Issue: April/May 2007
Editorials

FIRST WORD

Private equity and public interest

“While over time there is scope for larger funds to shift to a ‘prudent expert’ approach to the investment process, it is expected that any future regime will be a hybrid of prudent expert guidelines and quantitative limits”.

The surge of private-equity deals creates a real problem for retirement funds. The more JSE-listed companies are taken private, the more shrinkage of the universe for investment by retirement funds in public companies.

This implies three possible outcomes, each unsatisfactory:

  • The JSE becomes a hothouse where ever-increasing contractual savings chase ever-fewer proven stocks, causing unrealistically high valuations relative to dividend yields and thus poorer returns for fund members;
  • Vulnerability to risk is heightened by a less-diversified spread of investments in listed entities;
  • Retirement funds participate in private-equity transactions. But the hallmark of privacy is opaqueness, running counter to the transparency that fund trustees require for the monitoring and communicating of their investments. Minority participation in a private-equity transaction would give trustees an insight into the performance of the private-equity firm, not necessarily the ability to trade their investment or influence direction of the underlying company where they’re indirect shareowners.

In South Africa, private-equity firms have been tying up Edcon, Shoprite, Consol, Alexander Forbes and possibly also Primedia. Together, they represent a rather smallish percentage of JSE total market capitalisation. However, excluding the blue chips whose primary listings are abroad, they are among the cream of JSE-listed South African companies. As such, these locals are favourites of local institutional investors because of their profit records and the abundance of their “free float” shares that allow for easy liquidity. So the relative percentage of JSE market capitalisation, suitable for institutional investors but being swallowed into private equity, is rather largish. And the party’s just beginning.

Regulation 28 of the Pension Funds Act, which places a ceiling on various types of investments that may be made by a retirement fund, creates its own set of additional problems.

What are funds to do with their money?

For one, the regulation as it stands provides that a 75 percent maximum of a fund’s assets may be invested in equities; it offers no prudential guideline on the split between public and private equities, if it allows for private equities at all, or whether the latter should instead fall under the paltry 2,5 percent maximum in the “other assets” category. For another, the regulation prescribes that no more than 15 percent of a fund’s assets may be invested offshore; to raise the ceiling, for the sake of more diverse portfolios, will encounter political opposition at least from the unions. They’ve long contended that funds of their members should contribute to building the economy at home.

National Treasury’s second discussion paper on retirement fund reform does flirt with a revision to Regulation 28. Concerned about “trustee knowledge of investment principles”, it goes no further than to note: “While over time there is scope for larger funds to shift to a ‘prudent expert’ approach to the investment process, it is expected that any future regime will be a hybrid of prudent expert guidelines and quantitative limits”.

Although no profound changes to the regulation might be expected immediately, the authorities do recognise a need for review. They acknowledge the defects in a “one size fits all” approach, as well as the omission of structured products and derivatives. Hedge funds and private equity need be thrown explicitly into the mix.

Meanwhile, internationally, private equity is coming in for serious stick. A lobby of antagonists, growing in number and vociferousness across a broad spectrum, consider private equity to be synonymous with asset stripping and jobs destruction. They finger its focus on leverage and reliance on plentiful debt at low interest rates, concerned for the impact of an upward turn in rates. They question how private-equity firms will exit their investments on a typical three-to-four year time horizon, particularly after the fees they extract, to enjoy all the post-fees value they’re supposed to add. They ask why well-paid and incentivised executives of public companies are unable to realise similar value without private equity.

Either fund managers are valuing companies too low, or private-equity players are valuing them too high. Both can’t be right. Either the fund managers have impeded visibility of earnings potential or the private-equity players are pricing in a leverage premium for the debt assumed and yet to be serviced. Either way, it’s a temporary aberration. Once the private company returns to public ownership, for the private-equity firm to exit, this premium evaporates as debt is restored to levels with which institutional investors are comfortable. Which leaves open the question of how private equity actually adds to longer-term value for companies as opposed to firms playing on the fees bandwagon.

Proponents counter that private equity can add value by enhancing efficiencies, for instance by ending the propensity for growth at all costs to meet short-term market expectations. They dispute that their trick is to exploit the tax-deductibility advantages of debt, and take pride in restructuring balance sheets to reduce companies’ costs of capital. They profess that they can grow employment faster than others, and that there need be no inhibitions on financial disclosure or on pursuing corporate social responsibility.

Way back, when called leveraged buy-outs, retirement fund trustees were hesitant to push assets their way. These days, under the more fashionable nomenclature of private equity, the jury’s still out.

Sit tight. The heat’s on.

Allan Greenblo
Editorial Director