A growing track record of superior returns internationally is making private equity an increasingly important investment vehicle, not only for large institutional investors but also for wealthy individuals.
Private equity investment provides capital to enterprises that are not listed on a stock exchange. Until recently, this kind of investment was the hunting ground of government-backed bodies, such as the Industrial Development Corporation and the Development Bank of Southern Africa, and institutional investors such as banks, life assurance companies and retirement funds.
But private equity investment is gaining ground in South Africa, much of it going into empowerment companies created to transform the economy so that its ownership reflects the demographics of the country.
According to a recent joint report by the South African Venture Capital and Private Equity Association (SAVCA) and auditing company KPMG, private equity investments can be divided into three main areas:
- Venture capital for start-up companies;
- Development capital for the expansion and development of existing companies; and
- Capital for buyouts, such as the management purchase of a family-owned, private company.
The South African private equity industry has about R40 billion in assets under management, and about 60 entities may be classified as being involved in private equity investment.
Banks have for many years been major players in the private equity business, financing numerous deals.
Riaan van Dyk, the head of investments at financial services company Momentum, says a large proportion of private equity investments go to relatively established companies that operate in mature industries.
International experience is increasingly showing that private equity investments yield superior returns compared with other asset classes, if you are prepared to leave your money invested for more than 10 years.
Van Dyk says the trend towards private equity investment is not a new "fad". Worldwide, the private equity investment business is almost double the size of the global hedge fund industry.
However, there are considerable risks involved in private equity investments. It is a sector where many scam artists roam - Masterbond, Supreme Holdings, ProPlace, FundsTrust and the notorious Jack Milne's PSC Guaranteed Growth Fund spring to mind.
Expertise and thorough investigation are the non-negotiable prerequisites of private equity investing if you want to ensure that your money does not disappear into a worthless business or a crooked venture.
These requirements have given rise to specialist companies that conduct research into whether or not a business is soundly managed and is capable of producing sustainable profits. On unearthing a good investment opportunity, the specialist company raises capital from a variety of investors.
Often, specialist private equity companies not only fund the businesses, but also play a direct role in managing them or advising their management.
But even the experts can get it wrong. Some companies listed on the JSE Securities Exchange that put together portfolios of underlying private equity investments have had a rather sorry time of it. Most of these companies listed at the height of the market boom in the late 1990s, and many of them invested in start-up technology companies. The poor results in some cases have been "spectacular"!
For example, Cycad Financial Holdings, which listed at 200 cents a share in March 1999, slumped to four cents a share by September 2003. Another specialist private equity company, Aquila Growth, listed in December 1997 at 180 cents a share and is currently trading at 165 cents.
The bright side
But it is not all bad news. Companies such as Brait, RMB Private Equity and Ethos have proved successful at managing private equity investments.
Life assurance company Metropolitan, with its Futurebuilder portfolio, has made some choice selections in recent years. For example, it invested R3 million in Plessey Cellular in the mid-1990s and exited the investment a few years later after gaining more than R30 million. An investment in MTN yielded equally impressive results. Alusaf was another particularly successful investment for Metropolitan that returned in excess of 30 percent a year.
Carmen Maynard, a director of Sanlam Asset Managers and one of the early supporters of life assurance companies making private equity investments, says the safest route to private equity investing is through a portfolio, because "some ventures pay off and some bomb out and you take a huge risk just holding one or two".
Van Dyk says investors also face difficulties in selecting the right private equity manager. This is where multi-management comes into play.
Momentum recently launched South Africa's first true multi-manager private equity product, the Momentum Private Equity Fund of Funds. With a minimum investment of R1 million, the fund is aimed at wealthy individuals and small-to-medium retirement funds. Momentum Private Equity is managed by Momentum's associate company in the FirstRand stable, RMB Private Equity, which has been in the private equity field for 13 years.
Other companies are expected to follow Momentum's lead shortly.
Thando Mhlambiso, the chief of private equity at Sanlam Investment Managers, says if you want to invest in private equity, you should either invest in funds that are managed by private equity firms or invest in a multi-manager fund of funds.
Mhlambiso says the main benefits of investing through multi-manager funds are:
- The fund of funds manager conducts extensive due diligence into prospective fund managers and seeks to select the best funds and fund managers;
- You achieve diversification of manager, investment and, in some cases, geographic risk;
- A fund of funds typically enjoys unique (if not exclusive) access to the top funds, which may not be available to an individual investor; and
- A fund of funds manager maintains corporate governance oversight over the fund managers.
The long view
The experts agree that private equity investment is the playground of high-net-worth individuals, who must have a long-term investment horizon if they are to derive true value.
Errol Shear, an executive director of Stanlib Asset Management, says you can expect fairly low returns in the early years of your investment and the better returns only after five or more years.
Mhlambiso says the best way to express the private equity investment risk profile is through what is called a J-curve. Returns are negative at the early stages of an investment, but they move steeply upwards after about five years.
The major risk faced by private equity investors is illiquidity (the investment may be difficult to sell) and obtaining the true value of their investment.
Unlike listed investments, Mhlambiso says, there is no ready market for private equity investments, so assessing "a true, willing-buyer, willing-seller value is very subjective".
Van Dyk says liquidity comes at a price. With private equity, investors are sacrificing this liquidity in favour of getting superior returns.
Although Momentum has made private equity investment accessible to individual investors, most private equity investment providers do not accommodate retail investors because, Maynard says, individuals do not want the long ride, nor do they feel comfortable with it. These concerns explain why successful private equity managers, such as Brait and Ethos, have not offered products to individual investors.
But this may change in future. Private equity is gradually becoming accepted as an alternative asset class that provides investors with superior returns - as long as they are willing to stick with their investments for the long term.
The trouble is that many private equity investment funds have very high entry levels that tend to exclude many individual investors. However, there are routes by which individuals can enter the private equity market without the outlay being enormous. These include:
- Directly, by investing in privately-owned com-panies not listed on a stock exchange;
- Directly, through companies listed on the JSE that specialise in making private equity investments and in listed venture capital companies; and
- Indirectly, through retirement funds and life assurance endowment policies with managed investment portfolios (in other words, the life assurer makes all the decisions on the underlying investments).
Academic approval
Shear says academic research has shown that private equity is a valid asset class that promotes diversification, and thus reduces risk and should increase the overall return of a portfolio. And, in some cases, you can get a capital guarantee. Sanlam, for example, offers a full capital guarantee to reduce risk.
Maynard says Ivy League universities in the United States, such as Yale and Harvard, have placed substantial amounts of money in private equity investments, increasing the sector's worldwide popularity.
The universities argue that US equity and bond markets are mature and efficiently priced, and "if you want really superior returns you need to move into things like private equity early on - before it becomes efficiently priced and over-traded," Maynard says.
Joshua Mafolo, the head of private equity at Metropolitan Asset Managers, says you should place no more than five percent of your assets in private equity investments, because of the risk. But the upside, he says, is that you can expect returns of up to 75 percent on seed (start-up) capital investments.
For an asset manager, investing in private equity is more arduous than investing in more formal opportunities, such as listed companies.
Not only does the asset manager have to seek out opportunities and evaluate them, but often he or she plays a role in the management of a company to ensure it stays viable. The asset manager may even be represented on the board of the company.
Derrick Msibi, the executive director of alternative investments at Old Mutual Asset Management, says the extra work involved results in higher costs.
"Generally, investors pay an annual management fee of between one and 2.5 percent. On top of this the manager gets up to 20 percent of the gains made."
Room for growth
Private equity management can be divided into:
- Captive funds. These are companies, such as banks, that use their own capital to make and manage investments; and
- Independent funds that raise money from third-party investors, such as retirement funds or individuals, to make investments. Investments can be made either by taking an ownership stake in a project and/or by providing loan capital.
Most private equity investments are in what are called "closed-end funds". In other words, a private equity manager will raise a fixed amount of capital and then close off the fund to any further investment.
Shear says private equity has an important part to play in financing entrepreneurs, and this is particularly important in South Africa, where emerging black entrepreneurs often struggle to raise finance.
Private equity also helps to generate employment. Thus an investment in private equity can also be an investment for the good of all South Africans.
Michael Segal, the chairman of SAVCA, says private equity investment accounts for about 2.9 percent of the total value of the economy (gross domestic product), but there is much room for growth.
If private equity investments were to increase by six or seven percent, "this would act as an incredible catalyst for economic growth, by making available the capital this country so urgently requires", Segal says.
Need for regulation
Retirement funds are allowed to invest up to five percent of their assets in local private equity opportunities and another 2.5 percent in foreign private equity offerings. A number of "bad" private equity investments have been made by retirement funds in the past.
For example, the 9 000-member Construction Industry Retirement Fund had to write off R18 million that it invested in Telkom's largest empowerment consortium, Ucingo. After buying up shares at R33 in the hope that the price would rise on listing, Ucingo incurred significant losses when Telkom listed at R28 on March 4, 2003.
As a result of the problems with private equity investments, reputable private equity companies, such as Brait, are asking the Financial Services Board to introduce regulation to give investors more confidence in the sector. Currently, private equity companies are only regulated by the Companies Act.
This article was first published in Personal Finance magazine, 1st Quarter 2004. See what's in our latest issue