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December 2011

Force for Good Interview

PUBLISHED: Private Equity International 1:10:100

BY: André Roux, CEO, Ethos Private Equity

Click here to view the pdf version of Force for Good Interview

Private equity has played an important role in South Africa’s social and economic transformation – there’s plenty more to come, says André Roux of Ethos Private Equity.

To understand what has happened in South Africa over the past decade, you have to go back a little further: to 1994, the year that apartheid ended and Nelson Mandela was elected as the country’s president. Prior to that, says André Roux, the founding partner of South African private equity firm Ethos, the black population barely participated in the economy; but once they were able to play their part, things really started to take off for South Africa.

And private equity was a part of that boom. The local industry has experienced phenomenal growth in the past 10 years, of almost 15 percent per annum; it now boasts more than $13.5 billion of funds under management.

As in other emerging markets, South Africa has seen independent managers come to the fore. “Ten years ago, over 50 percent of fund managers were affiliated with the large banks, but today eight of the top 10 are independent or third-party,” says Roux. This has, to some degree, been driven by regulatory change, particularly Basel III.

South Africa also attracts more overseas capital now. “When I look at the profile of where we got our money 10 years ago, around 30 percent was sourced from international LPs. Today, well over 50 percent of the industry’s commitments are internationally sourced.” Capital is increasingly arriving from the Middle East and Asia – a trend that Roux believes will accelerate over the next decade. This is a great endorsement of the South African industry, he says.

Private equity has come to account for a much greater proportion of merger and acquisition activity over the period. “Ten years ago we probably represented somewhere around 1 to 2 percent of total M&A. Today the industry – depending on where you are in the cycle – accounts for more like 6 to 8 percent,” he says. In developed markets, private equity can sometimes constitute 10 to 15 percent of M&A; so while the industry is far more established in South Africa these days, it arguably still has a way to go.

The vast majority of private equity deals over the past decade have been involved partnerships with black-owned businesses, and Roux believes this will continue to be the case.

“Because of the way buyouts are structured – with the ability to use the cash flows of the business to fund the acquisition cost – it’s been an efficient mechanism to catalyse black ownership.” So private equity has played a positive role in the country’s social and economic transformation, he argues. Importantly, the industry’s ethnic composition has also evolved: now, around 43 percent of professionals are black, up from about 5 percent 10 years ago.

Clouds on the horizon

Roux believes regulatory change is currently the industry’s biggest threat. “I think that we have not seen the last of where the regulators want to move the industry to in terms of additional red tape. It will mostly affect those GPs who are less established, particularly first-time funds, and that may prevent new blood from coming into the industry. I don’t think that is a positive.”

Tax may be another issue; recently the authorities have started to challenge the rules on the deductibility of interest and that will require adjustment and change. Roux thinks all the countries in the G20, including South Africa, will tend to adopt similar standards going forward.

Then there is the low growth issue. “The other factor to bear in mind is that if we are moving into a slower growth world, we have to accept that with slower growth, comes lower returns. That is something both GPs and LPs will have to come to terms with. We have to think about what is the new normal, in terms of what represents top quartile returns.” Roux doesn’t believe in the concept of decoupling; he argues that emerging markets cannot be immune from the developed world’s macroeconomic woes, given that a large proportion of their exports still go to Europe and North America.

Then again, South Africa can still sell itself both as an attractive market in its own right, and as a gateway to the sub-Saharan region. Recently Walmart bought a majority stake in local retailer Massmart – a transaction not only focused on South Africa’s 50 million consumers, but also the rapidly growing middle class of sub-Saharan Africa.

“We see that phenomenon in other industries, and believe it presents a great opportunity for private equity to back South African businesses that are going to access sub-Saharan African markets,” says Roux – whose own firm’s most recent deal is predicated on the growth of supermarkets in South Africa, Nigeria and across the sub-Saharan region. “We see a huge growth potential in the region because growth of supermarkets will be synonymous with the growth of the middle class.”

Challenges remain, of course. Some of these are common to all frontier markets: finding deals of the right size, finding the right skills locally, dealing with corruption, and so on. And then there are some that are specific to South Africa: notably its growth rate, which currently sits at around 3.5 percent. That might sound pretty good by developed market standards, but it’s low in comparison to some of the fast-growing economies of Asia and South America.

However, that doesn’t mean that returns will necessarily be lower. Independent analysis by RisCura has shown that the industry’s aggregate average net returns in South Africa over the last 10 years have been around 22.8 percent – well above other emerging markets, and a meaningful premium over public market returns. This is partly because the country has more efficient capital markets and better-established investor protection mechanisms than other emerging markets.

“Compelling growth rates do not necessarily make for a great investment case,” says Roux. “Our local industry has been successful because we’ve been able to exploit the innate advantages that our economic structures and institutions provide. As the sub-Saharan region opens up for increased investment, we see South Africa as a natural launch pad to capture African growth.”