Private Equity in South Africa Explained

What exactly do private equity firms do? What other types of methods do they employ? What is the normal organizational structure of private equity firms? Which are the most notable South African private equity firms? These are some of the questions this post will explore.

What is private equity?

Private Equity in South Africa refers to investments made in non-listed companies on the Johannesburg Stock Exchange or other stock exchanges. Private Equity typically invests in companies recognised as Private Companies by the Companies Act 71 of 2008 (PTY LTD). Occasionally, though, they acquire publicly traded corporations, delist them, and transform them into private entities.

Why the name ‘private equity’?

Private because these are funds that are mainly interested in acquiring private companies that have not been listed on the Johannesburg Stock Exchange or any other stock exchange. Equity because Private Equity Funds are exclusively focused on equity investments.

How do Private Equity firms work?

The majority of private equity firms specialise in transactions involving a certain type of target based on the stage of the target’s life cycle. Some of these firms are interested in fledgling companies with significant growth prospects and a good management team, while others are focused on leveraged buyout transactions involving mature companies with reliable cash flows.

In addition, private equity investments in distressed enterprises are not uncommon. In fact, distressed investments are one area of operation where private equity and hedge funds have some overlap. Both sorts of funds could invest in a public firm in financial difficulties. The primary distinction between hedge funds and unlisted companies is the investing horizon.

Before exiting the investment through a sale or a new listing, private equity would normally attempt to acquire all of the shares of the target, delist it, replace management, and implement measures aimed at enhancing financial performance, and then be patient for at least a couple of years. In contrast, an investment in a hedge fund would presumably have a relatively limited duration.

The hedge fund would purchase the securities of distressed companies if it believed there was a high prospect of reselling them for a profit within two to three months. This comparison provides a decent insight into the goals of the majority of private equity transactions. Which is to purchase a substantial share in a company, preferably 100 percent but no less than 50 percent, and position the company for growth through active involvement advice.

If necessary, they go so far as to hire and reorganise the company’s employees. By their very nature, private equity firms are patient enough to allow a business to expand, enhance its profitability, and then exit the investment within ten to ten years. It is essential to understand that the art of the private equity profession consists of placing wagers on the proper organisations. Then provide effective guidance to maximise their chances of success.

Private Equity Structure

There are two main ways in which private equity firms are typically structured, a limited partnership or a closed-end fund. Limited partnerships are much more popular in the US while closed-end funds are prevalently used in South Africa and European Countries.

Limited Partnership

There are two sorts of partners in a limited partnership: general and limited. General partners participate in fund administration, portfolio selection, and post-investment advisory. The function of limited partners is to supply investment funds. General partners charge a management fee to the partnership and are eligible to collect carried interest.

This is the renowned 2-20% compensation structure, where 2% is paid as a management fee regardless of the fund’s performance, and general partners receive 20% of all revenues beyond break-even. In some instances, a hurdle rate is added to the partnership agreement, defining a minimum rate of return that must be attained prior to carried interest accruing to general partners. Limited partners receive the whole fund’s proceeds, less any distributions made to general partners.

Closed-end Fund

A closed-end fund is different from a Limited Partnership, it typically involves a newly created entity, investors provide capital to that entity. The management firm signs a management contract with the entity.

The compensation schemes remain similar to those of a Limited Partnership. Under this type of structure in most cases the classical 2-20 arrangement plus a hurdle rate for management after which are accrued 20% of carried interest.

Life cycle of a Private Equity Fund

The duration of the fund’s investments, which might range from a couple of months to two or three years. This is mostly dependent on the management firm’s reputation and the demand for their services within the financial community. Established industry players have a major advantage. Typically, the investment phase lasts up to five years.
During this phase, the general partners or management firm, depending on the type of fund structure chosen, would hunt for target companies that align with the fund’s investment strategy. Once an investment has been made, it would be the responsibility of fund managers to determine the optimal company strategy and performance optimization.
The majority of these organisations are quite hands-on throughout the whole investment lifecycle. They hold frequent meetings with management to ensure that the company is on track to be ready for sale or listing on a stock exchange. The concluding phase is divestment. For obvious reasons, divestment may take several years; in some instances, the process may take up to five years.
Multiple factors influence the optimal time to exit a firm. Some of the most prevalent causes include, but are not limited to, the status of the economy, the volatility of the market, and, most crucially, finding a buyer ready to pay the appropriate price. Once the entire portfolio is sold, the fund terminates and all proceeds are paid to general and limited partners in a partnership structure or to investors and the management business in a closed-end fund.