Access for buyers, liquidity for sellers. South African investors are faced with a number of challenges, and while many investors have made the decision to invest as much as they can offshore, most of us resident here (in particular pension and provident funds) do not have a choice other than to invest a portion of our portfolios in South Africa.
South African investors are faced with a number of challenges, and while many investors have made the decision to invest as much as they can offshore, most of us resident here (in particular pension and provident funds) do not have a choice other than to invest a portion of our portfolios in South Africa. And then there is the question of where can one still get a decent return within acceptable levels of risk. Private equity investors in South Africa have been on the receiving end of attractive returns over the long term. According to the Southern African Venture Capital and Private Equity Association (SAVCA), the pooled returns for private equity in South Africa have outperformed public markets consistently over the long term (Figure 1). However, Naspers makes up such a substantial portion of the JSE All Share Index (ALSI), particularly due to its shareholding in Tencent, so to see a more realistic comparison it makes sense to exclude Naspers (Figure 2). The difference between public returns and private equity returns over the last 10-year, 5-year and 3-year periods would then be 7%, 9% and 1% respectively for public returns, compared to 14% for private equity returns over the same periods.
Although South African private equity continues to deliver superior returns, we live in a time where the unexpected seems to have become the norm rather than the exception. This leads to investors searching for greater yield with less volatility combined with optionality and the ability to trade when they need to.
Until recently, the private equity secondary fund market in South Africa has been limited and opportunistic. A secondary private equity transaction involves the sale and purchase of an investor’s existing interest in a private equity fund, e.g. the remaining assets as well as the remaining fund commitment to meet future capital calls for new investments, fees or follow-on investments. In any market, the growth of secondary activities is driven by volume of the primary market, investment structures, and participants willing to buy and sell. The private equity (primary) market in South Africa has grown by 190% (see figure 3) over the last decade, is well established and well developed. Since 1999, the industry has achieved a compound annual growth rate of 11.4% of funds under management, dominated by late stage private equity funds (i.e. relatively very few venture capital and/or early stage private equity funds under management).
Oversees, particularly in the US and Europe, private equity secondary markets are very active. Although the volume of the primary private equity market in South Africa has reached the point where it justifies a more active secondaries market, the question is why has this not yet happened locally. The answer lies within the second and third drivers, i.e the way private equity funds are structured and the lack of active buyers in the secondary market. Most private equity funds are structured as limited liability partnerships (or en commandite partnerships), mainly for their beneficial look-through tax advantages (which is important because the largest investors in private equity are non-tax paying, e.g. pension and provident funds) and their limited liability status for investors. These partnerships are often subject to a ‘right of first refusal’ or ‘pre-emptive’ processes, meaning that when a partner/investor wants to sell its interest in a fund, the other partners/investors would have the first right of refusal to that stake before it could be sold to a third party. In addition, it also requires approval from the ‘general partner’, or simply put the private equity management team, before it can be sold to a third party. Although there are often similarities, private equity funds may have the different terms (‘hurdle rates’, ‘catch-up’, carried interest on a ‘whole-fund’ basis versus carried interest on a ‘deal-by-deal’ basis, to name a few), which can influence the pricing of a secondary significantly. This combined with the fact that private equity fund commitments are by their nature long-term and illiquid, does not exactly make them ‘trading’-friendly investments. Hence, the existence of specialised participants are needed to spur the evolution of a secondaries market for these assets.
An active secondary fund market is important for the growth of the private equity industry as it provides liquidity for an illiquid asset class. It is the only way for investors to exit early before the expiry of a private equity fund’s 10 to 12-year term. In addition to an early return before maturity, it also makes it possible for investors (i.e. sellers) to actively manage their portfolios in response to macro-economic, regulatory or strategic changes.
The attractiveness of secondaries for investors (buyers)
Secondary private equity fund investments are attractive to investors for the following reasons:
One of the greatest benefits of allocating capital to a secondaries fund is to gain diversified exposure to known private equity positions. Like traditional fund-of-funds, secondary funds also provide investors with diversification by assets, fund manager, geography, industry sector, investment strategy, etc. However, secondary funds have the added advantage of vintage year diversification and the benefit of hindsight. The ability to invest into carefully selected and matured portfolio with a single commitment is particularly attractive.
2. Attractive risk-adjusted returns
The private equity secondaries market is by its nature an inefficient market, which often creates opportunities for superior risk-adjusted returns.
Depending on the quality of the underlying assets left in the fund, secondary fund commitments could sometimes be bought at a discount, especially when limited or no other buyers are present in the market. The so called ‘blind-pool’ risk that is associated with primary fund commitments or traditional fund-of-funds are also eliminated, because in secondary transactions the assets of the fund are known and often fully-funded, hence the ability to perform a bottom-up valuation to determine the exact price to be paid. It is therefore possible to generate attractive returns with significantly lower risk. As can be seen from figure 4 above, secondaries are clearly very attractive from a risk-return perspective.
3. Smooth ‘J-curve effect’
Secondaries can deliver a more evenly distributed risk-adjusted return over time. In the first few years of a private equity fund, an investor will typically experience a certain period of negative returns due to the outflow of capital for investments and management fees (the ‘j-curve effect’).
A secondary investment would typically mitigate this effect, because the buyer of a secondary would acquire the original fund commitment at a later stage and does not refund previously paid management fees that the seller has paid. Acquiring a more matured portfolio also means that the underlying fund investments are closer to their exits (time when assets have to be sold), as can be seen in figure 5 below.
The attractiveness of secondaries for investors (sellers)
Sales of private equity funds are mostly driven by the strategic needs of the seller and not the quality of the manager or the portfolio. In fact, most secondary transactions internationally have been driven by banks and insurance companies that have decided that primary private equity fund commitments are no longer core to their business and/or due to onerous regulatory capital requirements on these investments.
Some of the most common reasons for investors selling their fund commitments include:
• change in institutional strategy away from private equity (i.e selling of non-core businesses/investments);
• unable to fund undrawn commitments or want to utilise future funds for something else;
• demand for current cash and/or a view to realise a return on unrealised gains in the portfolio;
• portfolio allocations need to be rebalanced (internal, macro-economic, or regulatory reasons);
• breakdown in the relationship between parties; or
• a decision to sell stub positions or problem funds.
The current opportunity for secondaries in South Africa
In South Africa, it is often challenging to source and successfully close an attractive secondary private equity fund transaction, because it requires a very specific set of skills, a dedicated team to evaluate detailed information about the existing portfolio and its underlying assets, a well-established network to source these transactions, the ability/mandate and readily available capital to act quickly to transact when such opportunities arise. Also, as mentioned earlier, secondary activity is driven mainly by three factors – primary market volume, investment structures, and active participants. Although the volume of the primary private equity market in South Africa justifies the existence of a relatively sized secondaries market, the investment structures and lack of active and sophisticated buyers largely mitigates the natural evolution of a secondaries market and the result is a classic illiquid investment.
However, since the launch of the Ashburton Private Equity Fund I in 2014, Ashburton Investments has been leading the way by inventing the private equity secondary fund market in South Africa for the benefit of the whole industry. With our innovative approach, experienced and dedicated team with well established relationships in the industry, we have sourced over ten secondary transactions and successfully closed five with leading South African and Sub-Saharan African fund managers, providing our investors with exposure to 24 underlying portfolio companies through these transactions alone.
Ashburton Investments is planning to launch the Ashburton Private Equity Fund II early this year and aims for a first close by June 2018. Fund II will be a specialised secondary private equity fund, with a mandate to opportunistically include direct co-investments alongside some of South Africa’s leading private equity firms. Fund II will target “blue-chip” private equity opportunities, i.e. investment bias towards cash-generative, leveraged buy-out opportunities predominantly in South Africa with a maximum of 35% investable in Sub-Saharan Africa. The fund will aim to deliver double digit returns regardless of the macro-economic conditions and will not invest in venture capital/early stage private equity, distressed or turnaround businesses, property focused funds, primary agriculture, primary resources or mining and will avoid business/industries that are cyclical in nature. Ashburton Investments’ longstanding relationships in the private equity industry and the experience of the team means we have access to opportunities, insights, and trends that provides our investors an undeniable edge.
For sellers that want to sell, finding a potential buyer is extremely difficult and because execution is also challenging, the solution is a specialised secondary private equity fund.
A more active secondaries market will introduce liquidity for current investors into this asset class that has been classically labelled as illiquid, and it will not only provide optionality for current and regular investors, but also attract new investors to this asset class. Ashburton Investments is pioneering the industry and we believe that our spesialised secondary private equity funds will not only be beneficial for its investors, but will also have a significant long term positive impact on the industry as a whole, paving the way for increased interest in private equity as an asset class in South Africa.