The Old Mutual Hybrid Equity (HE) Fund I, having closed at ZAR2.1 billion, has returned an IRR (Internal Rate of Return) of 18,5% since inception of the Fund (May 2021)*.
In addition to the strong investment performance, the strategy has experienced zero capital loss on any of its investments (over 33 transactions and 20 exits concluded) since inception of the strategy in 2007. Few institutional strategies have achieved such success. In an environment where returns from most asset classes have been less than 10%, often not even beating inflation, and in an economy with weak economic growth, this is no small feat.
Mujaahid Hassan, co-head of Hybrid Capital at Old Mutual Alternative Investments (OMAI), says the success of the fund is owed to the perfect blend of the fund’s investment philosophy, the benefits of the hybrid asset class, as well as the skill and experience of the team.
“We are delivering returns well above growth assets at significantly lower levels of risk,” says Hassan, adding that the fund has been doing exactly what it says on the box since inception.
How has it managed to do this?
“Our philosophy has always been to protect capital first before pursuing upside potential. This consistent strategy of downside protection has meant that even when we put the asset through the most severe stress tests, we are still able to get our capital back. We have built in a hurdle rate for investors so that even if we have negative growth on an underlying asset we can still generate returns,” says Hassan.
However, he adds there were challenges over the last three years that are still playing out today, given the market dynamics.
“In 2022 we had plenty of potential opportunities, but none of them suited our strategy, so we didn’t deploy a cent. This was tough, and today the market is just as depressed. In this climate it is important to be highly selective of the sectors you invest in, and cherry pick the opportunities you believe are going to deliver.”
The fund’s strategy is to focus on high growth areas in infrastructure that are critical to support the South African economy, such as energy, broadband and fibre as well as food security. “We think deploying capital to these areas is going to turn the dial and make an impact to people’s lives over the longer term. But equally important is that it works for our product’s defensive nature; we can protect our client’s capital because food needs to be eaten, we rely on energy, and data will always be consumed.”
Against this, having the right experience is crucial, yet it is a challenge that many new managers in this niche space are grappling with, says Hassan.
“When we initially brought the fund to market, investors were not very familiar with the hybrid equity strategy and needed to get a better understanding of the mechanics of the asset class and strategy. Investors wanted to know if we could really deliver what we promised. The team’s extensive credit risk and mezzanine finance experience has been key to delivering the stable and protected return profile of hybrid capital, but minus the volatility associated with equities. Many managers in this space struggle to get deal flow because they don’t have this experience coupled with a private equity mindset,” says Hassan.
He explains that mezzanine finance differs to private equity in that a loss from one deal jeopardises the return profile of all the assets, so it is “important to have the technical experience in the investment team that recognises this.”
Hassan says another key benefit of hybrid equity besides its stable return profile characterised by low volatility, is a better liquidity profile compared to other longer term asset classes.
“It functions more like debt than equity. You have the security of the underlying assets and liquidity thanks to a predetermined exit profile.”
Hassan explains further by saying that the strategy of the Hybrid Equity Fund I was always to exit assets after three to four years, rather than staying invested for 15 to 20 years before realising returns.
Looking forward, Hassan believes that the time is now for hybrid equity’s place in the sun.
“Private debt is making investors sit up and pay attention because equity markets locally have not been delivering the returns. And for equity markets to deliver strong absolute returns, we will need GDP growth rates in SA to be between 4% and 5% for at least the next five to 10 years.”
He says that the team’s future growth strategy is looking to Africa to replicate the successes it has achieved since 2007, when it first started deploying the HE Fund I strategy.
“We will also continue focussing on sectors that are capital hungry, which means there will always be a place for this product,” says Hassan. “In South Africa, there is a lot more scope for transformation to take place, even after almost 30 years of democracy.”
Hassan says that the Fund’s focus around impact and transformation will continue, given the necessity in the SA economy. Eight out of nine assets in the Fund have been empowerment transactions, with every single deal having been a success.
“We are transforming financial services through the provision of capital. We believe our transformation story happens at day one. We make an impact when the deal closes and influence that over time through our relationship with the empowerment shareholder,” concludes Hassan.
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