Issue: June/July 2006

The Investment Case for Private Equity

Today's investor has a wide range of asset classes to choose from when investing for retirement. The obvious ones that come to mind are equity, bonds, cash and property. Increasingly though, the focus is turning to alternative asset classes such as hedge funds, socially responsible investments and private equity. Many of these alternatives have significant investment merit and are gaining popularity amongst investors. Here we discuss the investment case for private equity.

What exactly is private equity?

Simply put, private equity describes investments in unlisted companies i.e. those companies that are not listed on a public stock exchange.
There are various categories of private equity, and terminology varies from country to country, but in SA the following broad classifications apply:

  1. Venture capital

    This covers seed capital to fund research and development before the business starts. Staff up funding is for the development of those companies which have generally been going for less than three years.
  2. Development Capital

    This refers to funding for companies which are already profitable or have just broken even.
  3. Buy-out

    Buy-out or replacement capita! typically provides funding to a management team or empowerment party to acquire a business from the existing owners.

Venture capital is considered the highest risk category and is typically avoided by most SA private equity funds. Thus SA private equity funds are generally a lower risk investment than many of their global "venture capital" counterparts.

The South African Private Equity Market

The local industry is sophisticated by emerging market standards and has been fuelled by Black Economic Empowerment initiatives in recent years. The Southern African Venture Capital and Private Equity Association "SAVCA" was constituted in 1999, which has helped formalise the industry. SAVCAhave also developed a set of valuation and disclosure guidelines which are consistent with European standards.

According to the KMPG and SAVCA Venture Capital and Private Equity Industry Performance Survey of South Africa 2004, the South African private equity industry had R42.7 billion in funds under management as at 31 December 2004. Our private equity industry is significant when compared against GDP. (As displayed in the graph on the below)

Potential Rewards of Private Equity

  • Internationally, the net returns achieved by private equity investments have outperformed the stock markets over both medium and long-term time periods.
  • Private equity returns have traditionally had a low correlation to other asset classes i.e. they generally do not respond in the same way as other asset classes under the same set of circumstances. This makes a case for private equity to be used in portfolio risk diversification.
  • The risk / return profile of private equity is fairly similar to developed equity markets. In other words, the superior performance achieved by private equity investments is not achieved by taking greater risks, but rather by giving up some liquidity.
  • Private equity funds have better access to information about their underlying investments than their listed counterparts as they are not governed by stock market guidelines such as insider information.
  • Private equity funds are better able to influence, and often control, company strategy as they are more closely involved in the day to day operations of their investments.
The Investment Case for Private Equity

Constraints of Private Equity

  • A very low level of liquidity. Private equity funds typically invest in companies for approximately 5 years before disposing of the asset, and therefore investors into these funds are typically locked in for a long period.
  • A long-term view has to be taken when assessing performance. The returns of a fund in the first 2-3 years of a fund can be misleading as this is usually when the fund is making the initial investments, which may only render a positive return in later years.
  • Manager selection is key. There is a big performance gap between the top and bottom performing private equity funds.

The booming South African economy, and the increased emphasis on Black Economic Empowerment, provide increasing opportunities for private equity deals. Provided investors are able to sacrifice some short-term liquidity, they should be amply rewarded in the long run for investing in this growing asset class.