Aug 21, 2015 - Globally the Private Equity industry has grown to around $4 trillion in AUM, larger than the Hedge Fund i
Private Equity Overview Private Equity, along with Hedge Funds, is classified as Alternative Investments, a growing area of interest amongst investors. The main attraction of Private Equity is its unique and uncorrelated return characteristics compared with traditional equity, bond and cash asset classes. Alternative assets by definition are less exposed to traditional equity risk premia and aim to expose investors to an attractive set of diversified risk premiums. Private Equity differs from traditional listed equity in that it consists of capital invested into unlisted private companies.
The practice of buying private companies has been around since the US Industrial Revolution. Initially, wealthy families and individuals were the main investors, but after the World Wars Private Equity firms were set up to buy stakes in private companies. Private Equity funds allow retail and institutional investors to participate in the returns delivered by their investments.
The investments made by Private Equity funds are typically focused on a particular strategy which may represent a stage in a company’s life cycle (i.e. seed capital, growth capital) or a business strategy (i.e. buy-out, distressed or special situations). Due to the long-term nature of these strategies, investors are typically locked in for 7-10 years. Returns are realised when the underlying investments are sold or listed on an exchange.
Globally the Private Equity industry has grown to around $4 trillion in AUM, larger than the Hedge Fund industry with around $3 trillion in AUM, but small in comparison to listed equities at around $70 trillion in market capitalisation. The industry experienced an annual compound growth rate of 15% over the last 10 years and today many of the world’s largest institutional funds have a sizable allocation to Private Equity. For example, the Yale University endowment fund, one of the world’s top tier institutional investors with around $24 billion under management, has a 31% target allocation to Private Equity for 2015.
Private Equity in South Africa In South Africa, the Private Equity industry has experienced similar growth. Despite South Africa’s emerging market status its financial and capital markets are mature and well developed. In many instances the capital market compares well with those of developed market countries. According to the World Economic Forum’s 2014/2015 Global Competitive Rankings, South Africa is ranked under the world’s top 10 for the following categories; Financial market development
(7th), Soundness of banks (6th), Efficacy of corporate boards (3rd), Financing through local equity market (3rd), Protection of minority shareholders’ interests (2nd), Strength of auditing and reporting standards (1st) and Regulation of securities exchanges (1st).
World Economic Forum Global Competitiveness Index: 2014/2015 Country (Rank) Strength of auditing and reporting standards Regulation of securities exchanges Protection of minority shareholders’ interests Financing through local equity market Efficacy of corporate boards Soundness of banks Financial market development
SA 1 1 2 3 3 6 7
US 32 30 23 6 16 49 9
UK 16 22 15 10 17 89 15
China 82 58 67 34 78 63 54
Brazil 41 17 35 55 56 13 53
India 102 62 76 39 94 101 51
Sources: World Economic Forum Global competitiveness Index 2014/2015
Another measure of capital market maturity is the size of capital markets. SA’s equity market capitalisation is around R1 trillion, more than twice the size of its economy. This compares well with the US, UK and Singapore where equity market capitalisation is between 1 and 2 times the size of the economy. For the BRIC economies the market capitalisation is closer to 50% of the size of their economies. South Africa’s Private Equity industry is benefiting from its maturity and desirable characteristics. At the end of 2014 South Africa’s Private Equity industry had R171 billion in funds under management. Despite its rapid growth, 16% annually over the last 10 years, the industry is still fairly small at only 4% of GDP. Private Equity activity in SA is also low (0.2% of GDP) relative to the US (1.2% of GDP) and the UK (0.8% of GDP), but higher than other emerging markets China (0.15%), India (0.19%), Brazil (0.12%) and Turkey (0.02%).
SAVCA: Private Equity annual investment by independents Country (%) SA PE activity as % of GDP 0.21%
US 1.23%
UK 0.81%
China 0.15%
Brazil 0.12%
India 0.19%
Sources: SAVCA & KPMG Venture Capital and Private Equity Industry Performance Survey- June 2015
We believe the Private Equity industry in South Africa will grow significantly over the next few years, driven by attractive low correlation returns, a solid and reputable financial market framework and an array of local and offshore opportunities (including Africa). The industry has already started to attract foreign investors with more than 40% of funds raised during 2014 coming from the US, Europe and UK.
Geographical Sources of Funds Raised 2013/2014 Country (%)
SA
US
UK
Funds raised during 2013
70%
13%
Funds raised during 2014
57%
24%
Sources: SAVCA & KPMG Venture Capital and Private Equity Industry Performance Survey- June 2015
Europe
Rest
8%
6%
3%
0%
16%
3%
Return Characteristics Private Equity returns compare very well with listed equity market returns despite the strong equity bull market we’ve had since the global financial crisis. On a trailing basis as at the end of 2014, Private Equity outperformed listed equities over the last five and 10 years, but underperformed over the last three years.
Returns over different time periods (ZAR) Time Period
Per annum Pooled IRR
ALSI TRI
10 Year
19.1%
18.0%
5 Year
17.7%
16.0%
3 Year
14.1%
19.5%
Source: SAVCA & KPMG Venture Capital and Private Equity Industry Performance Survey- June 2015
Over the first six months of 2015 listed equities have only returned around 6%. We remain positive on the equity market and believe that the current bull market could continue despite its current length. Equity valuations are at the high end of the spectrum for a large part of the market and fundamentals do not support a rebound in commodity prices or above trend global growth. It is hard to see how equity markets will continue to deliver double digit returns in an environment where US and South Africa’s monetary policy is geared towards tighter policy. We believe listed equities will continue to deliver high single digit returns over the next two years.
In this environment Private Equity could prove to be an attractive asset class relative to listed equities. Not only does historic data suggest that double digit returns can be generated across the business cycle, but also that it comes with less volatility and may contain a significant liquidity premium that is unlocked when the private investment goes public. Due to the long term nature, private capital investors are not exposed to listed equity market volatility which is often a distraction to both investors as well as the managers running the private company. Private Equity allows managers to focus on how to unlock value over the long term. Due to the illiquid nature of Private Equity, investors often demand a risk premium, or a price discount for their investment. This illiquidity premium is captured throughout the life of the investment and can be unlocked once the private company lists. These characteristics contribute to the uncorrelated nature of returns and suggest that diversification benefits may be derived when Private Equity is added to a portfolio containing traditional asset classes.
We believe the Private Equity industry in South Africa has evolved into an attractive asset class for both institutional and retail investor portfolios. The return characteristics and maturity of the capital markets’ infrastructure in South Africa may draw more interest over the coming years.
Glacier Research would like to thank Jacobus Lacock for his contribution to this week’s Funds on Friday. Jacobus Lacock: B Com (Hons) Economics, CFA Charter holder Jacobus joined Fairtree Capital in 2011. He currently co-manages the multi asset class portfolios and acts as macro strategist for the firm. Prior to joining Fairtree Capital he was at Goldman Sachs Asset Management in London where he was the head of fixed income and currency product management.
