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Private equity has evolved into an asset class not only capable of providing the smooth returns demanded by investors, but also the ability to generate economic growth and drive job creation. It’s time retirement funds take notice, writes Ola Leepile, the Chief Executive Officer of Novare Holdings
The recent elections have brought sweeping changes to South Africa’s political landscape, offering an opportunity to address challenges that could alter the country’s economic and financial market trajectories. Thirty years into democracy, many early gains have been eroded, but not all is lost.
There is hope that a Government of National Unity (GNU) will advance the economic plans set by the previous administration, with potential benefits from lower inflation and interest rates boosting growth and mending business and consumer sentiment.
Progress had been slow, with projects hard to come by and action lagging behind rhetoric. However, optimism persists that, despite potential upheavals from opposition parties in Parliament and political noise, the GNU will embrace a business-friendly approach and accelerate initiatives to address key growth impediments: power, logistics, education and skills shortages, corruption, crime, racial exclusion and inequality.
In these uncertain times, it’s crucial to shift gears. Private equity could be a powerful tool for making a difference. Simply put, private equity firms invest in companies not traded on stock exchanges, pooling them into funds to increase their value over a set period, typically 5-12 years, before selling them for a profit.
The lack of understanding of private equity explains why so few South African retirement funds are invested in the asset class. Pension funds, including the Government Employees Pension Fund (GEPF), oversee R5.32 trillion in assets, according to the Institute of Retirement Funds Africa. A survey by the Southern African Venture Capital and Private Equity Association (SAVCA) showed that private equity firms in the region, mostly from South Africa, had R213.3 billion in assets in 2022.
Despite the tentative approach from the previous government to more private-sector involvement in addressing the deterioration in infrastructure, frameworks have been put in place for pension funds to participate more in rebuilding the economy.
Since the beginning of last year, pension funds have been able to allocate up to 45% of their assets to infrastructure. For the government, which has very little fiscal room to address its massive infrastructure backlogs, that funding is critical – as long as pension funds can make returns on their investments. We don’t want a population with shiny trains but no retirement savings.
According to the World Bank and the Development Bank of Southern Africa, the country must spend between R4.8 trillion and R6.2 trillion on transport, water and sanitation, basic education, and technical and vocational education and training between 2022 and 2030 to close the gap in these sectors and meet the Sustainable Development Goals. For context, the government’s entire spending budget for this financial year is R2.37 trillion.
Other changes have been implemented to allow pension funds to participate more directly in the economy. They can now invest up to 15% of their portfolios in private equity, up from 10%, although it’s clear they are nowhere near this limit.
For example, the state-owned Public Investment Corporation, which manages the GEPF’s assets as well as other funds such as the Unemployment Insurance Fund, currently allocates just 0.6% to private equity, according to its annual report.
Globally, allocations are higher and rising. Australia’s largest pension plan aims to increase its private equity allocation to 9% from 5%. In North America, an average of 10.3% of pension funds were invested in private equity in 2022, according to Preqin data. The California Public Employees’ Retirement System (CalPERS) plans to boost its target allocation to 17% from 13%, Bloomberg reported.
Last year, following the UK government’s plan to double pension allocations in private equity to 10%, nine of the UK’s largest workplace retirement schemes committed to investing at least 5% of their assets in start-ups, infrastructure, and green growth.
Private equity funds offer many benefits within an investment portfolio. They add to diversification. Returns are uncorrelated to the market, so investors aren’t always bound to what drives shares or bonds, and, if properly selected, offer higher yields.
However, they also have limitations. Bankable opportunities, those likely to return a profit, aren’t easy to find. Liquidity concerns, which is the ability to exit an investment, also deter investors. A lack of education among trustees and investors is another challenge, as is poor experience among brokers who focus on selling more liquid assets like shares and bonds.
Returns haven’t always been great. Private equity-owned companies showed a mixed performance in 2022, according to SAVCA’s survey. While 42% of these businesses achieved a compound annual growth rate of over 20% in earnings before interest, tax, depreciation, and amortization (EBITDA), 38% saw a decline in profits.
While private equity funds have been outperformed by local stocks, history isn’t always an indicator of future performance. As skills in the industry sharpen and private equity firms acquire assets battered by South Africa’s low structural economic growth, performance might improve. Progress in reducing loadshedding and steps to resolve port blockages should also support the economy.
Private equity funds provide long-term horizons for investors, more closely aligning with the liability profile of a pension fund, given that returns are generated over an extended period. While risky, the smaller companies that these funds invest in are often fast-growing businesses. Unlike their South African peers, UK private equity firms, for example, have outperformed equity markets and the growth in pension fund assets over three, five, and 10 years, according to Invest Europe data.
The economy could benefit most from increased investment in private equity. Private equity firms employed nearly 12 million people in the US in 2020, generating 6.5% of the country’s gross domestic product, according to a study by EY and the American Investment Council. Benefits extended to suppliers, with 7.5 million workers employed, and an additional 11.9 million retail jobs supported by extra spending.
The quality of jobs in companies that private equity firms invest in improved, with rises in productivity, job satisfaction, and benefits, the study found. In Europe, between 2017 and 2022, private equity and venture capital firms invested over €550 billion in 30,000 companies, with job growth in these firms at 7.2%, compared to 2% for all European businesses, according to Europe Invest. These firms employed 10.9 million people at the end of 2022, representing 5% of the European workforce.
They weren’t always popular, and in the 1990s, private equity firms were notorious for their ruthlessness. They acquired companies, financed the purchases by selling below-investment-grade bonds (known as junk bonds), and often left the businesses in ruins under piles of debt.
A notable example is Edgars, once South Africa’s largest retailer. It struggled for 10 years under the weight of leveraged buyout debt, eventually entering business rescue and being sold, leading to reductions in the number and size of its stores.
Private equity firms now often build businesses by acquiring companies that complement each other and integrating them to avoid duplication, cut costs, and create a full suite of products or target specific markets. They are also more serious about environmental, social, and governance (ESG) issues, with 83% of private equity firms polled by SAVCA linking key performance criteria to achieving more than financial returns. About 57% have a specific impact investing mandate, and 79% of those who don’t are considering one.
With an unemployment rate of 32.9%, South Africa needs to do what it can to strengthen and support companies. Businesses need capital when they are ready to grow and reach the next level of scale. Often, they cannot get bank funding, and selling shares on the stock exchange is too expensive and complicated. This is where private equity investors step in, injecting money into the business, collaborating with owners and existing management if they’ve chosen to stay, and expanding strategically.
The private equity firms need retirement funds, their principal officers and trustees to take the time to understand what they’re potentially investing in on behalf of their members.
It’s an opportunity that’s not being fully exploited. What the country has tried hasn’t been as successful as hoped. Maybe it’s time to give something else a chance.
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