What should private equity investors be considering?
Globally, private equity has had a phenomenal 10 years and deal multiples are at historic highs
The last 10 years have been a period of unprecedented success for the global private equity industry. During this time, more capital has been raised, invested, and distributed back to investors than ever before. Private equity funds have produced strong returns globally for investors, outperforming public (listed) markets across all regions for multiple periods to the end of June 2018 . The global growth has been fueled by low interest rates and a recovering global equity market. According to a McKinsey Global Private Markets Review published this year and titled ‘Private Markets Come of Age*, the number of companies backed by US private equity firms has doubled to over 8 000 since 2006. Over the same period, the number of publicly traded firms dropped by 16%, from 5 100 to 4 300. Deal activity for 2018 surpassed that of 2007, and there is almost $2 trillion in private equity capital looking for investments globally, as more investors pursue private market investments to get diversified exposure to global growth. The sheer volume of capital flooding into the private equity industry has created enormous pressure to complete deals due to the massive quantity of so-called ‘dry powder’, arming private equity managers with the capital to match higher offer prices. As a result, global private equity deal multiples are at historic highs.
* Using the modified public market equivalent metric developed by Cambridge Associates, which replicates the timing and size of private equity cash flows as if they had been invested in public equities, Bain Consulting made a comparison of private equity returns with public equity returns.
The South African private equity cycle has however lagged the global cycle
In contrast, South Africa has seen higher interest rates and an underperforming equity market. These factors, together with the headwinds of negative sentiment around SA Inc, have made fund raising challenging for private equity managers. With private equity funds taking longer to close, managers are having to demonstrate differentiated and innovative offerings. These factors create an attractive environment to deploy investment funds.
A closer look reveals the scale and opportunities inherent in the South African private equity industry
- It is well established and significant in size relative to most emerging markets
According to the Southern African Venture Capital and Private Equity Association (SAVCA), the South African private equity industry had R171 billion in funds under management at 31 December 2018, having grown at a compound growth rate of 9.3% per annum since 1999. Investment activity as a percentage of GDP reached 0.8% in 2018, but trails developed markets such as the UK at 2.1% and the US at 1.7%.
- It is a great diversification tool and provides access to opportunities that listed equities don’t
Similar to the US trend, since 1994, the number of domestic listed companies on the Johannesburg Stock Exchange (JSE) has halved. This makes private equity very appealing due to its ability to provide access and exposure to under-represented sectors on the JSE and companies with high growth prospects that are too small to be listed.
- In South Africa, private equity consistently outperforms most public equity indices
Over the 10-year period to the end of 2018, private equity outperformed the FTSE/JSE All Share Index (ALSI) on a Total Return Index basis. Over the five-year period to December 2018, private equity outperformed all three listed benchmarks (ALSI, FINDI and SWIX)**.
Despite its attractiveness, private equity is an under-utilised asset class locally. South African pension fund allocations to private equity remain less than half the global average of 5%, even though local regulation permits an allocation of up to 10% in private equity.
**South African Private Equity Performance Report produced quarterly by Riscura in conjunction with SAVCA.
Looking ahead, what local and global trends may affect private equity investors?
- There has been a resurgence of listed investment holding companies in South Africa
Private equity managers find this vehicle attractive since money can be recycled, eliminating the fund-raising cycle. However, this investment approach does not necessarily improve liquidity for investors, and vehicles often trade at significant discounts to net asset value.
- Many well-established local private equity managers are expanding their underlying investment offerings to include additional asset classes and sector-specific mandates
- Despite the higher regulatory capital requirements, South African banks have expanded their investment teams and have shown a willingness to increase direct private equity investment exposure
Recent examples of this include Nedbank’s acquisition of a direct shareholding in telematics group Tracker and the purchase of Efekto, Marltons and Afrikelp from Ascendis for R480 million in a management buyout together with RMB Ventures.
- Globally, the need to cater for the long-dated nature of many investors’ liabilities has seen the emergence of ‘long-duration funds’
This extends the terms of the common 10-year partnership structures used in South Africa.
- There is an increasing trend for investors to build in-house co-investment capabilities
Research by Cambridge Associates indicated that up to 20% of private equity investments fall into this category, while a 2019 survey by Private Equity International indicated that 65% of respondents intend to co-invest in the next 12 months. This strategy is the preserve of larger, more established fund investors and allows fund investors to make additional minority investments in companies alongside the fund on an attractive fee basis, with the objective of enhancing overall returns. A select number of sophisticated local institutions are now following this trend.
- Locally and globally, there is an increased focus on impact investing
Environmental, social, and governance (ESG) issues have become central to the investment decision-making process, with the United Nation’s Global Compact principles (which include human rights, labour rights, the environment and anti-corruption) being used as a standard benchmark. There is growing evidence that companies that prioritise ESG and embrace diversity are starting to outperform their peers.
To benefit from the opportunity, what should investors consider when choosing a private equity manager?
Manager selection is a crucial determinant of success in private equity investing as the dispersion of potential returns from managers is material. It is also important to bear in mind that there are substantial differences between the role of a listed equity fund manager and that of a private equity manager. Unlike listed equity funds, which invest in the same pool of assets and use similar benchmarks, private equity managers are difficult to compare. There are no league tables that rank managers and comment on recent performance. There are also far more variables that influence performance, and the risk factors are different too. This makes evaluating private equity managers a far more rigorous process.
- Scale, financial strength, institutional depth and regulatory and risk management rigour are crucial
Following the collapse of Abraaj, a Dubai-based private equity manager, investors are showing a strong interest in managers with institutional alignment that provide strong operational support, risk management and regulatory rigour. Financial strength, a strategically diverse but collaborative network to source lucrative deals, and the ability to deploy capital for large investments are also important.
- Value creation strategies create superior investment returns, but require skill and experience
For managers to consistently maintain strong returns in the current investment environment, they must invest heavily in a team that has the right combination of skills and industry knowledge. Superior returns can be generated through value creation strategies over the investment term given the influential nature of most private equity investments. But this requires private equity managers to work with and be able to in-source industry expertise to assist management strategically. The investment committee is as important as the investment team, and small committees with strong, cumulative buyout experience often deliver superior returns.
- Effective portfolio construction is ultimately key
Long-term investors who allocate an appropriate proportion of their overall portfolio to private market opportunities should benefit from the exciting potential that private equity offers. This however requires portfolio construction expertise, experience and insights to optimise this allocation relative to other asset classes and in the context of each investor’s objectives and risk/return parameters.
Effective portfolio construction is ultimately key
Long-term investors who allocate an appropriate proportion of their overall portfolio to private market opportunities should benefit from the exciting potential that private equity offers. This however requires portfolio construction expertise, experience and insights to optimise the allocation relative to other asset classes, in the context of each investor’s objectives and risk/return parameters.