- What is the difference between private equity and venture capital?
- Who are the typical investors?
- Why do investors invest in PE/VC funds?
- What are the disadvantages of investing in private equity?
Both private equity (PE) firms and venture capital (VC) firms aim to raise money from investors, with the intention of investing in private companies, increasing the value of these companies and in due course, selling their interest in these companies at a profit. The sale could be to another private firm, or by listing on a stock exchange. However, VC firms invest in early-stage companies, while PE firms generally invest in more mature companies. The VC or PE firm that raises the money, chooses new investments and manages the turnaround of these investments is called the general partner (GP). Investors who commit capital to the GPs are called limited partners (LPs).
In South Africa, LPs generally consist of development finance institutions (DFIs), insurance companies, pension funds, banks, investment holding companies, government agencies and wealthy individuals. The high minimums and sophistication required to manage committed capital have traditionally kept ordinary investors away from investing in PE.
In recent years however, governments have become keen promotors of both PE and VC investing, as there are important social returns to be gained from investing in small- and medium-sized businesses. SMEs have been found to play a vital role in job creation, particularly for employees with low skills. In a South African context, the PE investment structure lends itself to creating opportunities for black management and BEE beneficiaries.
As a result of these developments, maximum thresholds for pension funds have been increased. From 2011, South African pension funds have been allowed to invest up to 15% into ‘alternative investments’ – a group that includes private equity funds, hedge funds and other derivative or pooled vehicles. In addition, tax breaks have been introduced for small companies and those who invest in them.
Possible outperformance: The chief investment premise of investing in a PE or VC firm is to catch the upward growth of a promising business and/or the ‘value-add’ of a talented PE firm. The ‘2018 SAVCA Private Equity Industry Survey’, released in February 2019 by industry body the Southern African Venture Capital and Private Equity Association, reported that the private equity industry delivered a ten-year internal rate of return (IRR) of 11.6% compared with the 10.7% from the JSE All Share Total Return Index over the same period.
According to CEO of SAVCA, Tanya van Lill, over the past two years the average PE IRR has fluctuated between 16% and 11%. Globally, the top PE firms traditionally offer returns higher than 20%.
She commented that PE is cyclical in nature and it takes a few months from the initial investment for the PE firm to unlock the value through bringing expertise such as people, processes, new products or services, access to markets and other relevant innovation.
Internationally, some PE/ VC returns, relative to public investments, have been more compelling. The ‘Asia-Pacific Private Equity Report 2019’, published by management consultancy firm Bain and Co, reported that the pooled IRR for Asia-Pacific-focused funds with a five-year investment horizon was 14%, compared with 8% for Asia-Pacific public markets. The IRR for a ten-year investment horizon was 11% versus 6% for public markets.
The liquidity premium: The PE industry is particularly attractive to investors who have a long-term horizon. By sacrificing liquidity, an investor gives a PE manager time to make meaningful changes or for a new idea to gain traction, which has a greater chance of yielding greater returns over time. On the other hand, investors can be locked into loss-making investments. There is an old joke that a PE relationship is generally longer than the average marriage in the United States, which is eight years.
Uncorrelated returns: PE returns tend to be uncorrelated to listed equity returns. This makes them popular with institutional investors looking for diversification, reduced portfolio risk and lower portfolio volatility. Both PE and public equities are exposed to the same broad macro-economic conditions but PE/VC valuation is not affected by the same investor sentiment and stock price volatility – which is a normal feature of publicly-traded markets. The investment horizon of PE investment is well suited to the long-term horizon of a pension fund.
Alignment: In private equity funds, the tradition of a general partner commitment ensures that there is full alignment between the interests of the PE or VC firm, the management team and the LPs. Everyone has skin in the game.
Investing in PE and VC funds can be risky.
Investors essentially agree to invest large sums of money, for long periods, for no guaranteed outcomes, with no regulatory protection other than the law of contract.
While clearly target firms are identified due to their potential, relative to listed companies, they are higher on the risk curve, either because they are either small with untested ideas or because they offer turnaround potential. Turnarounds can sometimes be longer and more difficult than planned.
Returns in PE investments are notoriously uneven; there is a significant return disparity between top-performing private equity firms versus industry laggards. Manager selection is a key determinant of success in PE investing, and unlike most investing, past performance and a strong track record is a stronger indicator of future performance, a proud hallmark of PE.
Like many other investments, timing of the entry and exit points is crucial to investment success. Big winners and losers tend to emerge during periods of turbulence and volatility. While most PE investments have a pre-planned exit arrangement, these plans can go awry. In difficult economic environments, PE firms tend to defer planned listings until investor appetite is deemed ready, further locking in LP money.
Disclaimer: Please note that this article should not be construed as solicitation, advertising or sale in any shape or form. Nor is it advice of any description. It is an information-only article of general interest that aims to describe the risks of investing in PE and VC opportunities.