The tide of global liquidity has turned decisively and as it recedes on the pull of higher global interest rates, prompted by runaway global inflation, investors are getting a glimpse of who has been swimming naked.
The local private equity industry has been battling to shake off the COVID period.
Despite attractively priced assets, the lure of remaining listed companies declining, and a swift bounce back from COVID for the broader economy, Private Equity suffered its annus horribilis last year.
Private equity investments totalled R14,9bn in 2021, a marginal increase from R14,5bn in 2020.
But the number of deals was still the lowest since 2011, and the value is less than half of what the local industry attracted at its peak in 2018.
Fund raising remains tough for South African private equity GPs as evidenced by the latest Southern African Venture Capital and Private Equity Association (SAVCA) survey, which shows that Funds Under Management increased by 5.6 percent to R206,2bn, down from a 5.8 percent increase in 2020.
Siya Nhlumayo is a Partner at Vuna Partners, with over 12 years’ experience in mid-market private equity, and he is concerned about the emigration trend’s impact on deal flow.
“If you add on some of the specific South African risks where entrepreneurs are looking to leave the country, they are taking their skills abroad,” says Nhlumayo. “I think there's a lot of opportunities for mid-market focused fund managers to source deals, however, it does create challenges in terms of who's going to continue leading these organisations.”
Nhlumayo believes the emigration trend has supported deal flow, but it is taking a bit longer to complete transactions because GPs now have to consider things like succession, and who the second- generation management team is that will close the gap.
On review, the 37-page 2022 PE Industry Insights Survey includes detailed industry analysis, but fails to provide any data on the two things that matter to investors: investment performance and fees.
Is this a deliberate choice to overload the public with data while hiding critical information, or merely an oversight? Can it be that the PE industry is hiding its superior track record in fear of embarrassing fund managers operating in a less lucrative part of the investment industry?
Phathutshedzo Mabogo, Acting Chief Investment Officer, Eskom Pension and Provident Fund, believes it would be unfair to judge managers on a one-year basis, but is starting to grow concerned about the lack of performance being delivered in the local market.
“We're not wanting to make any decisions based on what happened over a 12-month period, but the numbers don't look great,” says Mabogo. ‘It's quite uninspiring if I’m being absolutely honest. And it hasn't been good for a while.”
Mabogo acknowledges that the South African economy’s anaemic growth has to shoulder some of the blame because it’s an asset class that, for the most part, will invest in South Africa. And for as long as South Africa is not looking good, there's no growth. You don't expect the portfolio companies you're investing in to perform.
The Eskom Pension and Provident Fund is one of the biggest supporters of local private equity, and when its acting CIO speaks, the industry better pay attention.
Mabogo raised serious concerns around the growth of funds being raised while transactions aren’t showing commensurate growth, leading to a potential bubble.
“We've been discussing with the GPs, particularly around returning capital to investors and whether there’s – if you look at the growth in funds under management versus the number of transactions happening out there – a bit of a mismatch, because it looks like funds under management have continued to grow, while transactions are not growing. There's a lot of capital chasing the same transactions and I'm hoping that's not the case, but that's something we're watching quite closely. We have experienced something similar on the continent; in Africa, excluding South Africa, and that didn't end well. So the hope is that those numbers pick up. There's a lot more transactions to be done out there... more exits, and there's a lot more capital to be returned to investors.”
Langa Madonko, SAVCA Board Member and an Investment Principal responsible for Investor Relations at Summit Africa, acknowledges that dealmaking in the sector is becoming increasingly difficult.
“I do think there are a significant number of managers that are in the market, but we are seeing quite diversified strategies and approaches to investing,” said Madonko.
“We know that there are some businesses that are focusing once again on taking advantage of the transformation imperative, and they've positioned themselves to play, particularly in that space, where they can become a transformation partner to some businesses that were plateauing or tapered off. I think one of the things that we have to take into consideration is that a significant proportion of our economy is in that SME to mid-cap space, and many of those are not listed, so they would not have been able to attract capital in the way that they would have needed. Also, because of the lack of scale, they would also not have been able to attract bank capital. So a lot of the private equity solutions that are coming in are going into that space. But I do think that, to some extent, there is a need, especially from an LP side, to determine how the strategies differentiate themselves. And one of the considerations is going to be around how the teams are originating the transactions. If it's always going to be a market process, then we are going to have the challenge of capital chasing after the same set of transactions.”
He believes that two and twenty ("two" means two percent of assets under management and refers to the annual management fee charged by the fund for managing assets, while "twenty" refers to the standard performance or incentive fee of 20 percent of profits made by the fund above a certain predefined benchmark) is appropriate for South Africa because funds raised are generally small.
“Funds are being raised between R600m, maybe a billion rand and two percent is probably appropriate,” says Mabogo. “We would obviously have been raising the issue that when we do private equity offshore, those rates are much lower. You're looking at one percent, sometimes even lower than one percent, maybe no more than 1.5 percent. But that's because they raise much bigger funds. But our view on that is that for as long as we're going to try and remain at two and 20 percent base fee, we then need to see performance, because if you're charging two percent and you're not getting to the hurdle rate, it becomes a bit more difficult for us to justify to our investment committee. If you charge two and 20 and return 15 percent net, for example, then it doesn't matter because you know you have returned our fees, right? So it's fine for as long as there is performance.”
The problem arises when you look at the returns being delivered over the last few years; it's becoming increasingly difficult justifying shifting from listed to unlisted because investors would generally be expecting the unlisted assets to provide two percent or three percent above listed markets. And that hasn't happened for a while.
“Let me just make it clear that this is not me suggesting that EPPF has lost faith in private equity,” stresses Mabogo; “We haven't. We are just saying that there are some issues out there and we need to talk about them with the investors, with the GPs and find a way forward, because we want South Africa to work. There's no point in us suggesting that we're not going to invest in South Africa, take the money offshore, kill the local industry, because in any case, 10, 20 years from now, I'll be in South Africa, my children will be in South Africa. So we need South Africa to work. What we're saying is, is there another way of looking at this? Is there support that GPs maybe need to do better than they are right now, because when they do well, we do well. It's that simple really.”
The time has come for tough conversations in the industry.
Madonko is quick to add that South Africa has failed to attract its historical levels of foreign direct investment. And this new, local private equity capital formation is one of the things that's going to drive growth in the mid-market space and potentially drive the growth of new segments in the market by allowing the formation of this new capital. This is needed for us to advance the economy and maybe even solve the Eskom problem.
But that still doesn’t explain away the cost concerns that investors have with an asset class that is sold as delivering uncorrelated outperformance of the listed equity market and commands an illiquidity premium on top of that.
Coming back to the issue of performance versus costs, Mabogo says it’s a continual conversation that the EPPF is having with its GPs.