It takes time, but the returns on private equity are worth the wait
The private equity industry’s returns over three, five and 10 years are better than the performances of the JSE all share index and the top 40 returned over the same periods
The recent RisCura-Savca South African Private Equity Performance Report reveals that the industry’s returns are nothing short of spectacular.
Precluded from investing in the asset class, asset management and institutional investors have missed an opportunity to get a slice of the consistent, healthy returns the industry has achieved over the past decade.
In line with global norms, SA’s private equity has surpassed equities, bonds and other asset classes for several years.
As an asset class, there are key differences between private equity and the listed equities market. Typically, private equity fund investments have a lower correlation in market performance to the listed equities markets. Investments made in the private equity market are relatively illiquid, with lock-in periods often longer than three years, in most cases around five years and often longer, particularly in the early seed stages.
Fittingly, the typical private equity investor has a long-term outlook and while this may not necessarily appeal to most investor groups, the industry’s returns cannot be ignored.
Since its inception, the Southern African Venture Capital and Private Equity Association (Savca), the advocacy body for the local private equity industry, has lobbied for institutional investor participation.
The reason is obvious: to attract and access larger pools of capital from public institutional investment firms such as the Public Investment Corporation, which has R2-trillion in assets under management.
Significantly more investment is needed for the private equity industry to scale.
Savca asserts that the industry offers institutional investors an opportunity to invest in an asset class that has historically outperformed listed equity over the long term. Although this may be true, it comes at the cost of longer holding periods. While they may acknowledge the contrast between private equity and the listed equities market, these differences are nonetheless tantamount to comparing apples and oranges.
The key for private equity in raising capital from institutional investors lies in actively engaging the institutional investment community. For this to happen, it is crucial that institutional investors consider the ability of private equity to fulfil their investment mandates. For the private equity industry, this easier said than done.
The most widely accepted method used to calculate returns of private equity funds is the annualised internal rate of return achieved over a specified period. In the Savca report the performance of the funds is measured in two ways: "since inception" and "end-to-end" (over a three-, five-and 10-year period). The internal rate of return calculated excludes fees subtracted by the fund managers (over all periods).
The "since inception" approach is the most widely used internal rate of return measure. It measures the return of private equity funds based on all cash flows (going in and out the fund), as well as the remaining net asset value of the fund.
Proponents of this measure argue that it most closely reflects the return investors would achieve if they invested at the start of the fund. It is suited to the South African market because investors in private equity funds are locked in for the entire stipulated term of the fund and must catch up on initial fees if they join a fund after the first round of investors.
In the "end-to-end" approach, the internal rate of returns allow the computation of the return of groups of private equity funds that do not necessarily have the same start date. It serves as a better comparison between private equity returns and those of other asset classes.
While this method has advantages, the caveat is that it allows the returns of private equity funds at different life-cycle stages to be combined. For instance, if a certain period is selected and contains more new funds than older funds, returns will be negatively affected (will include a higher balance for fees than a selected period with more funds that are older).
Proponents of this measure believe longer-term internal rate of return calculations are considered the most indicative across different stages of the economic cycle. The private equity industry considers them to be the headline measures.
With that said, short-term private equity returns should be viewed with caution. Private equity investments are a part of a long-term, relatively illiquid asset class. However, analysts and investors are always keen to know the short-term returns within the industry, to benchmark these against their allocations to other asset classes and their overall risk structure.
According to the Savca report, the private equity industry achieved a pooled internal rate of return of 10.9% (compounded annual growth rate) between the fourth quarter of 2014 the fourth quarter of 2017 (three years); 13.1% between the fourth quarters of 2012 and 2017 (five years) and 11.6% between the fourth quarters of 2007 to 2017 (10 years).
This is better than the returns on the JSE all share and the top 40 over the same periods.
These impressive returns show this kind of performance comes at a trade-off: longer investment holding periods.
To tackle this problem, the local private equity industry can draw more capital from the plethora of independent institutional investment firms by broadening its funding and investment model, which will appeal to investors who seek more flexible liquidity terms than the current model imposes. This will take time, much effort and trial and error.
• Sibindana is a freelance business writer.