20 August 2024
South African equity returns have been elusive for a long time, given the challenging macro backdrop and negative sentiment. Coupled with a narrowing universe of South African listed equities, investors have been on the hunt for returns in alternative asset classes, which has propelled a rise in private equity. While private equity investments can offer handsome returns and provide diversification benefits in portfolio construction, clients should be aware of the risks that are embedded in this asset class. Against a backdrop of the growing interest in private equity vehicles in the retail investment market, this document has been compiled by Glacier Research to provide a better understanding of private equity as an asset class.
1. What is private equity?
Private equity is an alternative asset class in which investors invest in private companies that do not trade on public exchanges like the JSE, S&P 500, etc. Private equity investors are expected to be patient, with investments made over long periods of time, with the aim of increasing the companies’ value, before eventually selling them to realise returns or profit. Private equity investment is characterised by a buy-to-sell philosophy as investors expect their money to be returned, with a handsome profit, typically within 10 years of committing their funds.
2. What are private equity funds?
Private equity funds are vehicles that typically source capital from institutional asset owners and invest this capital into portfolio companies that are not listed on public exchanges. Private equity funds are usually structured as limited liability partnerships, hence the use of terms general partner (GP) and limited partner (LP) to refer to the fund manager and investor, respectively.
3. Are private equity funds regulated?
Private equity funds are not regulated. However, private equity fund managers must comply with the FAIS Act. Importantly, following the changes to Regulation 28, the allowable allocation to private equity increased from 10% to 15%.
4. What are the benefits of private equity funds?
- Potential for high returns. Private equity investors tend to invest in high-growth companies that produce high rates of return that exceed those provided by traditional asset classes.
- Unique investment opportunities. Given their private nature, the companies and/or projects that form part of private equity funds are not available through public markets, and therefore could provide exposure to sectors and companies that are not represented on stock exchanges.
- Active value creation. Private equity investors do more than make static allocations to investments; they add value to portfolio companies through strategic guidance, operational improvements, and sometimes financial restructuring. These activities combine with the intention to grow the value of the business and generate high returns.
- Non-correlated returns. Due to the illiquid nature of the investments and the unique investment universe, private equity investments tend to be less correlated with traditional, publicly available asset classes. Including private equity in a portfolio containing traditional asset classes can reduce overall portfolio volatility and risk.
5. What are the potential risks of private equity funds?
- Liquidity constraints. Investments in private equity are typically illiquid and involve lock-up periods during which an investor’s capital cannot easily be accessed. This poses issues for clients with regular liquidity needs or who may need to access their capital in an emergency. In addition, the illiquid nature of this asset class also exposes the private equity fund to the risk of not finding a buyer when deciding to exit an underlying investment.
- Valuation challenges. The underlying or companies in private equity funds are private and unlisted, and therefore cannot be marked to market easily. This means that estimating the value of the underlying may be challenging or may involve a significant degree of subjectivity at times.
- Increased complexity and risk. Private equity deals are typically funded through a combination of equity and lots of debt. Understanding these risks is critical in managing expectations around growth and the potential for capital loss.
- Limited transparency. Unlike publicly traded companies, private equity investments may not have detailed financial disclosures nor provide frequent updates to investors, which makes it more difficult to gauge their health and growth. Importantly, the underlying companies that the private equity fund manager or GP invest in have no obligation to disclose performance to the public, but at an overall fund level the private equity fund is required to disclose its financials to all its investors.
6. What is the fee structure of private equity fund?
Private equity fund managers charge relatively high management fees as well as performance fees. These fees are typically higher than those charged on traditional asset classes and often encompass a performance fee component that allows the manager to earn a fixed percentage of returns above a particular benchmark or hurdle. These fees can significantly impact the net return the investor receives.
Typically, the private equity fund manager charges a management fee of between 1.5% and 2% of committed capital, plus a share in the fund’s profit (after a certain hurdle rate), which is typically 20% but can be lower.
7. What questions to ask
Before making an allocation, it is imperative that a set of foundational questions are asked and answered satisfactorily. Additionally, clients should seek out investment managers that provide an adequate level of transparency together with a willingness to provide further detail when required. The inability or unwillingness to answer any of these questions should raise a red flag and prompt pause for deeper consideration.
The key questions:
- What are the fund managers’ qualifications and experience, and how do they support the fund’s strategy?
- What are the legal and regulatory considerations associated with investing in the fund and what impact do they have on my investment?
- What are the potential risks associated with the fund’s investment strategy, and are there strategies in place to mitigate these risks?
- How transparent is the fund reporting? How detailed are the fund reports and how often will I receive updates on performance, valuations and underlying investments?
- What are the liquidity terms, lock-up period and penalties for early withdrawals?
- What are the management fees, performance fees, and any other underlying fees/hidden costs? A comprehensive breakdown of total fees, including different performance scenarios, should be provided.
- If there is a guaranteed return, how is the guarantee provided and sustained?
- What recourse do I have if the strategy fails or the management company ceases to operate?
8. Glossary of terms
Carried interest or carry
The private equity fund manager’s share of the profits generated by a private equity fund. It’s typically in the range of 20% of the fund’s profits (after management fees).
Committed capital
Capital that you have formally committed by the LP and earmarked to be used by the GP. This is a notional amount that the LP needs to avail whenever the GP requires it.
Drawdown capital
The capital that the PE manager has drawn down to date (either for fees or for investments).
General partner (GP)
The private equity fund manager who is responsible for business decisions, makes investment decisions, oversees portfolio companies and manages the day-to-day operations of the fund. The GP bears liability for all debts incurred.
Hurdle rate
The internal rate of return that a private equity fund must achieve before the PE fund manager receives any carried interest.
J-curve effect
The typical profile of reported private equity fund returns, where low or negative returns are reported in the early years of a private equity fund (typically as a result of the impact of fees on net returns as well as the underlying investments ramping up to profitability), followed by increased and exponential returns in the later years of the fund.
Limited partner (LP)
Typically, institutional investors or high-net-worth individuals who provide capital. These investors initially commit a certain amount of capital to the private equity fund which is then subsequently drawn by the fund to deploy to investee companies. LPs have limited liability, which means they do not bear a higher risk than the amount of their investment in the fund.
Vintage year
The year the private equity fund is launched.
