Introduction to Private Equity

February 2013
We will be looking at…

1 What is Private Equity?

2 Private Equity Strategies

3 Risk and Return

4 Why Do Pension Funds Invest in PE?

What is Private Equity? A comparison

PRIVATE EQUITY LISTED EQUITY

• Low liquidity • Strong liquidity

• Long investment horizon • Short or long term

• High active involvement • Little active involvement

• Low market efficiency • Higher market efficiency

• No published information • Published information

• Low regulatory oversight • Highly regulated

 Stages of Funding

Seed Early Expansion Late

Certainty of cash flows

Consol
Nandos
Glass

Debt

Private Equity
Venture Capital

Angel Investor

Business Maturity
Why Do Companies Seek PE Funding?

Increase
Working PE vs. Debt Financing
Capital Base
• Not every business
suits debt funding
Buy Out
Shareholders Business • Balance of debt and
to Expansion &
Restructure THE SAME Development equity needed
Ownership & REASONS
LISTED • Experienced
Management COMPANIES
SEEK professionals
FUNDING
• Political / corporate
Connections
Develop New
Finance
Products in • GP’s have experience
Acquisitions
Order to
of Other in sector / stage of
Grow/Remain
Businesses
Competitive
business

Non Monetary Benefit

 Structure and roles of LPs and GPs

Individual Pension PE FoF

General Bank (limited
(limited Fund (limited (limited
partner partner)
Advisory partner) partner) partner)
Committee

Advisor PE FUND

Investment
Committee
Investment B Investment C
Investment A (Company)
(Company) (Company)
Commitments vs. Drawdowns

Investment Period Realisation Period

Understanding the J-curve

Cash flow J-curve

80
60
40
20
-
-20 1 2 3 4 5 6 7 8 9 10 11

-40
-60
-80

Drawdowns Distributions Cumulative cash flow

Returns J-Curve
100%

80%
7%
60%

Fee % of draw downs

40%

20% 2%
Return

0%

-20% 1 2 3 4 5 6 7 8 9 10
-3%
-40%

-60%

-80% -8%

Return Fee % of Drawn capital

Where Does a Company’s Value Come From?

Financial Performance Company Valuation

Sales 100 EBITDA 15
Cost of sales (60) EBITDA Multiple X6
Gross profit 40 Enterprise value 90
Overheads (25)
Operating profit (EBITDA) 15
Where Does the Value Go?

Enterprise
Debt Equity
Value

Low debt (leverage) Higher debt (leverage)

Debt 10 10 0% Debt 50 50 0%
Equity 80 90 13% Equity 40 50 25%

Enterprise Value 90 100 11% Enterprise Value 90 100 11%

Debt and Equity Risk and Return

Return Risk
Debt Return limited to interest rate Low risk
All equity must be eroded before any
loss for debt
Equity Unlimited upside More risky than debt
Takes the first losses of value
The more debt there is, the more risky
the equity

• As long as returns on debt taken on exceed the interest rate on the debt,
equity returns are enhanced
• But there are limits – ratio of Debt : EBITDA is common (2-3 times is normal)
Fee Structure

Single Fund Fund of Funds

Advisory fee – an annual payment is made by

the fund to the Advisor to cover the costs of the
2% advisory fee 1% advisory fee private equity firm's investment operations (the
fee is typically 1% to 2.5% of the aggregate
committed capital of the fund)

A participation in A participation in Gains and surpluses – a participation in the

gains and surpluses of the fund (typically up to
the gains and the gains and 20%) is paid to the General Partner or Trustee as
a performance return. The remaining 80% of the
surpluses up to surpluses up to gains and surpluses is paid to the investors pro
20% 10% rata to their capital

Hurdle rate or preferred return – a minimum rate of return

(normally 8% to 12%) earned by investors on their committed
capital must be achieved before the General Partner or Trustee
can receive its participation in the gains and surpluses
SA Private Equity has Outperformed

SA private equity has largely SWIX tests market cap vs.

FINDI tests resources bias
outperformed the major tradability bias - less than 10
of JSE
listed indices years old

Source: RisCura Fundamentals SA Private Equity Performance Report

Vintage Year Performance

Older vintages have Newer vintages are largely All vintages show positive
performed better unrealised returns

Source: RisCura Fundamentals SA Private Equity Performance Report

What Are the Risks of Private Equity?

Lightly
Regulated

Conflicts of
Liquidity
Interest

RISKS

Valuation Concentration
Ways to Invest in Private Equity

INSTITUTIONAL INVESTOR

PE FUND PORTFOLIO OF FUNDS

1 company PE FUND PE FUND PE FUND

8-10 companies

PE FUND PE FUND PE FUND

80-120 companies
Building a Private Equity Portfolio

Risk & Complexity

Portfolio of Funds Direct (PE Fund) Co-Investment

Diversified portfolio of Interests in funds with direct Investing directly into a

interests control over portfolio co. private company

Lowest level of due diligence

Lower level of due diligence Greater Skill set required
required

Additional layer of fees Manager Selection Knowledge of local market

Specific industry expertise

Access through relationships
and networks

Exposure
Asset Allocation Decision

IS PE THE RIGHT ASSET

CLASS FOR YOU?

• Historic performance

• Risks may impact returns

• Micro/macroeconomic

• Regulation

• Diversification benefits

• Developmental impact
Why Do Pension Funds Invest in PE?

“Long-term savings vehicles, such as pension funds, are uniquely positioned to manage the
long investment term and limited liquidity of private equity investment to capture what
appears to be a significant performance premium and diversification benefits.”
- “Is Private Equity a suitable investment for South African Pension Funds?”
released at the Convention of the Actuarial Society of South African in October 2006

PORTFOLIO OPTIMISATION DEVELOPMENTAL VEHICLE

• Performance premium to listed equity • Facilitation ownership by company staff

• Low correlation to listed equity (although • Provides finance and expertise to
becoming more correlated) unlisted companies
• Exposure to small and medium sized • Improves governance
companies
Many Other Benefits to Private Equity

Efficient Markets
Concept

Alignment of
Bridges the Gap
Incentives &
Between
Risk: PE Fund
Medium-sized
Managers
Companies &
Rewarded After
the Listed
Investors
Market
Realise Return

ECONOMIC
BENEFITS

’Corporatise’
Management & A Source of
Enhance Growth for
Corporate Listed Markets
Governance
Benefits of
Active
Management
Maximise Value
& Correct
Performance
What is Happening in Developed Markets?

LARGE US PENSION FUNDS’ ALLOCATIONS TO PE

How to Manage Risk as an Investor into PE

1ST ASSET ALLOCATION DECISION 2ND MANAGER SELECTION DECISION

• Should an allocation be made to PE? • Has the manager run a previous

• Historic performance successful fund?
• Risk • Manager reputation
• Regulation • Manager network
• Diversification • Risk management processes
• Geography
• Local
• Regional
• Global

3RD FUND SELECTION 4TH ONGOING MONITORING

• What is the fund going to invest in? • Performance analysis

• Legal & tax structuring • Independent valuation
• Fee structure – alignment of interests • Regular interaction with managers
• Quality of advisors
• Reporting requirements
• Mandate fit
• Who are the other investors?
• Essentially a due diligence process
Thank you
About RisCura Fundamentals

The leading provider of independent

PROJECTS COVERING MANY
valuation, risk and performance analysis AFRICAN COUNTRIES
services to investors in unlisted instruments in
Africa.
We work in partnership with our clients to
deliver the transparency and accountability
that increasingly is demanded by investors.
Our clients include private equity funds,
pension funds, credit funds, banks and
other investors in Africa, and cover industries
as diverse as agriculture, retail, manufacturing
and the extractive industries.
Email [email protected]
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