Prospects for the private equity industry are looking better than ever, according to Craig Dreyer, chairman of the Southern African Venture Capital and Private Equity Association (SAVCA).
Speaking at the SAVCA conference held in Stellenbosch at the end of February, Dreyer said private equity continued to outperform listed equity indices.
The latest available South African private equity performance report, compiled by SAVCA and RisCura, showed that a representative sample of SA’s private equity funds delivered a 10-year internal rate of return (IRR) of 12.9% at the end of September 2017, which beat both the FTSE/JSE All Share Total Return Index (compound annual growth rate of 9.5%) and the FTSE/JSE Shareholder Weighted Total Return Index (10.6%).
It also outperformed these indices over five-year and three-year periods.
Dreyer said the local industry was becoming more competitive. “Last year, for the first time, we saw the addition of private equity funds listing permanent capital vehicles. There has also been an abundance of new Section 12J companies.”
Examples of JSE-listed vehicles include EPE Capital Partners, also known as Ethos Capital, and Universal Partners.
Section 12J companies refer to firms that qualify as venture capital companies under section 12J of the Income Tax Act, which entitles investors to a tax rebate on their investments in these companies.
The aim is to encourage equity investment in small and medium-sized firms.
John Gillmer, a director at law firm Cliffe Dekker Hofmeyr, said the increase in permanent capital vehicles was mainly because “most of these investments entail long-term, public/private partnerships, such as renewable energy or desalination initiatives, where the traditional 10-year investment is not viable because of the longer time frame”. (See table.)
The change in political leadership also bodes well for the industry. Simon Freemantle, a senior political economist at Standard Bank, said it was clear from the State of the Nation Address that President Cyril Ramaphosa was set on addressing the blockages and bottlenecks hampering economic growth.
“We may also look forward to a more benign relationship between government and businesses.”
Dreyer said the change in leadership should result in a marked improvement in investor confidence.
“The change in leadership will result in the normalisation of the economy and in time positive GDP growth, which in turn will enhance private equity returns and create new opportunities for foreign direct investment.
The positive climate should boost the number of new local entrants wanting to partake in returns that did not previously exist.”
While prospects are looking good, competition for funds is increasing. Motlatsi Mutlanyane, head of alternative investments at Momentum Investments, said at the conference that the “cake is not getting bigger, but the space more congested”.
This was mainly because pension funds still only invest a small percentage of their funds – less than 5% – in private equity.
The industry has also become much more regulated. According to Dreyer, more regulation should be anticipated.
Shaun Zagnoev, a partner at Ethos Private Equity, recalled that there were limited regulations governing deals when SAVCA was initiated 20 years ago.
“Investors had to improvise and learn as they went along. Transactions were much simpler and costs much lower than now.
We were able to finalise big deals in a matter of months, whereas complex transactions can take up to a year or two to implement today.”
Requirements for fund managers
The bottom line is that investors have become more discerning. Mutlanyane told finweek that it was no longer enough to merely claim to have past experience as a fund manager.
Teams now need to prove they have the track record, skills, composition and ability to execute the investment objective.
Fund managers also have to think of ways in which they can add value and differentiate their services from others.
“A fund manager cannot afford to be passive: They need to show how they will help improve logistics, management and or production to reach the investment targets,” Mutlanyane said.
Co-investment was one way in which value could be added to projects, because “it significantly reduces costs and greatly enhances the potential return on investment”, he said.
Mutlanyane added that there was too much talk about fees, when the focus should actually be on strategies to improve returns.
“In general, the industry dug its heels in a traditional fee structure that is no longer viable under the current economic environment.
Fund managers should be open to negotiations and ways aimed at reducing costs.”
While the trend towards specialisation is taking root in South Africa, it is not yet as strong as it is in First-World countries.
“South African companies should, however, take note of this trend as it will grow stronger in the future, especially in the mid-market segment where there is more competition for funds,” he said.
The transformation imperative
Transformation is also becoming increasingly important.
The Eskom Pension and Provident Fund (EPPF), for one, sees transformation as imperative for sustainable growth and applies transformation principles to all its dealings.
The fund specifically looks at ways to empower first-time black fund managers.
“When selecting fund managers, we look at the individual skills and experience of teams as well as their investment philosophy,” said Sbu Luthuli, chief executive and principal officer of EPPF.
“We intend to engage the services of experienced private equity managers to assist in the assessment and mentoring or incubating of first-time black managers to minimise their risk of failure.”
The fund is also considering alternative models to help create a track record for these new managers.
“Instead of placing first-time managers with traditional funds that require long-term commitments, we are looking at alternative models, such as seed funds, where only a year or two’s commitment is required.
“While working on this fund, the manager may generate a couple or more new funds, allowing them to build their portfolio,” Luthuli explained.
This article originally appeared in the 15 March edition of finweek. Buy and download the magazine here.