The private equity asset class has been driving growth in private markets globally.

Fundraising rebounded and global totals fell only marginally short of pre-pandemic levels said McKinsey in its Global Private Markets Review. The report found that private equity was once again the highest-performing private market asset class with a pooled internal rate of return (IRR) of 27% in 2021.

Increased funding for venture capital and companies remaining private for longer means the investable universe of growth companies has expanded significantly — and private equity firms have moved to fill the space, said McKinsey, disclosing that global buyout and growth equity deal volume grew nearly 50% year on year in 2021.

Globally the industry continued to perform strongly in the first half of 2022, generating $512bn in buyout deal value, putting it on track to achieve the second-highest annual turnover in history behind 2021’s record. However, a Bain & Company private equity report warns that private equity’s record-setting performance in recent years is about to collide with the end of the business cycle, driven by uncertainty about inflation, asset valuations (which have slowed deal pipelines), and the end of the cheap debt era.

The SA private equity industry, however, is not expected to follow this trend. Jacci Myburgh, Co-head of Old Mutual Private Equity (OMPE), explains that while private equity in developed markets is expected to face a more challenging environment in the short to medium term with returns expected to be affected, the reverse is true in SA.

“Private equity has consistently outperformed listed equity over time because of its fundamental characteristics: active shareholder stewardship, perfect alignment between shareholders and management, and a focus on long-term value creation, as opposed to short-term profits. However, it is not immune to the environment it operates in, which typically moves in cycles.”

Myburgh explains that there are typically four macro variables affecting private equity returns. These include GDP growth (which is a broad barometer for how quickly businesses can grow); valuations; the cost of debt; and, finally, the amount of debt that can be used in a transaction. Until recently, all four variables have gone in the right direction for about a decade in developed markets. However, all four variables have now changed direction.

In contrast to this picture, however, Myburgh says the SA private equity environment is more conducive to growth than it has been in a while.

“With the state capture years and Covid-19 firmly behind us, SA’s fundamentals are pointing in the right direction: reasonable economic growth is expected, and politically, although the gains are slower than we would all like, we are going in the right direction. Inflation has increased somewhat but nowhere close to tripling, like in developed markets — and is expected to ease over time. And, while interest rates have increased, they are still not at pre-pandemic levels,” he says. Relative to the rest of the world, he adds, SA appears to offer a very attractive environment for private equity.

There is no question that private equity, which on average outperforms listed equity over the long term, is becoming very attractive for investors searching for growth. In addition, the active shareholder involvement and stewardship that the private equity model of investing offers, he says, translates into positive effects for environmental, social, and governance (ESG) factors.

Myburgh points out that unlike shareholders of listed companies who are only given the opportunity to vote on important matters on an annual basis, Old Mutual Private Equity uses its direct and ongoing interactions with company management to drive growth, transformation, and responsible business practices from the bottom up.

RMB Corvest CEO Mike Donaldson agrees that despite the noise locally, SA’s private equity market is poised for further growth. “Uncertainty creates opportunity and the local environment currently offers a buyer’s market, with a number of good opportunities available for private equity investors.”

He points out that the challenges facing SA right now are nothing new. “We are used to managing in a high-inflationary environment with a good deal of uncertainty.”

Donaldson believes less mature entities in the JSE’s small- to mid-cap space could benefit from partnering with private equity investors prior to listing, to give themselves time to optimise their balance sheets, improve their governance systems, and better prepare for the regulatory oversights that accompany a listing.

“Private equity is, by its nature, very hands-on and transparent. As investors, we get involved in our investee companies and build a very close relationship with the management teams.

The biggest benefit is that everybody has skin in the game and we share the risk. Governance tends to be far superior in the private equity environment, given the oversight,” says Donaldson.

This contrasts, he says, with the listed environment where there is a great deal of confidentiality regarding what can be shared with shareholders, who are largely kept at arm’s length.

Where the listed environment currently has the upper hand, is in the ESG space. “Private equity has performed well on the social and governance aspects but still needs to catch up as far as environ- mental factors are concerned. That’s starting to happen and once they have caught up, the private equity space is very likely to surpass the listed environment, particularly as there is an acknowledgment of the value of ESG to the business if it is done correctly.”

RMB Corvest, an on-balance-sheet private equity vehicle of Rand Merchant Bank, targets small to mid-sized businesses with good assets that produce predictable cash flows.

Given the far superior returns compared to the listed environment, Donaldson believes private equity is an asset class that is well worth investing in. “In SA, private equity is delivering higher returns than the industry is globally. However, these higher returns need to be balanced with higher risk, including higher interest rates.”

While RMB Corvest has had a positive 2022, Donaldson expects that locally the environment will be getting tougher, as investee companies battle global supply chain issues and feel the effects of the ongoing war in Ukraine. Locally, they are also being negatively affected by load-shedding.

“Business sectors have cycles, which is why from a private equity perspective it’s important to be diversified and not to be too exposed in any one sector,” he reports.

The biggest looming challenge to the industry, he believes, is a critical skills shortage. “SA is losing skilled professionals to countries such as Israel, the UK, and Australia at an alarming rate. Our population of experienced management professionals is ageing and nearing retirement and there are not many experienced potential CEOs with 20 to 30 years of management experience under their belts available.

Compounding the problem is the fact that many companies are struggling to put succession plans in place as talented younger professionals are also emigrating in large numbers.”

RMB Corvest invests in companies where the founders or management retain some equity and are prepared to remain invested for at least 5-7 years. It prefers not to get operationally involved in its investee companies. Its portfolio of 53 investments includes the likes of Fidelity Security Group, Excellerate Holdings, Seesa, JoJo tanks, Halewood and Brunel (a pharmaceutical group), and a number of other services and engineering businesses. Since its establishment, the company has exited more than 150 investee companies with an IRR in excess of 30%.

For its part, Old Mutual Private Equity targets companies that demonstrate strong cash generation ability and numerous growth levers underpinned by supportive industry and macro trends, with an ability to win market share.

“Irrespective of the macro environment, we’re looking for sectors, companies, and management teams that can thrive as they harness their competitive advantages or growth opportunities from African and international markets,” says Myburgh.

The company partners with experienced management teams with meaningful ownership in the business to create an alignment of interests. “We work closely with portfolio companies and add value through strong partnership, perspective, and active ownership, including board representation and helping management to develop and implement their business strategies to create long-term shareholder value. Of course, it is important to create value for all stakeholders, but we feel it’s equally important to have a positive impact, which we are very well positioned and equipped to do,” Myburgh adds.

Investments in the portfolio include large interests in Actom (a manufacturer, repairer, and distributor of electromechanical equipment in Africa); Tourvest; Footgear; In2Food; 10X; Ti-Auto; Primedia; Morecorp and more recently adding the Long4Life businesses; Holdsport; Chill & Inhle Beverages; and a personal care and wellness business that includes Sorbet, Clayton Care and Limelight.

This full article was originally published in Financial Mail in September 2022.