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Analysis > Analysis and Strategy

Global shift to private markets and the role of fund of funds as efficient allocators in Africa

Rory Ord, Head of Unlisted Investments, 27four Investment Managers
July 25, 2019, 10:51 p.m.

Word count: 1215

The good news for private equity fund managers in recent years has been the marked shift in global institutional investment towards private markets investments. According to Blackrock, one of the world’s largest asset managers, the largest pension fund markets have increased their exposure to alternatives from 4% to 25% over the past 20 years. This has included private credit, infrastructure, unlisted real estate, and a host of more niche strategies, and has led to a dramatic increase in fund sizes and capital available for investment in unlisted investments globally. It has also shifted the balance of power from LPs to established GPs, who have had more than enough interest in their funds to pick and choose their LPs. In certain instances this has even led to enhanced economics for the GPs, as LPs have agreed to skewed terms just to gain access to top rated funds. In a few instances, we have heard of the emergence of 3 and 30 fees arrangements being agreed.

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The good news for private equity fund managers in recent years has been the marked shift in global institutional investment towards private markets investments. According to Blackrock, one of the world’s largest asset managers, the largest pension fund markets have increased their exposure to alternatives from 4% to 25% over the past 20 years. This has included private credit, infrastructure, unlisted real estate, and a host of more niche strategies, and has led to a dramatic increase in fund sizes and capital available for investment in unlisted investments globally. It has also shifted the balance of power from LPs to established GPs, who have had more than enough interest in their funds to pick and choose their LPs. In certain instances this has even led to enhanced economics for the GPs, as LPs have agreed to skewed terms just to gain access to top rated funds. In a few instances, we have heard of the emergence of 3 and 30 fees arrangements being agreed.

This shift at a global level has come on the back of the search for yield, and lower public market return expectations and continued liquidity, as well as sustained low interest rates. For institutional investors who have gained confidence in the ability of private equity to deliver outsize returns from the last decade of extraordinary performance, increased allocations to developed market private equity has been an easy choice.

Global fund of funds have also grown massively over this period, as institutions have used them as an easy allocation channel to the best global funds. Funds of funds have also used this period of growth to scale and expand their operations to bring down average costs. Most have expanded their co-investment capability and have increased the proportions of their funds that are made up of co-investments.

Shifting tide

This global shift, however, is yet to be felt in Africa, even in South Africa’s more established PE market. The poor economic environment of the past several years has led local investors to maximize their offshore allocations, and be wary about additional local exposure through private equity. South Africa’s share of global private equity fundraising has halved over the past five years as global allocations have ramped up and South African fundraising has stayed static. If South Africa has kept up with global allocations, an additional $1bn would have been committed to SA last year.

However, the tide is shifting. Local listed equity markets have stalled, and most analysts expect below average returns in the coming years. This, combined with several scandals involving listed companies, is creating some investor appetite for alternatives. Among South Africa’s largest institutional investors, private equity has been part of the mix for some time, but outside of the ten largest investors, the remaining 2,000 retirement funds have little or no exposure to private markets.

The reasons for this are mostly practical rather than ideological. Smaller pension funds have smaller potential allocations to private equity, and most often do not have the resources or specialist skills to interview and differentiate between the many private equity funds in the market. Consultants are also not adequately incentivised to undertake these resource intensive processes for smaller parts of the overall pension fund portfolio. A common refrain from pension fund trustees and consultants is that investing directly into PE funds can absorb 80% of the time for 5% of the portfolio.

With around 130 PE fund managers in South Africa, and another 100+ in the rest of Africa, entering the space is intimidating and costly for almost any institutional investor.

In other asset classes this is well addressed by a good consultant, but they typically do not have unlisted fund selection specialists, and rely on their generalist fund research teams. As a result they often make mistakes in allocation, or fail to contract against certain unfavourable outcomes. This is in the name of keeping costs down, but often results in less than ideal investment outcomes, more than wiping out any cost saving. In addition, consultants are not aligned to their clients in terms of investment outcomes in unlisteds, where returns take time to crystallise. Unlike in other asset classes where success or failure is judged quickly (and within a consultant’s tenure with a pension fund), private equity returns evolve over a 10 year period, by which time a new consultant may be in place.

Similarly, for global investors looking at South Africa or the continent as a whole, looking at individual managers outside of the pan-African mega funds is simply not worth their time, even where strong returns are on offer. Any allocation to African PE from a global investor will be a fraction of 1% of their portfolio, meaning that their consultants will not want to dedicate time to it, and the necessary due diligence and time with teams to make an investment decision simply cannot happen.

In addition, private equity funds have a much wider dispersion of returns than listed funds. Private equity fund managers have a much larger universe of companies to choose from than listed managers, and choose highly concentrated portfolios of 5-12 companies. This means that there is little commonality between different PE funds, and results in top quartile funds returning IRRs in excess of 20% over their life, while bottom quartile funds struggle to preserve capital invested. This is compared to listed equity where funds are largely benchmark cognizant, and take relatively small over or underweight positions relative to the benchmark.

In most other asset classes, the asset class allocation alone is easily the biggest driver of returns, but in private equity, as a result of the high dispersion of returns, fund selection is absolutely critical and plays an outsize role in the results of the allocation.

A role to play

For these very practical reasons, funds of PE funds in South Africa and Africa as whole have a key role to play as skilled allocators on behalf of institutions to facilitate more capital into this space. Fund of funds must bridge the gap between institutions which would like exposure to private equity, but do not have the skills or resources to do it in a way that makes practical sense, and not overburden the governance budget of the retirement fund.

The challenge for funds of funds is therefore to cost-effectively solve the issues highlighted above for institutional investors. Funds of funds must put teams of specialists in place and continuously assess the market conditions and filter opportunities on behalf of their clients. Once commitments to underlying funds are made, these funds must be continuously monitored to ensure that the fund managers invest according to their respective mandates, that governance is properly applied, and that the terms of the partnership agreements are properly applied.

This is easier said than done. Each set of partnership agreements differs, and sets different expectations of the parties and different shares of economics and other terms. When this is done well, institutional investors gain access to a widely diversified portfolio of unlisted companies through specialist managers, with exposures to a variety of growth drivers across the portfolio, without having to allocate their own or their consultant’s resources. It also enables relatively small amounts of capital to be deployed into private equity in a responsible and diversified way.

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