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The Private Equity landscape - through the lens of DEF

20 Apr 2020

Conway Williams / Joint Head: Unlisted Credit

Article

Over the past decade Futuregrowth Asset Management has built our Developmental Equity Fund (DEF) into a R2.6 billion portfolio which is invested in assets across a broad range of developmental sectors, such as agriculture, SMME development, tourism, healthcare, financial technology, student accommodation, housing finance, education and aquaculture.

In the process, we’ve gained useful experience and a growing understanding of the private equity (PE) landscape as well as the growing array of sectors in which we invest. Our investments are focused on the infrastructure and developmental requirements of South Africa, as well as industry specific opportunities that can be harnessed to achieve the Fund’s developmental mandate.

 Our observations of the evolving nature of the South African PE industry can be summarised as follows:

 1. Increased competition for good quality assets

As is noted in the Riscura South African Private Equity quarterly performance report, September 2019, PE’s performance in comparison to the listed market remains favourable, with outperformance across the three listed benchmarks (ALSI, FINDI, SWIX) over the three-year and five-year periods.

 

 

Pooled IRR

ALSI TRI

FINDI TRI

SWIX TRI

5 year

12.1%

5.3%

6.3%

4.6%

3 year

7.5%

5.1%

4.0%

2.6%

Given that the PE industry has demonstrated the ability to generate relatively strong financial returns while positively contributing from a developmental perspective, the industry has seen a significant increase in capital allocated to the sector.

The revision of regulations (specifically Regulation 28 in 2011) also had the impact of easing restrictions on alternative investments, in the hope that this would prove to be a “pro-development funding channel”. This created an environment characterised by increased competition between incumbents and new players for investment opportunities within this asset class.

In light of South Africa’s prosaic economic growth, the increase in available capital has not been matched by a similar increase in the number of investable companies – and so competition amongst investors has intensified. Furthermore, we have witnessed the influx of foreign PE funds with Dollar/Euro backing, which has resulted in elevated and, at times, unrealistic valuations being placed on investable opportunities.

We have seen investor behaviour adapting to these competitive pressures. The adage, “it's far better to buy a wonderful company at a fair price” has evolved into buying “a fair company at a wonderful price.”

2. Impact of uncertain times

External factors beyond the control of the investor cannot be ignored. These can cause market jitters, despite the fundamentals of a business remaining sound. We have seen that, during uncertain times, capital providers (including the very important working capital providers) are nervous to deploy much-needed capital, resulting in calls on shareholders to fill this void, reducing returns on equity capital.

3. Increased demand for developmental vehicles

The asset class as a whole has also evolved into one that is increasingly used as a channel to deliver meaningful developmental impact. The ideal of providing capital to sustainable ventures that contribute meaningfully to economic development continues to attract the attention of investors globally, resulting in a burgeoning demand for more infrastructure and/or developmental PE vehicles.

4. Need for patient capital

Based on our experience, viable businesses take time to establish themselves, and each industry and business is subject to its own peaks and troughs. With these cycles, companies require sustainable and patient sources of capital as they navigate the ebbs and flows of the business cycle.

With ‘open-ended’ funds, there is more time to support the progress of investee companies and ultimately realise value for investors. Not all PE funds have this benefit, given their ‘closed-ended’ nature: With the pressure to exit investments, they are not always in a position to play the patient, supportive capital provider that is often needed.

HOW WE HAVE NAVIGATED THE PRIVATE EQUITY LANDSCAPE?

The following factors have helped us on our PE journey:

1. Alignment of interests from the onset

Our primary aim with PE investing at Futuregrowth is to ensure the alignment of interests between shareholders and management. This is often achieved by requiring that management have “skin in the game”, pre-eminently through investing their own capital in the business. We have seen that this is a key risk mitigant in addressing the intrinsic conflict of interest between management and shareholders.

When interests are aligned, we are able to address issues in the appropriate manner, effectively and efficiently.

2. Investment rigour and active asset management

Given the points noted above, and taking into account competitive pressures to invest, we cannot reiterate more the importance of pre-investment due diligence, along with active management post-investment.

To meet the objectives we set out to achieve for our clients and our beneficiaries, active management of our portfolio holdings has to match our pre-investment rigour. This requires a team-based approach, where we are able to share experiences and challenges, pull on various levels of expertise, and, importantly, act in unison when faced with the complexity inherent in this asset class. This underlying philosophy has helped us navigate many complicated situations.

3. Integration of Responsible Investing, and Environmental, Social and Governance (ESG) factors into our investment process 

We have seen that non-financial risks, if not adequately managed, inevitably translate into financial risks, and, in the end, have a direct impact on client returns.

Given our fiduciary responsibility to our clients, we believe that being a responsible investor implies that we allocate capital to those sectors and entities that adopt transparent, sustainable policies and practices.

ESG forms part of our arsenal of risk-mitigating tools and aids us in assessing non-financial risks as part of the due diligence process. ESG integration is embedded across all stages of our investment process, from initial screening to analysis to post-investment monitoring. This allows us to consider non-financial risks upfront, and thus price for these. It also allows us to assess our holdings for these risks throughout the life of our investment, to monitor ongoing changes in the environment and, if the changes are negative, allows us to implement measures that, in our view, would improve the sustainability of the business.

 4. Strategic input at board level

We generally endeavour to hold meaningful minority stakes in businesses that allow us to have representation on the investee’s board of directors.

Here, we assess what a company does from a risk mitigation/internal control perspective, and can add value to these discussions at a board level, based on our past lived-experiences. We have encountered many challenges on our journey over the past decade, and with this experience behind us, we are able to provide strategic input in terms of risk mitigation strategies across our portfolio of diversified holdings.

This involvement talks to our belief in active asset management to maximise impact and shareholder returns.

5. Diversity of holdings

Finally, diversity in our portfolios is essential. This ensures that no single name in a portfolio will deeply impair the performance of that fund. Diversity is built up over time and is a key protection in the maintenance of the performance of the fund. 

A learning journey

All in all, our experience in the world of PE has been one of learning, adapting, and applying and sharing our insights. This has been particularly relevant to the Development Equity Fund, with its developmental focus and long-term horizon. Our close relationships with our investee companies in this fund have made this journey an exciting and fulfilling ride!

Futuregrowth’s Development Equity Fund

The Development Equity Fund (DEF) is part of Futuregrowth's suite of development funds. It has a broad risk mandate to participate in a range of suitable projects, companies and instruments in socially responsible projects and businesses or developmental assets in southern Africa. Investments are predominantly unlisted equity and equity-related instruments.

The DEF’s objective is to build a diverse portfolio of developmental investments with a range of low/medium/high impact characteristics, while achieving good, stable, long-term returns within a developmental framework.

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private equity