Value creation strategy of private equity funds – opportunists or corporate marauders?

October 2017 | EXPERT BRIEFING | PRIVATE EQUITY

financierworldwide.com

In the last decade, the growth of private equity funds (PEF) in Africa has been phenomenal. According to a 2015 study by the African Private Equity and Venture Capital Association (AVCA), South Africa and Nigeria remain at the forefront of sub-Saharan African fundraising and investment for PE. Between 2007 and 2015, 311 private equity deals were reported in West Africa, totalling around $6.1bn investments. Notably, Nigeria accounted for 67 percent of deal value – over $4bn – in this period.

How private equity firms operates

The PEFs’ structure involves a general partner (GP) and limited partners (LPs). The GP generally manages the fund, makes investment decisions and employs the fund’s personnel. The GP, with the assistance of the investment managers, seeks out viable investments, raises funds from investors, and manages the PEFs’ investments until they exit their portfolio companies (PCs). The LPs, on the other hand, comprise of accredited investors – institutional investors, pension funds, banks, high net worth individuals and insurance funds, among others, who provide investment funds. The LPs, in addition to providing the necessary funds, also provide governance oversight and monitoring functions to ensure that PEFs and PCs are adequately managed.

For managing the fund, the GPs are paid different fees. Firstly, a 2 percent management fee from the committed capital, the called capital or the total invested capital in deal assets, including borrowed money. Additionally, GPs are also paid a performance fee (carried interest), usually 20 percent of capital profit generated by deals once the investors reach a certain hurdle amount, as agreed in the limited partnership agreement (LPA). The hurdle rate, typical between 6 percent or 8 percent per annum, is a predetermined measure of performance that LPs are expecting to receive from their investment.

Furthermore, LPAs usually include provisions that enable GPs to charge ancillary fees for services provided to PCs. These fees are often charged to the PCs rather than directly to the LPs. They may include fees for arranging acquisitions and divestitures of assets, monitoring PCs and attending board meetings and arranging financing, among others.

Value creation v. asset stripping

There are two schools of thought on PEFs: those who believe that PEFs represent value creation for PCs and those who think PEFs are about asset stripping. The value creation school of thought believes that PEFs refocus ailing PCs and strategically position them in the league of stable companies capable of contributing to the economy. While to the asset strippers, PEFs are essentially about profiteering; their interest is basically about what they can get out of an investment and how they can further the interest of their investors.

The asset stripping argument of the sceptics appears untenable. Granted, PEFs’ investment model sometimes entails disposing of PCs’ assets, but the question is whether they dispose of valuable assets to weaken the main business. Since PEFs divest into a free market, they are incentivised to ensure that the assets are as valuable as possible in order to make profit. Strategically speaking, if the assets are valuable then undertaking an asset disposal would be in tandem with PEFs’ economic objective and profitability. In addition, undertaking an asset disposal to a strategic buyer would prevent massive job losses that could arise from failed companies.

The asset stripping argument is a win-win approach to both PCs and PEFs. A prospective acquirer will only acquire the PC if there is a growth prospect, and PEFs would not generate a profit unless they dispose of assets at a premium. To divest at a premium, PEFs are duty bound – at least in the interest of its investors – to ensure proper management of the asset to make it attractive to an acquirer. This ‘asset stripping’ strategy of PEFs is indicative that PEFs, in as much as they are structured for profit, take steps to ensure value creation in order to generate profit. This structure is mutually inclusive.

To further portray PEFs’ responsible investing strategy and value creation mindset, its sponsors take skin in the game in every investment. For optimality, PEFs’ sponsors are contractually bound, via the LPA or the shareholders’ agreement of the PEFs’ vehicle (where the PEF is a company), to invest in the same, alongside the LPs. This alignment incentivises the sponsors to make result oriented decisions that will further the overall interest of PCs. PEFs – sponsors and investors alike – invest huge amounts into PCs to recapitalise and restructure them for a rewarding and profitable future. The investment and management, in most cases, ensures unparalleled growth and development in PCs.

An illustration of two cases will depict the economic impact of PEFs.

Jumia commenced operations in Nigeria as Kasuwa in May 2012. Like every Nigerian start-up, it battled with the difficulty of operating an e-commerce business under harsh economic conditions. At inception, it operated with only three members of staff. In June 2012, it was spotted by Rocket Internet, a global start-up incubator, which invested a huge sum in the company. This union created Jumia.com.ng. Currently, Jumia is arguably Nigeria’s largest e-commerce platform with an estimated turnover of about $600m annually. According to Alexa.com, Jumia’s growth has translated to 100,000 daily site visits, a social media community of over 450,000 people, growing staff strength of 300 people and partnerships with various foreign companies.

Another example is AfricInvest Capital’s investment in Mansard Insurance (MI) through its AfricInvest Fund I in 2006 and AfricInvest’s Fund II in 2011. These investments transformed MI into one of the strongest and most profitable insurance companies in Nigeria. The investment and eventual turnaround of MI made it an attractive proposition for French multinational insurance firm AXA Group, which acquired MI’s majority stake in 2014 for approximately £198m, culminating in the firm becoming AXA Mansard Insurance.

To be or not to be

PEFs have enormous economic impacts in PCs. PEFs create value through reshuffling the management team of companies. Arguably, the era when PEFs were associated with mere financial engineering is gone. PEFs now create value through underlying business and operational improvements. PEFs routinely replace incompetent managers with top, strong, highly motivated executive or management teams that embrace the need for corporate rejuvenation, while being capable and qualified to undertake a corporate turnaround of the business. The competence and managerial skills of the new team are typically rewarded with financial incentives.

Management turnaround teams employ professionals within the industry, competing company, or from strategic and operations-focused consulting firms. They can also be serial entrepreneurs who have expertise in management and corporate turnaround. Regardless of their previous industry experience, one theme that remains clear is that the team is focused on creating value for the PC.

Change of management team when the PC is underperforming (and at immediate risk of a financial crisis) is an excellent financial control mechanism that has the potential to enhance PCs’ performance basics, including, revenue, operating margins and cash flow. This turnaround mechanism protects PCs from bankruptcy, ensures their stability and prevents the huge negative economic impact that a possible PCs’ failure may cause.

Conclusion

The combination of sponsor’s alignment, investment monitoring, major funding, expertise and incentives are excellent strategies to revive any company and make it a going concern. Certainly, there is a need for Nigerian legislators to enact laws that will create an enabling environment for PEFs to thrive in order to create a more positive impact in the economy. Granted, there are already laws that regulate PEF activities, but more needs to be done to encourage PEFs to thrive and also, to protect portfolio companies against the unethical and irresponsible investment practices of some PEFs.

Tochukwu Chikwendu is an associate at Jackson, Etti and Edu. He can be contacted on +234 8 060 744 004 or by email: tochukwuchikwendu@jacksonettiandedu.com.

Tochukwu Chikwendu

Jackson, Etti and Edu