As private equity funding continues to enjoy favour among South African investors, we take a look at the traditional structure, and consider alternatives.
Private Equity investing has been a feature on the South African investment horizon for some time now, and presents many opportunities for savvy investors and venture capitalists alike. But it has its limitations and barriers to entry, the most notable being long lock-in periods and a lack of investment transparency.
The sector continues to evolve, however, reflecting the agility of the industry to respond pragmatically to shifts in investor demands fuelled by a change in circumstances in the markets and industries in which such operations take place.
Private equity investing in South Africa
According to Trevor Lee, writing on MoneyWeb [https://www.moneyweb.co.za/financial-advisor-views/four-more-things-to-know-about-investing-in-private-equity-and-venture-capital/], changing global market conditions over the last ten years, most notably lower interest rates and an equity environment now conducive to the concept of private equity, have resulted in an increase in private equity funding structures. Although this demand may dissipate internationally following a bubble-type burst, conditions still bode well in the South African context.
Higher than average real interest rates and a generally underperforming equity market have set the scene for private equity funds to offer an attractive upside at somewhat lower risk levels. Combine this with the predominant view that private equity funding remains largely underrepresented in investment portfolios, and the scope for private equity funding opportunities in South Africa becomes somewhat more promising.
A traditional private equity funding structure
Private equity funding structures in South Africa have traditionally been set up as limited partnerships, with some older funds using bewind trusts. Individual investors attract tax on a see-through basis as if they own the underlying assets directly, with each partner being taxed in his or her personal capacity on their share of the profits. The partnership is birthed by a general partner (GP) who sets out the rules and regulations to govern the fund. GPs contribute a relatively small portion of the total funding requirement (in some instances between 1% and 3%), with the remaining investment contributed by investors, ranging from individuals to pension funds, known as limited partners (LPs). Each LP carries liability in proportion to the capital contributed.
LPs make contributions for a predetermined time period, usually between four and six years. Once the portfolio of assets invested in has been realised, either via sale to a strategic buyer or as part of an initial public offering, the fund distributes proceeds back to limited partners.
Fee structure and returns
As is the case with hedge funds, a private equity fund charges both a management fee and a performance fee. The management fee is paid by the LPs, and is generally calculated based on a percentage of the assets under management to cover the administrative and operational costs of the fund.
The performance fee, on the other hand, is a share of the net profit that is allocated to the GP based on a percentage of profits made. Stipulations are often included whereby the GP only earns this fee after a hurdle rate is successfully achieved.
Due to their illiquid investment nature, the performance of private equity funds is not easily measurable. But internal rate of return and investment multiples are two measures that the astute investor can use to assess the performance of his or her private equity investment.
Private equity funding 2.0
The traditional private equity funding structure continues to evolve, with many alternative investment mechanisms presenting themselves as real options, particularly in the real estate space. Issues such as complexity, liquidity, regulatory mechanisms and fund management fundamentals continue to drive the conversation.
The contents above should not be construed as investment, tax, legal, accounting and/or other advice. For advice on these matters, consult your preferred adviser. All mentioned returns are forecasted, and calculations are based on an investor in the highest tax bracket.