices,” he says.
Says KPMG’s Watkins: “Private equity funds complained, but they weren’t prepared to sell assets at what the buyers were willing to pay. The only way deals were done last year was if it was a forced sale because (people doing transactions) were waiting for clarity on the future price of assets.” The upshot was that only R1,9bn was returned to private equity investors in 2009 - a far cry from the R4,2bn in 2008, or the R9,1bn from the year before.
This trepidation was evident in some of the smaller deals, where buyers insisted on getting “profit warranties” to ensure they hadn’t bought a dud. Deals were few and far between last year too. Pamodzi Resources Fund struck the largest – the R1,9bn purchase of Rand Uranium, but executive Gerard Kemp says it wasn’t easy. “It took us far longer than we thought. We had to sit down and really assess how the market was going, before we committed to it,” he says. Kemp says he believes normality will only return in about 18 months. “The whole model of private equity is being reviewed, as are relationships between partners, and investors are reconsidering their options,” he says.
Paul Botha, CEO of Lereko Metier which manages the R3,5bn Lereko Metier Capital Growth Fund is perhaps the most optimistic. “By July, we should see some quality deals coming through, with reliable cash flows and predictable earnings. Deal flow has already picked up in most sectors, with the exception of manufacturing which is still struggling,” he says. And Botha says that when these “quality deals” present themselves, there’s likely to be a lot of money from private equity funds set to chase these deals – which should be good for competition.
But when will the R3bn deals reappear? “Well, everyone is waiting to see the quality of earnings that come through. You’ve already seen signs that things are coming back,” he says. One such event took place as this publication was going to print: Brait’s R1,7bn bid to buy the 81% that it didn’t own in the JSE-listed Freeworld Coatings. The big problem in doing deals last year – whether buying companies or selling – was the vast difference between what buyers wanted and what sellers wanted.
A survey, also conducted by KPMG earlier this year and presented at the Savca Unquote Private Equity congress in Cape Town, highlighted this problem. In all, 66% of those polled believed the “expectation gap” between buyers and sellers was more than 20% - a hefty deterrent to any deals, let alone in the private equity space. “The private equity market in sub-Saharan Africa over the past two years has been characterized by unwilling sellers and an inability of fund managers to invest their funds. As a result the appetite for deals has been reined back significantly,” says Watkins.
But the good news is that things appear to be on the mend. Of those polled, 63% believed that pricing expectations would converge before the end of 2011. After such a grim year, perhaps it’s not surprising that people were more optimistic. But what is surprising is that relatively little damage was done to the industry.
The KPMG figures showed that black empowerment deals – a key driver of private equity deals – was also lower last year. “Black empowerment investments did drop,” says Watkins. “But what was interesting is that the black empowerment market is maturing: as there are more funds available for black empowerment, the narrower the discount specifically for these deals.” In all, private equity funds invested R5,3bn in companies that were either black-owned, controlled or influenced - down 67% from the R16,3bn in 2008. In all, 79% of the R106,5bn being managed in SA private equity funds were being handled by managers who had at least some degree of empowerment, or from government funds – up sharply from just two years earlier.
But if 2009 was synonymous with any one characteristic, it was the rise of “active value management” – a fundamental part of private equity that faded into the background to some extent, thanks to the plethora of cheap credit and race to grab assets of the mid-2000s. “The global financial crisis meant that we had to redefine strategies for driving superior earnings. Now we’ve always focused on managing the portfolio, but we placed an increased emphasis on this last year,” says Stuart MacKenzie, a partner at Ethos Private Equity.
Though it may seem to an outsider that a private equity firm could simply drink coffee for a year, and wait for things to improve, MacKenzie says this wasn’t the case. “We were exceptionally busy, focusing on boosting returns in companies we already own,” he says.
John Van Wyk, partner at London-based emerging market private equity firm Actis, says the need to manage portfolios was amplified because many companies had been bought during the good times for relatively full prices, and experienced earnings pressure from the economic downturn.
“In some cases where companies were leveraged, private equity investors needed to make sure these companies did not breach their debt covenants, and survived. The thing is, they might be really good companies but the high leverage that was used for some of the early deals meant they required extra attention during this period,” he says.
Brait also did no deals in 2009, but director Gnodde says the company worked hard on getting its portfolio firing properly. “The wonderful thing about private equity is that you can get really stuck into your business. You’re never going to run factories, but you spend a lot of time discussing strategic issues and opportunities with management and helping them plan through tricky situations,” he says. Brait’s philosophy for the tough times, he says, is simple: do more of what you’re good at. But if the more-established private equity firms had a tough time, the newer firms suffered the most.
RMB Corvest executive Mike Donaldson says: “You can still do deals in this market, but it helps to have a big partner, like we have with RMB, and to be able to take a longer term view on the investment horizon.” He says those firms without a big partner battled, especially the smaller firms that relied entirely on bank debt.
Luckily for RMB Corvest – along with the likes of the private equity houses linked to the banks – these “captive” funds at least could lean on their bigger brothers. Savca’s Fourie says that despite the tough year, a number of smaller firms re-emerged in the venture capital space. These include Mark Shuttleworth’s HBD, InVenfin, Hasso Plattner Ventures and Trivest.
Paul Johl, a senior account manager of the venture capital business unit at the state-owned Industrial Development Corp (IDC), says the recession did not cause a dramatic reduction in investment applications to his company. “We saw a good deal flow, thanks to the recession, as entrepreneurs were turned away from other venture capital and private equity investors. But we have a bigger risk appetite, so we saw more applications,” he says.
The IDC’s venture capital unit only started doing business in 2007, and plans to announce its first exit in the next few months. As a parastatal, the IDC’s goal is to “fill a gap” – and there is a big gap when it comes to venture capital funding.
Johl says that typical private equity funders can take advantage of many opportunities that provide good returns with little risk. So they’re unlikely to finance much venture capital, which is generally higher risk for similar returns. “We’d be happy to see more investors in the venture capital industry, but we aren’t seeing that yet,” he says. As the vigour flows back into the industry later this year, perhaps venture capital providers will find their appetite again, as Johl wants. What is heartening is that testament to the relative conservatism of the SA private equity industry – compared with their overseas peers – there has been no large “failure” of any of their investments.
This is somewhat surprising, given that the funding structure – with debt and leverage ratcheting up the stakes, and many companies having been bought for high values – makes the margin for error so much smaller.
Actis’s Van Wyk says “by and large, SA private equity deals have been robust” despite the economic environment.
KPMG’s Watkins says a survey of private equity houses last year threw up the estimate that about 15% of portfolio companies were likely to “breach their debt covenants” during this recession. “Interestingly, the banks didn’t use this as an opportunity to foreclose on these deals – as you saw elsewhere in the world. But instead, they used this as a chance to ”˜reprice’ these deals, adding on a few extra percentage points in interest,” he says.
Gevers says Old Mutual wrote down its private equity portfolio by only about 10% between the peak of September 2008 and the trough of last year. “We had some assets that were challenged, so we focused on those and nothing translated into terminal failure,” he says. Of about 15 deals that Old Mutual did since 2004, about two required what Gevers described as “intervention”. Of these two, one remains “under observation”.
Ethos’ MacKenzie says there was no “material stress” in its SA portfolio either. “There were some deals we were considering doing, that we didn’t execute. But that’s a good thing given the relative high values we’d have had to pay.” He admits that Ethos’ portfolio companies produced a mix bag of results. “As you’d expect, some earnings were flat or down. But we’re seeing these companies now pulling out of that,” he says.
Brait’s Gnodde says he had the same experience. “We saw huge resilience in our portfolio companies. The consumer businesses like Pepkor and Premier rode out the storm surprisingly well, but even the infrastructure companies slowed down despite growing at reasonable rates,” he says. Brait is the only private equity firm listed on the JSE, so its financials provide keen insight for the market into how the industry performed. And surprisingly, for the year to June 2009, Brait’s private equity portfolio, actually increased its margins at a time when everyone else sacrificed theirs. Though revenue grew 23% during that year, the portfolio’s operating profit expanded by 26%. “This talks to the strength of the cash consumer and the resilience of the country’s infrastructure sector,” says Gnodde.
The flip side of the private equity coin is that the investors in private equity funds themselves take a lot of strain and seek to withdraw their investment – as seen in the US and Europe. Gnodde says that in SA, the investors also kept their heads above water. “None of the investors in any of our funds defaulted or came to us and asked to renegotiate terms,” he says.
It remains testament to SA’s private equity industry that it pulled through 2009 without any major casualties.
Old Mutual’s Gevers puts it bluntly: “Look, if you made a bad investment, you made a bad investment. What protects any company in this time is making the right calls and having access to top-notch research.”
Thanks to years of making the right calls, the industry is ready to emerge again.