Issue: June 2012 / August 2012
Private equity’s place in the sun
The revised Regulation 28 bumps up the permissible allocation of retirement funds to this asset class. So trustees need a clearer understanding of why, and what it’s about.
There’s a side to the reputation of private equity that’s distinctly dodgy. It’s to do with the exhorbitant fees highlighted in contoversy over how Mitt Romney, Republican nominee for the US presidency, made his fortune. It’s also to do with slash-and-burn techniques of buying companies, loading them with debt, exploiting a tax system for interest on the loans to be deductible, destroying jobs and stripping assets to reduce overheads for loan servicing. And so on to extract the most hard-nosed return.
But there’s another side altogether. It’s this side that the new Reg 28 encourages.
Better get over it. The old Reg 28 confined a pension fund’s investment to a 2,5% maximum in “other assets”, the category into which private equity fell. The new regulation promotes private equity into a class of its own at 10%.
We’re talking big money here. For instance, although it isn’t subject to Reg 28, the Government Employees Pension Fund has earmarked R50bn (5% of its portfolio) for investment in Africa. Of this, R30bn is for African private equity.
“African markets are characterised by thinly-listed equities,” explains Elias Masilela, chief executive of the Public Investment Corporation which manages the GEPF assets. “So what is likely to drive us going forward is private equity, development funding and property.”
What then is private equity? How does it work? Why is it seen around the world as an important contributor to the asset-allocation mix of pension funds, endowments, family offices and other long-term investors?
What is private equity?
Generally speaking, it’s an investment in the equity of a company whose shares are not listed or publicly traded. This is the “private” in private equity. It would be equally appropriate to call it “non-public equity”. It is not “private” in the sense of being exclusive, secretive or secluded from view.
How big is the SA industry?
According to the SA Venture Capital & Private Equity Association (SAVCA), there are some 53 independent fund managers in SA. Together at end-2010 they had about R46bn in funds under management, up from R14bn in 2005. “It shows that the industry is well developed and has experienced sound growth,” points out Greg Voigt, a partner at Adlevo Capital which targets mainly expansion-stage investments in sub-Saharan businesses that use technology to deliver products and services.
There are additionally banks, investment firms and government agencies, such as the Industrial Development Corporation, which make private-equity investments and which form part of the industry. These are called “captive funds” because they generally source funds from a single investor and are not open to multiple investors as is the case of an independent fund. Adding the funds of captives to the SA private-equity industry, its size is roughly doubled to about R100bn under management.
The private-equity universe comprises several investment strategies and styles which typically define the type of private-equity firm. The major subsets are buyouts, development capital and venture capital:
The private-equity firm will undertake a buyout from existing investors. It typically uses a combination of equity (provided by the private-equity firm) and debt (provided by third-party investors like banks) to finance the deal. These transactions are also called “leveraged buyouts” because of the abundant use of debt in financing the acquisition.
Because these deals are large and complex, they are usually undertaken by firms with several billion dollars under management. Examples of large JSE-listed buyouts are Edcon by Bain Capital, Primedia by Brait and Alexander Forbes by Actis.
Buyouts are typically done when public markets are thought to undervalue a security relative to its fundamental analysis or when a company needs rehabilitation best undertaken when shielded from public glare. It is also a useful mechanism to alter ownership profiles for political purposes, as for black economic empowerment in the current era or when several US companies divested from SA in the sanctions era.
The Financial Services Board has prescribed conditions for Reg 28 approval of pension funds’ investment in private equity funds. They include criteria to assess the suitability of investment.
In fact, trustees shouldn’t even consider a PE investment until they’re entirely familiar with the FSB notice of March 15. It’s educative in itself.
Also known as “expansion capital”, it’s generally equity that is invested into an established business by way of subscription for new shares. This means the private-equity investors become shareholders in the company and accordingly have the rights which accompany share ownership. These investments are generally minority positions but with certain minority-protection rights. The funds can be used for organic growth, acquisition finance or product and market development.
HOW PE MANAGERS EXTRACT VALUE
It’s often surprising to outsiders that a formal private equity (PE) engagement can extract huge value from a company that a PE firm has elected to finance. How could they do it when the original owners couldn’t?
Perceptions play a role. More often than not, one reads about PE success stories. But not all PE deals are successful. On a number of occasions the deal might fail by merely mirroring what the entrepreneur himself could have achieved without the PE manager.
What makes PE funds attractive to investors is prospects for superior performance. How is it that a PE deal can catapult a company to the next growth level? Three factors are at work, believes Sasfin consultant Gavin Came.
Expertise: A well-run and financed PE firm employs people with business skills and experience. These generally embrace all the classic business disciplines.
The skills may not have been in the company previously. In this case, these new resources can focus on an area of relative underdevelopment and make an immediate difference. Also, these resources are available in addition to the existing resources in the business and their objectives are aligned at the highest level. So the company gains motivated human resources.
Access: The PE firm would have access to capital and finance, both temporary and permanent, to deploy in the company. This gives the company a financial firepower that it may not have had to implement its own plans. The PE funder would also provide access to the company in the form of its contacts and markets. Networking is facilitated by PE managers often specialising in a core industry.
Synergies: The PE firm is well rewarded for keeping its book of businesses growing. So, without prompting, it would continuously seek out synergies and loose or proper partnerships for the businesses in its fund. These activities would not normally be undertaken with success by the owner because naturally his focus would be more operational and inwardly focused.
This refers generally to funding provided to a young or emerging company for the launch or development of new products and services. It is usually meant for businesses that promise exceptional growth and are likely to become significant or high-impact businesses. It is not meant for lifestyle or franchise-type businesses.
Other types of funds
There are multiple sub-classes of private equity. They include mezzanine funds, distressed funds, special opportunities funds, property funds and infrastructure funds. There are also secondary funds and private equity fund of funds.
Who does “private equity” investing?
It’s usually undertaken by a private-equity firm which operates and advises a private-equity fund. The firm will operate according to an investment strategy defined by its investment mandate. The teams usually comprise business people with post-graduate qualifications and, more importantly, experience in accounting, corporate finance, law, business administration and engineering. Where specialised strategies are employed, the team will also demonstrate the necessary skill and experience in that particular domain.
How is a fund formed?
The private-equity firm will approach investors from pension funds, endowments and family offices. It will reveal its investment strategy, track record and credentials through a private-placement document or memorandum. If investors are convinced about the coherence of the strategy and the competence of the team, they will signal an intention to make a financial commitment to the fund.
A financial commitment is a legally-binding undertaking to pay an amount of capital on specified dates and to leave that commitment in place for the duration of the fund’s life. The fund is usually a closed-end fund which has a lifespan of about 10 years.
The private-equity fund will form when there are sufficient commitments from a number of investors. These investors are commonly known as “limited partners” or LPs. The LPs are essentially the owners of the fund, having contributed the capital. This is analogous to being the owner of a football team.
The private-equity firm managing the fund will generally by known as the “general partner” (GP) or adviser depending on how the fund is structured. This is analogous to being the manager or coach of a football team.
A key element of private-equity investing is the contribution of the GP to the fund. It means that a portion of the funds to be invested is contributed by the private-equity firm itself. This ensures that there is an alignment of interests between the LPs and the GP.
PRIVATE EQUITY 101
Like any other investment process, private equity begins with wealth in the form of financial capital (money) that is owned by an individual or an institution (the investor). These investors invest with a group of people to manage on their behalf. Money collected from different investors is pooled together in a specific fund.
In the case of PE funds, the capital is invested directly into private companies i.e. not listed on a stock exchange. “This is significant because long-term value is relevant and the share price isn’t,” points out a spokesperson for PE firm Actis. “The fund realises value only when the business is sold.”
This fund is put to a common goal; for example, “a telecoms fund” (which invests only in the telecoms industry) or a “clean energy fund” (which invests only in clean energy). Alternatively, funds can focus on different parts of the world; for example, an “emerging markets fund”. Thus financial capital is invested in a particular opportunity to generate a profit or return.
Usually this is achieved by committing money to specific companies and working to make those companies more valuable. The fund manager does this by influencing and supporting the management and/or strategy of the company so as to add value to it with a view to selling it for a substantial profit in the medium term.
Value/profits/returns can be generated in different ways for the investors by growing the business (including mergers or acquisitions), effecting operational improvements, injecting specialist skills and using leverage (borrowing money to improve financial returns).
Critical is how the money is managed, and by whom. This is how the PE partners (who are investing the money) differentiate themselves: they decide when and where to invest, and also play a more active role in the company’s strategy and management than shareholders of public companies.
The investment managers decide when to sell their shares in the company, or “make an exit”, in a way that maximises profit. Different funds have different periods of return (the time span from investment to exit), but five to seven years is typical.
Exits can be achieved by taking the company to market (floating it on a stock exchange), selling it to a new trade buyer, or selling shares of the company to another investor.
How are investments made?
It’s done in the same way that owners of a football team appoint the manager and retain the right to fire him. However, all decisions relating to the team -- which players to select, whom to substitute and whom to rest -- are left to the manager. It is similar in private equity. The manager decides which investments to make, how to structure them and when to exit from them.
The private-equity firm will deploy the capital provided by investors into several portfolio opportunities during the investment period, usually the first five years of the fund’s life. In the subsequent five years the investments in the portfolio companies are sold and the proceeds distributed back to the investors.
HOUSING FOR AFRICA: PE INITIATIVE
Soula Proxenos, managing partner of International Housing Solutions (IHS)*, writes:
Proxenos . . . strong case
While the private equity industry globally is not yet well understood, the industry in Africa has emerged as a leading example of how investors can realise above-average returns while at the same time providing much-needed capital funding to developing nations. The importance of private equity is that it capitalises businesses and opportunities with a potentially significant developmental impact -- where otherwise it would have been hard to secure capital -- at the same time offering investors good risk-adjusted returns.
The social and economic value of investing institutional funds in emerging markets is clear. In 2007, when we entered the affordable housing sector in SA, IHS led the vanguard of institutional managers which had begun to recognise the possibilities of private equity investment in residential real estate in sub-Saharan Africa.
At the time, the approach was considered niche and possibly more risky than visionary. But soon others started to follow and a trend developed as investor appetite for Africa grew, with SA considered the ideal launch zone. Over the past five years, Africa has increasingly been accessed by investors through private equity funds.
Clear from our experience is that market opportunity in emerging economies, particularly in Africa, is huge and applies across sectors - from retail to property, mobile to medicine. In our business – the affordable housing sector -- investors gain exposure to a growing market because of generalised urbanisation which necessitates the creation of housing in cities.
Additionally, many housing structures in neighbourhoods are substandard and require investment to fund improvements. At the same time, SA’s working-age population will grow. Industries will require worker housing, and increasing numbers of moderate-income households will want to move into higher-standard accommodation.
The characteristics of this market can only be found in emerging economies, but are replicated over a myriad sectors. Most have comparably favourable circumstances, setting them apart from the same sectors in developed countries.
It suggests compelling reasons for institutional investors to favour emerging markets over developed ones. And for these investors, equity funding is the ideal vehicle.
It provides flexibility, shared exposure, some liquidity, professional management and an opportunity to select partners with a proven local track record in the chosen sector. Few individuals or investors have the necessary knowledge and insight to be able safely and confidently to make direct investments into global markets. This is especially so in the case of emerging markets such as in Africa.
Private equity investment also enables the achievement of greater scales of economy, and therefore increased growth and subsequent return on investment.
* IHS is a global private equity firm at the forefront of affordable housing development in SA. It partners with financial institutions, real-estate developers and local government authorities to provide equity finance for housing projects. Launched in 2006, its R1,9bn SA Workforce Housing Fund has received capital injections from North American and SA organisations. They include Citibank, Development Bank of SA, the public Investment Corporation on behalf of the Government Employees Pension Fund, and the Overseas Private Investment Corporation.
How are returns calculated?
The difference between the cash out and the cash back to the investor is worked out over the duration of the investment. The investment return is then computed. This is called the IRR (internal rate of return).
How attractive are the returns?
There have been numerous studies indicating that returns on private-equity investments often exceed returns generated by investments in publicly-listed securities. As in any discussion about returns, a number of important points should be noted.
The long-term nature of private-equity investments suggests that a portion of the return is in fact a liquidity-risk premium (compensation to investors for tying up capital for a long period with no real alternative exit). The returns are frequently quoted before the impact of fees and profit share.
Top-quartile firms consistently produce top-quartile performance. Bottom-tier firms are vulnerable to failure in raising successor funds.
Attractive returns to investors can, and often are, produced by private equity. But there’s another important element. The need for portfolio diversification, specifically in retirement funds, doubtless accounts for its enhanced recognition under the Regulation 28 guidelines for prudential investment.
FLIPS OVER FLIPPER
Thank you to the dozens of people who responded so positively to our test run of a “flipper” digital edition of TT. It will now accompany all future editions. Recipients are welcome to forward it as they wish, and are encouraged to use the social media links for interactive communication.
The flipper version will be emailed for download to all those on our database for whom we have email addresses. At present our database contains the names and postal addresses of about 14 500 retirement-fund trustees and principal officers, amongst other industry participants such as senior FSB and National Treasury officials, but email addresses only for some 6 300.
Should you wish to receive the flipper version, please send your email address to our database manager at firstname.lastname@example.org.
There is no charge for this service. Neither is a login required. And should you want to try flipper beforehand, you’ll find it accessible from our website www.totrust.co.za.
Flipper allows readers to download the entire magazine onto their computers and to view it, page by page, as they would a hard copy. The download should take no more than 20 seconds.
A huge advantage of flipper – apart from lessened reliance on the SA Post Office – is that it provides links to such social media as Facebook and Twitter. In this way, TT will enable a platform for trustees and others in the retirement-fund industry to communicate directly with one another.
As in the past, distribution of hard copies via the post will continue. Flipper is additional to it.