The realm of the financial elitist. The kind of thing, that’s only discussed on Monday mornings at the golf course on the club-house terrace. That was the old view at least – which, fortunately, is on its way out. The asset class is gaining traction both locally and abroad; spurred partially by changes in regulation and the need for asset managers and to some extent individuals, to diversify their portfolios. This article is by no means a comprehensive guide to investing in private equity but is a good starting point for the novices among us.
Private equity as an asset class
It used to be simple to define, not so much anymore. The idea that private equity is simply making investments into unlisted companies is an overly simplistic approach. The scope of things that are considered to be within the domain of private equity activities is ever increasing. Several PE firms invest in listed companies with the intention of taking them private. Other firms don’t provide traditional equity but rather convertible debt. So in the general case private equity refers to these and other related activities that may vary from time to time.
Buyout vs Venture capital
There are a few distinguishing factors as far as buyout and venture capital transactions are concerned. Though somewhat of a broad delineation, buyout firms tend to focus on established businesses compared to venture capital firms which focus almost exclusively on start-ups. Buyout firms also tend to use debt or equity finance and sometimes hybrids of the two i.e. mezzanine debt. Tabulated below are a few distinguishing characteristics:
This article is geared towards firms involved in buyout transactions rather than venture investing although the firms that deal in these respective transactions do share several operational characteristics.
Structure
In South Africa private equity funds are usually structured as en commandite partnerships, with the parties to the contract being the manager, commonly referred to as the general partner and its investors, the limited partners. Older structures like the bewind trust lack the flexibility in terms of ring-fencing the liability of investors. Such structures are seldom used and will not be discussed further.
The deciding factors that influences the structure of a given fund are usually transparency, tax as well as the limited liability of investors. In the case of the encommandite partnership, it provides both tax advantages and the requisite liability protection required by investors.
Tax has in some instances been cited as a drawback of the partnership structure. Strictly speaking, when a partner joins or leaves a partnership, which may happen in the context of a private equity fund, the partnership automatically dissolves and a new partnership between the new partners is established. Therefore, under strict common law, at such a time, since the partners are connected persons in relation to each other, the existing partners are deemed as having disposed of the interests in the partnership at market value. Thus capital gains or losses must be determined. The South African Revenue Service (SARS) has however indicated in its CGT guide (Comprehensive Guide to Capital Gains Tax) that for practical reasons it is not intended that this strict approach be followed.
Growth of the industry
Take-up of private equity among Southern African asset managers has been relatively slow. In a study done by RisCura of asset allocation by pension funds across ten African markets, South Africa recorded the second-lowest allocation to alternative assets (for the 2016 calendar year). South Africa’s allocation of 2.3% compares with the 0.7% allocation in Botswana, 8.5% in Namibia, 10.9% in Swaziland and 38% in Zambia. The global average allocation is estimated at 24.8%.
A significant change for the South African pension industry occurred during 2011; Regulation 28, which governs pension funds in South Africa, was amended to allow a greater allocation to alternative investments. The limitation on alternative asset classes (that includes private equity funds, hedge funds and other derivative or pooled vehicles) was revised upward from 2.5% to 15% of funds under management; 10% of which could be allocated to private equity and with a maximum allocation of 2.5% to any single investment or 5% to a fund-of-funds.
Who can invest
Private equity funds are still largely the domain of accredited investors (individuals deemed to have sufficient financial expertise or wealth to navigate the intricacies of such investments). Retail investors may still be able to gain some exposure to private equity funds via funds of funds who usually hold shares of private partnerships that invest in private equity. Funds of funds are also, quite naturally, a more cost effective solution as investors are not subject to the hefty minimum investment requirements of accredited investors. It also has the benefit of exposure to more than one manager in the case where the fund of funds holds shares in several private partnerships.
Liquidity
A common misconception about private equity investments is that they are highly illiquid, which need not always be the case. There are a number of businesses that deal in the secondary market (the buying or selling of interests in existing private equity funds). If you hold an interest in a private equity fund and would like for some or other reason to sell it (thus also bringing to an end your obligation to continue to fund capital calls) then there are a significant number of specialist secondary purchasers who will be able to quote you a price for it. Various investors and funds of funds are active in this space, though it does not form part of their core activities. These specialist secondary players have grown rapidly in recent years, both in number and in size, to the extent that there is now usually an excess of demand over supply for secondary product.
Returns & timelines
Some level of sophistication is required to understand the dynamics of private equity returns and their calculation. Private equity funds may make subsequent investments to their initial investment in an investee company; holding periods of portfolio companies may be extended in order to fully realise the value creation within that company, all these factors weigh into valuations and returns calculations. The determination of returns metrics such as the IRR (internal rate of return) are outside the scope of this article as there are several more comprehensive guides on how to do so.
The timelines however are easier to understand. Investment holding periods for private equity funds range from 3 – 6 years in most cases but are dependent on the firm’s goals, sector and a host of other factors. Capital is drawn down as and when it is needed to make investments and may happen at various stages of the fund’s life. In chronological order the key stages of a fund’s life cycle:
All in all, the sector shows significant growth potential. Private equity still has the ability to absorb more capital as the number of large managers is still small relative to other types of investment managers. More comprehensive regulation in the future may make private equity more accessible to individuals and also the introduction of this much needed capital into growing businesses will do much for growth especially in developing regions.
