Forget medicine and law, today’s savvy parents would do well to urge their kids to take up a career in high finance — specifically, the cutthroat world of private equity. That’s if the prospectus of private equity firm Ethos, which has orchestrated mega-takeovers including Alexander Forbes, Defy and Twinsaver, is anything to go by.
What emerges quite clearly is that Ethos is making a killing in fees. After buying a company, it first levies an annual "management fee" equal to 1.5% of the value of that company. Then Ethos charges another annual "performance fee" equal to 20% of the growth in that company’s net asset value that year (provided it meets certain targets).
Sounds like it should be Cuban cigars and Laphroaig every day at Ethos’ offices.
But that would be an exaggeration, says Ethos Capital CEO Peter Hayward-Butt. "The private equity model requires the firms to commit significant time and effort ... We’ve got 15 partners, scouring the market every day looking for deals."
Still, how are these fees justifiable? "We’re not just investors," he says, "we’re active managers. We don’t just attend board meetings, we assist in the strategic and operational transformation of the companies. And there’s a cost to that."
In a typical deal, a private equity firm buys an underperforming company to mould into a leaner, better-run version, before selling it for a tidy profit within seven years. It isn’t always a one-way bet, as the company being bought has to repay the debt for its own purchase, and that can lead to a cash squeeze.
Nonetheless, it’s a model that can produce super returns for investors, despite the frothy fees.
Over the past 20 years, Ethos has provided a 27% internal rate of return, on average, every year. Once fees are deducted, that return drops to 20.9% a year. This trumps the 14.7% of the JSE’s all share index. Put differently, if you’d invested R10,000 in the JSE in 1996, it would now be worth R155,000; if you’d invested in Ethos’ funds, it would be worth R440,000.
"We have to perform," says Hayward-Butt. "We have to grow our returns at more than 10% a year — 34% over three years — to qualify for the performance fee." Still, it’s hard to shake the feeling that most private equity firms operate within a "heads-I-win, tails-you-lose" paradigm. Especially since these firms typically get their 2% fee every year, even if the company they buy crumbles.
A recent study by Oxford University’s Saïd Business School cited the US$32bn takeover of the Texas-based Energy Future Holdings in 2007 as an example. In 2014, Energy Future collapsed, but not before KKR and Goldman Sachs had extracted $666m in fees.
It’s these antics that have painted private equity owners as corporate raiders whose primary management technique is the selfish asset-strip.
Locally, we have the example of Bain Capital, which bought SA’s largest retailer, Edcon, for R25bn in 2007. Throttled by the enormous debt it had to repay, Edcon ground to a halt, its failure to invest in new stores allowing its rivals to capitalise.
But Hayward-Butt says Edcon isn’t typical of SA private equity. "Edcon had the wrong capital structure, and way too much debt. But there are consequences as Bain won’t make its performance fee. It means Bain has effectively worked for 10 years on Edcon without making anything," he says.
Except that Bain will still have sucked out a 2% management fee every year, while burdening Edcon with a debt that almost crushed it. Certainly the 3,000 people retrenched by Edcon since 2013 won’t shed any tears if Bain’s top brass miss their bonuses.
When it lists in August, Ethos will have the unenviable task of showing South Africans that private equity can actually forge better-run, prosperous companies. Rather than simply contribute to the unemployment queues.