Posted on December 30, 2020 by Staff Writer
What do private equity firms actually do? Which are the different types of strategies they pursue? What is the typical structure of a private equity firm? Which are the most notable private equity firms in South Africa. These are some of the questions we will address in this article.
What is Private Equity?
In South Africa, Private Equity is the investment made to companies that are not listed in the Johannesburg Stock Exchange or any other stock exchange. Private Equity primarily buys into companies defined by the Companies Act 71 of 2008 as Private Companies (PTY LTD). However, sometimes they buyout publicly traded companies, then delist and restructure them into private companies.
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?
Most private equity firms specialise in deals with a specific type of target based on the life cycle stage of these targets. Some of these Firms are interested in young firms with high growth perspectives and a promising management team while others are focused on established companies with stable cash flows leverage buyout transactions.
In addition, it isn’t rare to see private equity investments in distressed companies. Actually distressed investments are one area of activity where there is some overlap between private equity and hedge funds.
Both types of funds could invest in a distressed company which is public. Hedge funds are unlikely to engage with a non-listed firm, the main difference, however, is their investment horizon. Private equity would typically try to acquire the entirety of shares of the target, delist it, change management, introduce measures oriented towards improving financial performance and then be patient for at least a couple of years before exiting the investment through a sale or a new listing.
A hedge fund investment, on the other hand would likely have a very short term duration. The hedge fund would buy the securities of distressed companies when they believe that there is a good chance of reselling at a profit in the near term, within 2 to 3 months.
This comparison provides a pretty good insight into what most private equity deals try to achieve. Which is to acquire a large stake in a business, preferably 100% but not less than 50% and position the business for growth through active involvement advisory.
If necessary they go as far as appointing and reshuffling the business’s staff members. By nature, Private Equity firms have the patience to grow the business, improve its profitability and then exit the investment in a 10 to 10 year period.
It is important to note, the art of the private equity profession is to bet on the right companies. And then successfully provide guidance in order to optimise their chances of being successful.
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.
In a limited partnership, there are two types of partners, general and limited. General partners are involved with the management of the fund, portfolio selection and post-investment advisory. Limited partners’ role is to provide investment capital.
General partners charge the partnership a management fee and have the right to receive carried interest. This is the famous 2-20% compensation structure, where 2% is paid as a management fee even if the fund isn’t successful and then 20% of all proceeds after break-even are received by general partners.
In some cases, a hurdle rate is added to the partnership agreement which defines a certain minimum rate of return that needs to be achieved before accruing carried interest to general partners. Limited partners receive all of the fund proceeds minus what has been paid to general partners.
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 collection of investments in the fund which can be as short as a couple of months and as long as 2 or 3 years. Largely, this depends on the reputation of the management firm and the demand for their services within the investment community. Established players in the industry have a significant edge.
- The investment period which typically lasts up to five years. During this time the general partners or management company depending on the type of fund structure chosen would search for suitable target companies fitting the funds’ strategy. Once an investment has been made it would be up to fund managers to decide which is the right way to approach the business and optimise its performance.
Most of these firms are very hands-on throughout the entire lifecycle of the investment. They meet frequently with management and are keen on ensuring that the business is on the right track of being ready to be sold or listed on a stock exchange.
- The final stage is divestiture. For obvious reasons, divestiture could last several years in some cases the process can be as long as 5 years. Various factors determine when is the best moment to exit a business. Some of the most common factors include but are not limited to the general state of the economy, market volatility and most importantly finding the right buyer willing to pay the right price. Once the entire portfolio is divested the fund closes and all proceeds are distributed among general and limited partners in a partnership structure or among investors and the management company in a closed-end fund