SUCCEED MAGAZINE - FEBRUARY 2008

Private Equity Allows Ownership by Management

The private equity market is no longer just the playground of billion-dollar institutions. Outside the listed sector, the biggest drivers are senior managers keen to acquire a piece of the mid-size businesses for which they are working. This is achieved through private equity.

Although there are many ways of structuring private equity investment vehicles, there are two primary methods from which to choose. There is the fund method, where third-party investors invest in a fund that is managed by a dedicated manager. This is an exit-driven approach, because a return for the investors and fund manager is required.

The model that more readily allows ownership by senior managers is the investment company approach. “Our model does not require that we return our capital to shareholders by exiting investments,” says Kevin Homann, director of Spirit Capital, where this model is applied. “We will naturally return capital through dividends and every now and then sell something. If we are prepared to buy into a business, we should be prepared to hold it forever. We are trying to build up a portfolio of businesses that give us good earnings on an annual basis.”

Going this route means focusing on businesses that fall between the R20 million and R150 million revenue margins, which largely excludes the practice of identifying undervalued listed companies and delisting them. Although the public-to-private market offers some huge potential, there is also a need for investment in solid businesses that are family-owned or have private investors keen to exit.

Homann’s company investigates the businesses that show potential. If they like what they see, they leverage the business through bank debt, with the balance of the purchase price provided by an equity contribution by Spirit Capital and a co-investment by the management team. “We allocate the equity on a basis that works for the management team and ourselves. We effectively help them facilitate management buy-outs and expansion capital.”

Homann says that his company invests with management teams that are experienced, have good track records, and understand their business. He advises management teams to evaluate themselves along the same criteria when considering private equity. “If they feel they have the skills to run a business, grow it, and understand the industry in which they operate, then there is an opportunity for us to back them and for them to own material interest in the business that they manage.”

Private equity tends to have a dramatic effect on a company. Because the management is now growing its own wealth, it is an incentive to operate more effectively. This approach, with a greater focus on cash flow, growth, and strategic direction, is transferred throughout the business.

For private equity deals to realise their maximum potential, strong leadership in the management team is clearly a prerequisite. This is something that is rumoured to be in short supply in South Africa, and the world, for that matter. Homann insists, however, that the right people for the job are around. “We are involved in deals with good businesses, with strong leaders, and that is why those businesses are successful. There probably is a skills shortage and something of a leadership crisis, but that does not mean that there are no leaders around, it just means that there are less than there should be. People who have entrepreneurial flair and risk appetite will still take the risk and step up to a position where they can actually own their own destinies by having a share in the business. There are still lots of good people out there.”

Homann’s company occupies a special niche in the overall big picture of private equity, with some deals running into several billion rands. Many of these deals are funded by offshore capital and some institutions have even been accused of being loath to fund transactions of this magnitude. Homann does not believe this to be the case. “If you offer a good deal, you will get the funding locally. You may be able to source some cheaper capital offshore, but there certainly is an appetite locally for BEE funding and private equity deals. If you talk about a R10 million deal, that is massive. There may not be enough of a margin in the deal to be sharing it with lots of different parties. Generally, there is enough capital around to fund BEE parties for good deals.”

One of the necessary evils associated with private equity deals is the waiting game, especially in the listed sector. The regulatory structure demands a host of requirements to be fulfilled, including shareholder approval, competition commission approval, securing of court sanctions, debt funding, and often a negotiation period where the price has to be accepted by the shareholders. The period depends largely on the complexity of the deal. The smaller public-to-private deals could take three to four months, while the big ones take in excess of nine months.

The biggest criticism of private equity is that it is merely asset stripping by another name. Homann says that this is untrue. “What they are is financial engineering deals that have some clever financial structuring, which enables the private equity investor to get a good return. I do not think there are many deals where people are retrenched and assets stripped. They definitely try to dispose of non-core businesses ad refocus the core business area, and this is healthy.”

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