Mmitji Letsoalo, Thuso Partners
Private equity is increasingly becoming a preferred partner to entrepreneurs looking to undertake strategic growth- enhancement initiatives, whether operational, financial, or governance-related. Indeed, the asset class is also gaining favour amongst institutional investors as a key generator of returns, portfolio diversifier and mechanism to make socially responsible investments – which in addition to financial returns, are expected to provide social dividends.
This begs the question: why are entrepreneurs and institutional investors partnering with private equity funds?
In the first place, private equity funds are structured as limited partnerships that raise their funding from institutional investors and, in turn, provide funding to small and medium companies or infrastructure projects (e.g: renewable energy projects, broadband infrastructure etc.) by purchasing shares or providing mezzanine loan financing to these entities. These funds are closed-end structures, which provides them with a defined period (usually 10 years) to partner with owner-managers in implementing growth-enhancing initiatives. To be sure, private equity funds are active investors that partner owner-operator-managers who are significantly invested in their businesses, both financially and in terms of wanting to build a legacy. In turn, these owner-operator-managers are usually looking for a partner who, in addition to funding, will contribute by bringing unique networks, strategic and commercial acumen, governance best practice and the financial skillsets that, collectively, will be instrumental in taking the business to next phase of its development.
So how does private equity create value? The lingua franca in discussions on private equity value creation amongst investors is the “value bridge”. This waterfall-style calculation separates value created by a private equity investment into key growth areas, such as revenue, earnings and multiple expansion. For the most part, South African private equity transactions create value through fundamental business growth that is underpinned by revenue and earnings growth, and the resultant employment growth. Indeed, the 2020 SAVCA private equity survey reported that the private equity companies sampled had achieved revenue and EBITDA CAGR of 24% and 18.4% respectively since initial investment. Moreover, in contrast to its not-so-flattering reputation as an ‘asset stripper’ in some international discourse, the survey highlights that companies that have partnered with local private equity funds had healthy levels of capex and R&D expenditure and reaped the rewards through the introduction of new products to the market.
All-in all – from a value-creation perspective – it seems that this active partnering style of investment has been the “secret source” that has enabled private equity to outperform listed markets over the long term, both locally and internationally. In addition, another feature that attracts institutional investors to the asset class is its limited correlation to the listed market and the resultant diversification benefits that emanate from its inclusion as part of a broader portfolio. It is, however, worth mentioning that private equity investments are generally illiquid. Hence the growth in infrastructure (or “real assets”) private equity funds which invest assets that, after development, provide a steady stream of income – which is important to the asset/liability matching requirements of institutional investors such as pensions funds.
Notably, the infrastructure asset class has historically mostly relied on government for funding. But the growth in the number of real asset funds focused on mission critical infrastructure (including property, telecoms infrastructure, renewable energy etc.) provides institutional investors with an efficient single-entry point into a diverse portfolio of infrastructure projects, that can provide predictable cash flows and returns.
All things considered, private equity is a key catalyst for economic development and can play a meaningful role in assisting an investor achieve its impact and developmental objectives. It boosts job creation and helps new generations of businesses and business leaders to emerge.
Critically, private equity plays a significant role in enhancing BBBEE participation, which is fundamental to the growth and sustainability of the South African economy. Indeed, the assets under management of funds managed by BBBEE level 1 fund managers has increased from 2.7% in 2018 to 30.7% in 2020 according to a recent report. In the same fashion, the DTI reported an increase in investments made into businesses with a BBBEE rating of 1 – 4 from 36.9% in 2017 to 50.3% in 2019.
What all of this suggests is that private equity enables institutional investors to provide their members not only with a financial return, but the benefits of knowing that their capital did well whilst doing good by contributing to sustainable socio-economic development and the transformation of our economy. Copyright. HedgeNews Africa – November 2021.
Mmitji Letsoalo, investment professional, Thuso Partners. Mmitji is a member of the Thuso team and, beyond portfolio monitoring and reporting, he has an avid interest in enacting ESG principles.