6.4 Major Product Segments
6.4.4 Venture Capital (VC) And Private Equity (PE)
Page | 137 Figure 6.16: Evolution of AuM of Hedge Funds in South Africa
Source: Adopted from Novare Investment, cited in PwC (2015: 24)
Page | 138 instruments. The venture capitalist takes a significant control of the decision-making process and also a significant portion of ownership in exchange for taking on the high risk of investing in a less mature and smaller company.
General George Doriot is credited with creating in 1946, the first institutional venture capital fund, regularising the establishment and helping shape companies into organised business and in the process, setting a standard for the VC industry (Doriot and Gupta, 2004, Ante, 2008, Mason, 2012). However, in a Securities and Exchange Commission (SEC) speech titled The Future of Securities Regulations, the general counsel of the SEC Brian Cartwright (2007) pointed out that, venture capital funds “came into their own” in the 1960s when the pivotal funding of Fairchild Semiconductor funded by Venrock Associates in 1959 to develop the first practical and commercially viable integrated circuit. Laurence S. Rockefeller, the fourth of the six children of John D. Rockefeller, founded Venrock in 1969 as a means to permit the other children of Rockefeller to gain exposure to the investments of venture capital (Singh, 2009).
Venrock concentrates its investments on start-up and early-stage companies in emerging technologies and information technology. These include: Intel, Apple, StrataCom, DoubleClick, 3Com Corporation, etc. and also has a major venture in the field of nascent nanotechnology, providing the initial funding of Nanosys and the nanotechnology division of Du Pont (Feder, 2004).
By June 2015, the private capital AUM of the PE industry reached $4.2 trillion (Preqin, 2016).
VC and PE managers (general partners, or GPs) operate in a similar manner by raising investor capital from investors who are classified as limited partners (LPs) to acquire, optimize, and eventually sell the acquired companies to make profits. LPs commit the bulk of the capital of a fund. GPs also commit around 1%–5% of the capital of the fund with the objective of aligning the interests of the GP with those of the LP. The lifespan of majority of PE funds is approximately 7–10 years which may be subject to extension, with the first few years spent in acquiring 10 or more target companies with a potential to grow. Unlike most asset managers who trade in public securities, PE and VC funds often adopt a hands-on approach to the companies in their portfolios. They apply a combination of financial engineering, placing their own board and executive members and make significant contributions in the development of the business strategy of the firms in their portfolio. The final stage, which is also known as the
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“exit” or “harvesting” phase, occurs when the fund proceeds to profitably dispose of its portfolio of firms through an IPO, a sale to another PE fund or a private sale to a competitor (“strategic buyer”). Table 6.3 shows the top PE managers as at March 2014.
Table 6.3: Largest PE Managers, Five-Year Fundraising Totals as of March 2014 ($ bn)
Source: Growth Business, “Ten Biggest Private Equity Firms in the World”, (May 2014) http://www.growthbusiness.co.uk/banking-on-the-cloud-and-saas-rise-in-europe-2401382/
• The Private Equity and Venture Capital Industry in South Africa
According to a KPMG and SAVCA (2015) survey, the private equity industry of South Africa had R171.1 billion in funds under management as at December 2014. This figure includes of undrawn commitments of R54.9 billion. This reflects a R1.8 billion increase from R169.3 billion as at 31 December 2013 with a 11.3% compounded annual growth rate of funds under management which excludes undrawn commitments since the survey began in 1999.
The South African PE industry is relatively small when compared to that of the United States and United Kingdom, however, it is locally significant and well established. The KPMG and SAVCA (2015) report that South Africa has an investment activity as a percentage of GDP 0.21 % in 2014 and 0.17 in 2013. The calculation is only in relation to the annual investments by Independents so as to make a direct comparison with the Emerging Markets Private Equity Association information. As a percentage of GDP, South Africa’s PE investment is higher than
Page | 140 China (0.15), India (0.19%), Brazil (0.12%) and Russia (0.01%). It is still however below that of the United States (1.23), the United Kingdom (0.81%) and Israel (1.64%).
Figure 6.17: Total funds under management at year end, split by undrawn commitments and investments (Rbn)
Source: KPMG and SAVCA (2015: 20)
Figure 6.18: Private Equity annual investment by independents as a percentage of GDP (2013 and 2014)
Source: KPMG and SAVCA (2015: 25)
In 2014, 25.5% of investments made were in the infrastructure sector, 24.7% and 18.2% in the other sector and in the Banks, financial services and insurance sectors respectively. Figure 6.19 presents investments in the various sectors in 2014.
Page | 141 Figure 6.19: Investments made during the year, analysed by sector (2013 and 2014)
Source: KPMG and SAVCA (2015: 35)
PE firms raise revenues through various means:
• Management fees
PE firms charge AUM-based fees that is between 1% and 2% calculated on the committed capital which sometimes may step down a number of years into the period of investment of a fund or, calculated based on the net invested capital.
• Investment income:
These are the gains that are generated on capital contributed by the GP to the fund.
• Transaction and monitoring fees
Fees paid to the GP by the companies in the portfolio for the various structuring and corporate services. In most cases, a percentage of this fee goes to the LPs as an offset to management fees.
• Incentive Fees (Carried interest)
This represents the share of the GP’s gains which is usually 20%, on the sales of portfolio companies. Distribution of the proceeds from the sales is subject to certain “distribution waterfall” terms. In a European-style distribution waterfall, the GPs receive their fees only after the LPs have received distributions that is equivalent to their committed capital in addition to a hurdle or preferred return that is usually between 5%–8%. In some instances, a GP “catch-
Page | 142 up” may where as long as the GP provides the LP with the preferred return, the GP claims all the profits or a majority of the profits up until the profit split which was agreed upon, as prescribed by the carried interest is reached. After the payment of the preferred return to LPs as well as the GP catch-up, the remaining distribution follows the normal split of 80/20 carried interest allocation. In some distribution waterfall structures where the calculation of carried interest is on a deal-by-deal basis, it is necessary to take into consideration the scenario where there will be a “clawback” clause in the case of a negative performance by the fund.