A foot forward for
The evolution of the private equity secondaries market provides access for buyers,
liquidity for sellers
Private equity investors in South Africa have received 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.
SA Private Equity pooled IRR vs JSE Alsi
Source: RisCura - SAVCA South African Private Equity Performance Report (2Q 2017)
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 – see below.
SA Private Equity pooled IRR vs Alsi (ex. Naspers)
Source: RisCura - SAVCA South African Private Equity Performance Report (2Q 2017), Bloomberg, and Ashburton Investments
The difference between public returns and private equity returns over the last ten-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 chart below) 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).
South African Private Equity funds under management
Composition of total FUM (R172bn in 2016)
Overseas, 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 secondary market, the question is why has this not yet happened locally. The answer lies within the second and third drivers, that is, 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, such as 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 or investor wants to sell its interest in a fund, the other partners or investors would have the first right of refusal to that stake before it could be sold to a third party.
Most private equity funds are structured as limited liability partnerships, mainly for their beneficial look-through tax advantages.
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 is needed to spur the evolution of a secondaries market for these assets.
An active secondary fund market would provide 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.
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.
"Private equity fund commitments are by their nature long-term and illiquid, which does not make them ‘trading’-friendly investments. Hence, the existence of specialised participants is needed to spur the evolution of a secondaries market for these assets."
The current opportunity for secondaries in South Africa
Ashburton entered the private equity space in 2014 with the launch of its Private Equity Fund I in 2014. Since then the company has developed the secondary fund market in South Africa, which benefits the whole industry. We have sourced over ten secondary transactions and closed five with South African and sub-Saharan African fund managers, providing our investors with exposure to 24 underlying portfolio companies through these transactions.
Ashburton Investments is planning to launch its 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, with an investment bias towards cash-generative, leveraged buy-out opportunities predominantly in South Africa with a maximum of 35% investable in aub-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. 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.
Juan Coetzer is the head of Private Equity at Ashburton Investments