Gandy Gandidzanwa and Itai Mukadira
A huge, game-changing, opportunity seems to have remained hidden in plain sight for many in the pension fund industry. Even recent regulatory changes shining the spotlight on this opportunity does not seem to have helped that much to open the eyes of many. Not only is this such a big loss to the industry, it also remains such an ignored potential trigger for kick-starting the turning around efforts towards the fortunes of our economy.
At about US$1.8 billion in total assets as of December 2021, the pension fund industry commands a significant share of the total asset stock of the capital markets. This is equivalent to about a quarter of the total market capitalisation of the Zimbabwe Stock Exchange.
The latest regulatory provision has now been expanded to a maximum allowable limit to unquoted shares of 15%, up from 10%. While this is still much lower compared to allowable limits in other jurisdictions, it is a respectable stride in the right direction. This now means that, of the US$1.8 billion of available capital, up to US$270 million could be allocated to private equity investments. Furthermore, on reading the regulatory provision closely, one could argue that, taking advantage of the “Other” allowable allocation at 5%, a further US$90 million could be allocated to private equity investments without breaching the regulatory provisions. Of course, this remains to be tested with the regulator, but there does not seem to be anything in the guideline that seems to suggest that the regulator would frown at it. That brings the total allowable allocation to private investments to just over a third of a billion dollars, US$360 million.
Under-Developed Market
Currently though, the total private equity allocation of pension funds is sitting at only US$10 million – a far outcry of the maximum allowable limits. That then begs the question, why has the industry not taken advantage of the allowable limits. That the direct allowable limits have just been recently expanded does not sound like the reason why. Even before the latest amendments, pension funds who wished, could still have been able to invest up to 20% of their total assets in private investments if they were to combine the 10% direct allowable allocation plus converting, using the same arguments as highlighted above, the 10% allocation to “Other” that was provided for in the old set of the guidelines.
In the absence of clear reasons as to why pension funds have not meaningfully allocated to private equity investments, one can only speculate that it is because the private investments space has remained quite under-developed. But then, is it not the role of the industry to develop capital markets? Or is the pension fund industry waiting for the private equity markets to develop before trustees can start allocating to it – sounds a bit like a chicken and egg question, doesn’t it?
That there are currently only about five private equity fund managers speaks of a sector that is in serious need of development. How then do the trustees, as asset owners and capital allocators, contribute to the growth of the sector? Important to mention that it is in the best interests of pension funds that this sector develops. It has been proven that, where it is properly developed and organized, not only is it an important asset class for return enhancements, but a significant diversifier too. At an economy level, private equity investments are considered investments into the real economy with immense potential for job creation, poverty alleviation, GDP growth boosting, equitable income distribution, unemployment reduction, creation of a more equal society, and the list goes on.
Not All That Glitters Is a Gem
Trustees need to be properly empowered though if they are to start giving this asset class the attention it deserves. Private equity investing is like picking diamonds from the rough – not all that glitters is a gem. Many an investor have had their fingers severely burnt after mistakenly taking every shiny project for the next vault of precious jewels.
While the regulatory provisions to unquoted shares alone are enough grounds for this discussion, the introduction of the prescribed assets status regime even compounds it further. Most trustees have been found ill-prepared and under-equipped to comprehensively evaluate all the different opportunities that are being presented to them with a prescribed-assets status. Finding themselves in such a situation, most trustees have been wise enough though to exercise maximum caution. With pressure to comply with prescribed assets requirements mounting, we know trustees will not be able to hold on forever and will inevitably start to make some of the worst likely mistakes. Out of desperation, they will, eventually, start to blindly allocate to any of the prescribed-assets-status investments that come their way- with no proper, comprehensive, and robust due diligence of their own. It would be wrong if anyone were to do it with their own personal money, it would be tantamount to negligence of the highest order if trustees were to start doing it with their members’ monies.
Complex, Involving, and Demanding Process
So, what exactly do trustees need to focus on once they have decided on an allocation to the private equity asset class?
First, and very importantly so, the fundamental decision trustees need to make right at the outset is that they shall never invest directly into any private equity investment opportunity that gets presented to them. But instead, that they shall only invest via private equity funds, or better still, funds of private equity funds. Admittedly, a bit of a hard stance to take, but one that is necessary.
Even with that said, private equity funds due diligence analysis per se is a complex, involving, and demanding process, and is not for everyone. It is especially the absence of a stock-exchange-type listing requirements and scrutiny, as well as ongoing regulatory monitoring of the underlying portfolio companies that makes it such a risky and onerous endeavour. However, with a proper, well-structured, and guided approach, trustees can become familiar with the ropes of the trade to a point where they can ultimately allocate to this asset class with comfort and confidence.
There are about seven key areas that trustees need to focus on when conducting due diligence exercises on any private equity funds. As with anything-investments though, the real value of the analysis is from focusing on nuances of the details.
Unlike with the listed equities space, the quantitative side of due diligence of private equity funds and in-depth analysis of track records is challenging due to many reasons. That then leaves trustees with only mostly the qualitative aspects to base their analysis and decisions on.
The Firm
Picking stocks on a stock exchange is difficult, picking portfolio companies in the private equity space is not only difficult, but pregnant with potential for real “ground zero” losses. A whole investment can be completely wiped away with no recourse for investors. It then matters how the private equity firm is structured, organized, and managed. While every firm can lay a claim to a vision, mission, and plan – it is the execution thereof that really matters the most.
Private equity fund management is a technically and intellectually challenging environment demanding critical thinking and risk assessment acumen in addition to people, marketing, financial management, technological, legal, corporate finance, business development, and many other skills. Skills that certainly cannot all be endowed in one or two individuals only.
It is then critical that the private equity firm is designed, organizationally, with a clear structure that pays serious attention to, and respects, the firm’s demands for all the different skillsets required for success. Attorneys, accountants, corporate financiers, deal originators, turn-around strategists, investment analysts, marketers, operations experts, information technologists, and other such specialists should all form part of the different specialist divisions and units found within the structures of a private equity fund manager.
The Fund
The fund is not the firm, and the firm is not the fund. That distinction always needs to be very clear in the minds of trustees. That a firm has run previous funds successfully does not, in and of itself, mean that they will successfully run the next fund too. Each fund should be looked at on the basis of its own merits. Even more still, that a firm comes along with a dominant brand does not automatically translate into potential for running a successful private equity fund.
Who the fund is designed for is a question that should come up early in the discussions. That then informs matters to do with the legal structure, fee structure, fund term, follow-on period, extension period, sector focus, waterfall provisions, claw-back provisions, co-investments, side-letters, alignment of interests, mandate fit, and other such issues of the fund.
The ESG consciousness of the fund is currently one other key element that trustees are naturally now expected to also assess and be happy with about a fund.
Investment Team
Private equity fund management is a team pursuit. As mentioned, by design, private equity fund management requires such a varied array of specialist skills, expertise, and talents that no one individual on their own can claim to have them all. It then matters who the people behind the fund are – in terms of their track record, their expertise, their experience, and their talents. The credentials and qualities of a private equity fund resides in its team. Where a whole team has left a firm, the previous track of that firm will not matter that much anymore on its next fund, but it will for the new firm that the previous team goes on to join or form.
Not only does it matter to know that past performance does not matter where the team has been replaced, it also matters to know there are not likely to be any key person departures from the firm during the tenure of the fund. While there might not be any assurances possible, trustees should convince themselves that the team is one with a common and shared vision, set of values, goals, and remains focused on what they set for themselves to achieve together. A well-articulated succession planning should also be an area of interest for trustees as part of the due diligence process.
Investment Strategy
Not all strategies are created equal. Trustees need to understand and appreciate the opportunities that the fund is aiming to explore and how it plans to deploy capital into those opportunities in a profitable way.
Issues around strategic, sector, industry, and regional focus, investment stage, transaction size, holding periods, and whether it is a specialist or general fund should all be considered as part of the due diligence process. Equally, clarity on investments that are totally excluded is just as important.
Diversification remains the only free lunch available in investments. The extent to which the strategy intentionally blends different portfolio companies with different profiles ultimately plays a pivotal role in the fund’s overall risk management approach.
Once the strategy is clear, the next natural question would be whether the firm, with the current team, can successfully invest in the planned strategy. Specific attention should be given to interrogating the firm’s self-proclaimed edge in executing the strategy.
While somehow an organisational aspect too, the firm’s preference for being a control, minority, joint, or sole investor is also a big part of the overall strategy. Similarly, trustees need to be taken into confidence on the firm’s typical methods to create value in its portfolio companies – be it by restructuring, strategic re-positioning, leveraging, operational improvements, or any other.
Investment Process
How deals are sourced is just as important as how they are executed once they are secured. Value creation for investors starts with having access to a rich pool of potential deals that the firm could invest in. So, how the firm sources deals, its competitive edge, and its deal funneling process of filtering through different deals and nailing down its investible universe are key determinants of success or otherwise. Firms’ proprietary networks play a significant role in distinguishing star players from average performers.
Investment management is risk management, else it’s gambling. The firm’s screening, due diligence, and risk management processes prior to acquiring an investment, to protect against fraud, corruption or more general risks of a fund are critical in determining the quality of the end opportunities that the firm pursues.
Market Environment
This, for many, would probably remain the elephant in the room. However, trustees need to remind themselves that they are long term investors. Besides, even though certain economic conditions might have proven sustaining over fairly extended periods of time, there are still strategies that have proven viable under very difficult conditions at times.
There are sectors of the economy that have shown remarkable resilience. The sectors the fund manager chooses to invest in can turn out to be the biggest contributors to the fund’s fortunes. A second quartile fund manager in a really well performing sector can easily produce performance that is superior to that of a top quartile fund in a poorly performing sector.
Exit Routes
Most of us with curious minds always walk past a building with an entrance notice that reads, “Right of Admission Reserved”, wondering what exactly goes on inside there. Those of us with even more curious minds and extreme imaginations have been left wondering, what if it was, “Right of Exiting Reserved”, instead. Such is the reality of private equity investing though – you may enter freely, but your exiting might require some very tough and serious negotiating. This happens at both an investor level with respect to the fund, as well as at a fund level with respect to the portfolio company.
There are a variety of ways that a fund manager, and by extension investors, can exit investments in their portfolio companies. Each one has its own pros and cons. Trustees need to properly understand and be convinced that the fund manager would be able to exit the portfolio companies when the term of the fund comes to an end. A private equity investment is a fixed term investment – ability to exit is a fundamental consideration on assessing the attractiveness of a fund.
Conclusion
No doubt, it is near impossible to do proper justice to this especially important topic in just one piece. A second go on it is definitely required. In the meantime, however, emphasis need to be made that this is an asset class that trustees need to be looking at a lot more closely, albeit with caution. On the part of the industry, we need those among us with the expertise to set up more private equity funds. For completeness, we also need to set up funds of private equity funds to do all the heavy lifting required of thoroughly researching the different private equity fund managers once they start sprouting out in large numbers in response to all the regulatory provisions that are now clearly very favourable to their viability.