9 minute read
Why private equity presents exciting opportunities
Overview
Private equity is a broad, catch-all category for essentially any equities that are not publicly listed. At its core, private equity represents capital that is invested into companies. This article looks at the investment opportunities in private equity and how this alternative asset class can drive innovation and help bolster industries and, ultimately, economies.
Private equity under Regulation 28 of the Pension Funds Act
Previously, “hedge funds, private equity funds and other assets” were defined as a single asset class with a collective limit of 15%. Private equity on its own had a limit of 10%; hedge funds of 10%; and other assets at 2.5%.
The amendments to Regulation 28 have delinked this asset class group. The overall limit for private equity funds is now 15% (with a limit of 10% per fund of private equity funds, and a limit of 5% per private equity fund). Hedge funds and other assets remain unchanged at 10% and 2.5%, respectively. The overall or collective limit has been removed.
National Treasury has indicated that the increase in the limit applicable to private equity is based on a number of studies which document that private equity investments in infrastructure projects (also see p.6-7 of this publication) have a positive impact and help in sharing project risk between the project sponsors, and for the fact that private equity investments can be more proactive in supporting the country’s economic recovery plan.
RECAP: What are private equity funds?
as defined in Understanding South African Financial Markets.
There are different types of private equity investment structures, but the most common is where silent investors (called limited partners) pool funds alongside an active investment manager (called the general partner) for a fixed period (e.g. ten years). During this time, the fund manager invests the pooled funds and actively manages investments to generate targeted returns. Investments are exited towards the end of the fund term, after which the fund is typically closed.
Characteristics of private equity investments:
• Private equity is privately held as opposed to publicly traded.
• Private equity investment entails active involvement in identifying the investment, negotiating and structuring the transaction, and monitoring the company once the investment is made. This may often require an investor to serve as a board member of the investee company.
• Private equity investments are not intended to be held indefinitely. Generally, alternative exit strategies are evaluated at the time the initial investment in the company is made. One such strategy would be to list the company on a stock exchange and sell the shares to the public.
• Private equity investments tend to offer higher risk and higher rewards to investors. Private equity investors seek a higher return on their capital when the company prospers as they risk losing most, if not all of their investment if the company fails.
SOURCE: : Understanding South African Financial Markets
STAGES OF INVESTMENT OPPORTUNITIES
Private equity covers a range of different assets (such as real estate and infrastructure, for example) across various stages. This can either be investing in young companies, or start-ups and continuing to invest through their growth, or investing in later-stage businesses that have established themselves and their profit potential, but are looking to raise capital to expand or improve operations. There is also the case where a publicly listed enterprise decides that the public markets aren’t suitable anymore, and they prefer to grow privately by being acquired and run as a private enterprise. All these investment stages have a significant role to play in the growth of an economy.
Early-stage/venture private equity
This is for pre-revenue companies, such as tech and biotech start-ups, as well as companies that have productmarket fit and some revenue but no substantial growth yet. Venture capitalists and angel investors operate in this space.
For example, a company that has been bootstrapped and has since raised angel funding marks the start of the private equity cycle. Venture capital funds and private funds can then become involved and start to support these companies from “seed” stage through to their various expansion stages.
What role does this stage play in the economy?
If vibrant ventures are supported – not only financially, but with the right network of experts – it can drive and spark innovation and unleash great potential.
Starting a business from scratch is challenging and venture capital certainly has a role to play in South Africa. Not only from a financial standpoint, but by providing entrepreneurs with the right networks and expertise to give them the space to innovate and grow. With South Africa’s high structural unemployment rate, nurturing well-trained, entrepreneurial leaders can lead to new industries and allow businesses to not only compete on a local level, but also a global one.
VENTURE CAPITAL IN SOUTH AFRICA
According to The Southern African Venture Capital and Private Equity Association’s (SAVCA’s) 2021 venture capital survey, 74 fund managers invested R1.39 billion into 122 entities through 167 investment rounds in 2020 amid the Covid-19 crisis, up from the R1.23 billion invested in 69 funds in 2019. At the end of 2020, the South African venture capital industry had R6.87 billion invested in 841 active deals, and added that, of those active deals, 53.4% were invested in seed or start-up businesses.
Expansion private equity
This typically involves financing established and mature companies in exchange for equity, often a minority stake, to expand into new markets and/or improve operations. In other words, a business that already has some traction and has already proved itself and needs capital to grow, but may not have access to traditional banking facilities. This could be because the company is still quite young, or it is not publicly listed and can’t raise capital through the market. Growth or expansion private equity helps bridge the funding gap.
A South African example:
Often, when a South African company wants to go offshore and expand into other markets, it doesn't have access to the required capital to achieve this. South African lenders are happy to provide capital for their South African growth market, but don't want to take risk on their offshore growth, as they aren’t familiar with those markets or customers. At the same time, offshore lenders are not willing to fund them because they come from a foreign country, whose market and customers they are not familiar with.
By providing these companies with private equity capital, South African businesses are able to expand into new markets and compete on a global scale.
Late-stage private equity
This investment is typically focused on identifying underperforming businesses and taking them private, where their performance can be significantly improved through creating operational excellence or changing their capital structure. The business can be grown and improved and is usually returned to the public market at a later stage. In doing this, the aim is to build these companies into industry champions.
Food for thought:
There’s much debate about what role private equity/outside investors can play in state-owned enterprises, for example. A debate which is very relevant in the South African context – particularly given our current energy crisis.
While this is a complex issue, the need to open up the space for private equity has certainly been identified by the amendments to Regulation 28 in order to unleashinvestment opportunities within the South African economy.
Investing in private equity
Private equity investors are looking to generate returns that are higher than they would generally achieve in public markets. They're able to do this by having access to interesting businesses and a greater pool of opportunities that are not widely available. This could be either because the operators of a company do not want to be in the public market, or perhaps they are still at early stage.
Investors are able to generate strong returns over a longer time period, with significantly less volatility than in a public market. This is due to the nature of private equity investments, which is centred around a sustained, consistent investment behind strong propositions in order to allow them to realise their potential. For example, when investing in a young company with potential, time is required for that company to be allowed to develop to a point where value will be reached – either by listing on a public exchange or being sold. Similarly, if investing in the expansion of a mature company, time is also required if they are expanding into a new market or building a new production facility, for example.
This long-term investor patience isn’t always possible in public markets, where a company’s equity is priced daily and investors are exposed to market swings and volatility of the public market, and are subject to global events, such as the war in Ukraine, as a recent example.
When faced with these types of market downswings, that may not even be directly correlated to their operations, listed companies that were perhaps looking to expand through raising capital on the public market, may have difficulty achieving this as their equity value has dropped.
In the private equity market, companies are not subject to the scrutiny of public markets. Of course, this doesn’t mean private companies don’t have a responsibility towards their investors, but given the long-term, steady nature of private equity investment, private companies operate in an environment where patience is the name of the game – and where broader market events do not generally impact on them as much as a publicly listed company.
However, the trade-off lies in this long-term nature of the private equity asset class. Although investors can typically expect greater returns and less volatility, private equity investments come with liquidity constraints. Typical private equity commitments are around 10 years, but can range anywhere from 8 to 12 years.
REFERENCES
• Corporate Finance Institute. Available online: https://tinyurl.com/mwv6dxbx
• Understanding South African Financial Markets, Sixth Edition. (2019) Van Wyk, K., Botha, Z., Goodspeed, I.
• National Treasury Draft Amendments to Regulation 28. Available online: https://tinyurl.com/25xsrfs6
LEARN MORE
To learn more about this topic, please visit our website www.atleha-edu.org or email us at info@atleha-edu.org to find out more about our educational publications, resources and workshops.
