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South African investors are missing out on diversified and attractive private equity returns

13 October 2021 Old Mutual Private Equity

A private equity specialist outlines key considerations when partnering with an outstanding manager.

Despite numerous delistings from the JSE and the current weak IPO environment culminating in the decline of listed investment opportunities – institutional South African investors continue to under-allocate to alternative growth assets such as private equity compared to their global counterparts.

There are about 300 listed companies in South Africa, whereas the private market allows access to over 1,500 mid-tier alternatives. "Not only are there more companies in the private market to capitalise on mispriced opportunities, but there is also far more diversification to benefit from," says Farhad Khan, a Partner at Old Mutual Private Equity.

The private market also represents great opportunities to get into high-growth markets early (long before they are ready to IPO). "According to a recent report, the medical device industry is predicted to be valued at more than $8,5-billion by 2025. Currently, there are no pure listed medical devices and innovation opportunities on the JSE, which is why Old Mutual Private Equity recently sought investment in a local medical devices company," he says.

According to Khan, this continued under-allocation to unlisted equity represents a missed investment opportunity, but he stresses that selecting the right private equity manager is critical for success. "Internationally, the allocation to private equity is up to 20%, whereas in South Africa this is below 2% despite access to several good quality, investable, highly cash-generative private companies," he says.

Research shows that, on average, private equity outperforms listed equity markets by over 3-5% in the long term. The Yale Endowment Fund –one of the best-performing investment portfolios in American higher education - performed a famous study on the value of alternatives in an investment portfolio.

"Following outstanding performance thanks to the asset allocation, today up to 70% of its portfolio is allocated to alternatives with less than 3% in listed equities. It has returned 11.8% in dollar terms per annum on average over the last 20 years compared to the 5.2% of the listed market," he says.

The Yale case study suggests that strong performance was driven by improved diversification, selecting the best managers and less competition in unlisted assets, allowing better entry prices. "Rather than trying to elevate private equity at the expense of the listed market, the point of bringing the Yale findings into the spotlight is to highlight the value of allocating a portion of a portfolio to alternative investments, especially where a shrinking listed sector risks reducing diversity and exposure to certain sectors altogether," he says.

However, he adds that investing in private equity involves complexities that need to be demystified to encourage more significant investment into the asset class. According to Khan, the variance of the mean return is one aspect of private equity investment that highlights the importance of selecting the right Private Equity Manager.

"The Yale Endowment fund research found that there was a 3% spread between the top quartile and bottom quartile among fixed income managers. This indicated that there was no logical argument to spend much time differentiating between the managers they picked. It's for a similar reason they only allocated such a small amount to listed investment opportunities altogether.

"In the private equity space, however, the difference in return between the top and bottom quartile managers was significantly larger," he says.

Private Equity managers invest in stable, mature cash-generating companies, while Venture Capital investors usually come in during the start-up phase. "In the venture capital space, where Old Mutual currently doesn't operate, the Yale study found that the variance in return between the bottom and top-quartile managers is as much as 40%. This means that while the potential returns are highly attractive, it is critical to back an experienced manager that specialises in spotting and driving value from private companies," he explains.

Khan says that investors need to choose to work with a seasoned investment manager with a clear vision and investment strategy to drive value. "An investment team's longevity is a good indicator that they have been around for some time and have seen patterns play out before, making them more adept at spotting the winners," he says.

A good specialist Private Equity team will assess investments from the bottom up – with a keen focus on identifying and backing strong management teams. They will seek opportunities to enter at a good price while proactively investing in companies with strong environmental, social and governance (ESG) considerations.

"The ideal team has a solid foundation in finance and investing, while additional skill sets are also very useful, such as engineers or medical doctors, often found in good management teams – depending on the area being invested in. Beyond skills diversity, gender and social diversity in a team is a key strength as it provides different perspectives and helps protect against biases," he concludes.

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