For the very first IFSA Prosperity Roadshow, MoneywebNOW host Simon Brown delivered a very successful keynote address on the value of private equity in South Africa. We used the opportunity to pick his brain on the topic and put together this Q&A based on his insights.

If you would like to first get a better understanding of private equity in our country, read our article on the history and rise of private equity in South Africa.

simon brown
Simon Brown at the IFSA Prosperity Roadshow.

Bill Clinton’s 1992 election campaign catchphrase, “It’s the economy stupid”, rings true for many of us. Is it still worth investing in South Africa?

Simon Brown: I hear you on that. It’s tough in South Africa. But as the saying goes, when the going gets tough, the tough get going. And that’s true of many of our large and small companies.

Of course, I can sum up the problem in one word – Eskom. But since the government increased the licensing threshold for independent power generation to 100 megawatts last year, companies – mostly the mining houses and to a lesser degree shopping centres, hospitals, and so on – are stepping into the breach.

Some 2,000 megawatts are currently in production and will probably come online by the end of this year. A further 4,000 to 6,000 megawatts will hopefully be added to the grid over the next 18 to 24 months. That could effectively put an end to Eskom’s generation shortfall.

Notice that it’s not Eskom or government that will have solved the problem but the private sector – business. And that’s the point I’m making. Yes, it’s tough doing business and investing. South Africa and its economic woes have never stopped businesspeople.

Does that mean there’s cause for optimism?

Simon Brown: I think so, especially as we’re enjoying a commodities boom that over the past two years has brought R180 and R160 billion more into the fiscus than anticipated.

As a result, we have a window of opportunity. With private power coming onto our market and potentially alleviating load shedding as well as high prices for mineral resources, things look more promising than they have since the 2008 commodity boom and optimistic lead-up to the 2010 World Cup.

If you would like to dig deeper into this topic, read about how the South African economy affects your investments:

Who should invest in private equity? How do I know it’s for me?

Simon Brown: Much like the rest of the world, we don’t do enough investing. South Africa sees just 6% of its population put together a suitably large nest egg to retire comfortably. The global average is 5%, which is pretty terrifying. In short, just about everyone needs to invest more, and private equity has its place in a balanced portfolio.

the risk pyramid

The risk pyramid is a general asset allocation framework based on the risk-reward trade-off. While cash in the bank is low risk because it’s pretty secure, its value won’t even keep pace with inflation. In contrast, private equity sits at the top of the pyramid and is categorised as high risk and high reward. In other words, you could make a packet or lose it all. To balance risk and returns, it’s a good idea to have assets at all levels of the pyramid.

Over the last decade, private equity has come out of the shadows. Before, if you weren’t rich and connected, you couldn’t access it as part of a broader investment strategy. That’s no longer true.

As you can see in the chart tracking private equity in South Africa, this asset class is growing. We are increasingly embracing the concept and using it as a viable, alternative investment process.

private equity growing in south africa

Are you saying that private equity is a good way to diversify? And what proportion of your portfolio should you invest in it?

Simon Brown: Private equity is a great way to diversify. Remember, it falls under a separate section of the pyramid to listed shares, bonds, bank accounts and real estate.

What’s more, we struggle to get strong sectoral diversification on the JSE because of our small market. Some 400 companies are listed on the JSE but they’re predominantly in retail, financial services and mining. You won’t find a pizza company, for instance, on the JSE.

Not only is the range of industries you can invest in through private equity much wider than what’s on the JSE but it’s uncorrelated to other assets. That means the stock market can crash without it having any effect on the value of your private equity. In contrast, shares and bonds are correlated so both will take hit from the same negative market events.

As for how much of your portfolio you should allocate to alternative assets, you might as well ask, how long is a piece of string? Some folks say 5%, 10% or 15%. It depends on your appetite for risk and how close you are to retiring. Just don’t go all in. You never go all-in on any one investment.

What vehicles are there for investing in private equity?

Simon Brown: There are two options – investing directly or via fund. My preference is typically for the fund. And I’ll tell you why: With direct investment, you’re putting your money into a single business and that’s a risk because any business can fail. Identifying which ones will is a skill.

Much like with unit trusts that are made up of a hundred stocks, a private equity fund also spreads the risk – not across a hundred companies but a couple of different ones. For example, there might be 10 companies and one or two will do incredibly poorly and perhaps even end up in business rescue. Five or so will put in decent performance and make some return. And one or two will knock it out the park.

You also have the option of picking a themed fund that focuses on businesses at a particular stage of their development or a specific sector. Generic schemes simply select businesses that present great opportunities, irrespective of the nature and age of the business.

Learn more about IFSA’s private equity fund.

Do private equity investments in certain sectors, such as tech, deliver better returns?

Simon Brown: No. As a species, people believe in the superiority and value of complexity. But that’s not necessarily true. Take Domino’s Pizza and Google – two companies that listed in the same month in 2003. Almost 20 years later, which share price has done better? Domino’s Pizza. Google knows more about us than our partners do, but the C-grade pizza people made better returns for investors.

That’s not to say that complexity doesn’t also win, but it doesn’t need to be that way. And there is no law that says more complex investments are better or deliver greater returns. Complexity can hide bad business plans and fraud – think Markus Jooste and Steinhoff. All sorts of things can get lost in complexity. With simplicity, very little gets lost.

My point is that private equity in South Africa isn’t necessarily exotic; it doesn’t have to be fancy. Some very boring businesses outshine their more exciting counterparts.

What’s the one thing to look out for when choosing a private equity fund?

Simon Brown: To my mind, the private equity investment managers are the make-or-break factor. That’s because they not only vet the company, ensuring that they are of investible quality, but also consult at board level, pinpointing shortcomings.

Because private equity managers are at a remove from the businesses, they have a clearer perspective on weak areas and can help bring in the skills to fill those gaps. And that can be invaluable.

In fact, that’s a key difference with listed equity on the JSE. Although stock exchanges insist on certain checks and balances, they don’t scrutinise the company – check the books, ensure the auditors are doing the job properly, etc.

Of course, you can and should ask whether private equity investment managers do a good job of sizing up businesses. As an investor, that’s your homework.

To be clear, a manager’s reputation rests on their track record in identifying which companies to take private and increasing their value. Reason enough for them to work to preserve it. That’s not to say they’ll get it right every time – no one does. What you’re looking for is a team that has more hits than misses.

Learn what sets IFSA apart.

When will I see returns and can I cash out?

Simon Brown: Private equity investments usually have a lock-in period of five to 10 years. That money is tied up. If you need money fast, look to the bottom of the pyramid – your cash or near cash, bonds, money market, etc.

You’ve got to accept that private equity is not a get-rich-quick scheme. It’s not only slow to mature but the exit process can also take time because the company isn’t traded on an exchange. That said, if the companies in the fund do well you may get some dividend income over the short term.

So how do the managers exit an investment and return your money – and hopefully profits – to you? Once again, the success of this phase depends on your private equity managers who should already have half an eye on the exit strategy when first investigating a prospective investment.

Designing exit strategies is not a perfect science. The wheels can fall off even the most brilliant plans. So, while listing the company and selling it are options, don’t be surprised if they decide to roll it or move the investment from one fund to another. Sounds like that’s pulling a fast one? No, it isn’t because the second fund pays out the first so that the initial funding can exit.

The upside to this lack of liquidity between investing and a distant exit date is that without the highs and lows of price discovery, you can’t sit back, relax and wait it out.

What about fees and tax?

Simon Brown: Fees are necessary to cover the private equity company’s salaries, legal services, research, marketing and other costs. Be sure to discover the fees before you discover the product. That way you won’t get a nasty surprise when you’ve already committed.

And if you can’t find the information, why is that? There should be fact sheets, fund documents and websites with all the details. If there aren’t, that should set off alarm bells.

Here’s a breakdown of the most common fees:

  • Initial transaction fee – paid upfront
  • Annual management fee – usually a percentage of the amount invested
  • Exit fees – these seem to have largely fallen away
  • Success fee – when annual returns exceed a hurdle, e.g. 15%, then the investment company receives a 20% portion of those returns

I repeat, make sure you’re comfortable with all that fine print. After all, this is your hard-earned money. The success fee hurdle, for instance, can be anything from cash to equities. There’s no right or wrong, but if the hurdle is zero, the investment hardly has to perform, and you’ll pay a premium. Does that really work for you?

On the tax front, the equation is very simple: If you’re making money, expect to pay tax. And it’s no different with a private equity investment. Since it’s a long-term asset, the returns are assessed as capital gains tax (CGT) and there are no special tax breaks.

What’s your next step to invest in private equity?

Reach out to fund managers and start getting to know how they operate and what skills they bring. Do they engage with the fund companies and are they investing alongside you?

IFSA Private Equity welcomes the opportunity to get to know you and your needs as well as to answer any questions you might have about investing. South Africa offers some great opportunities that we would love to share with you during a free consultation with our team. We look forward to hearing from you.

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