For private equity houses in SA, 2008 was a downright peculiar year reminiscent of Charles Dickens' famous phrase: "It was the best of times, it was the worst of times."
From the gloomy perspective of 2009, and even from the downbeat predictions made at the start of the year, it seemed unlikely that 2008 could possibly have been relatively good. But the private equity industry had a surprisingly strong year.
According to accounting firm KPMG's influential annual survey of the private equity (PE) industry, the total value of deals concluded in 2008 came in at R21,3bn - an 18% decline from the heady heights of 2007. Though the total value of deals dropped, this decline seems positively miraculous compared with the international industry, which simply fell off a cliff in 2008.
In fact, overall funds under management increased in 2008 quite substantially from R86,3bn to R103,1bn, KPMG has calculated. Though this is a surprising result, especially considering the sharp rise in funds under management in 2007 compared with 2006, it is partially explained by the sharply reduced number and value of disposals. In 2007, disposals came in at R10,5bn, compared with only R7,2bn in 2008, as private equity houses struggled to offload assets during the market decline.
Yet there were positives too, particularly in terms of funds raised, as some companies managed to complete their fund-raising just before the shutters came down in foreign markets. Total third party funds raised came in at R11,9bn, which is down from the R15bn raised in 2007 - but not by as much as most might have guessed at the start of 2008. The total number of deals was down too, but not by anything like the international figure. In 2007, a total of 834 deals were concluded, compared with 719 in 2008, KPMG's survey reveals.
The contrast between the situation in SA and the international scene was simply stunning. A paper produced by the Boston Consulting Group, written by Heino Meerkatt and Heinrich Liechtenstein, characterised the international industry as being in the middle of a "perfect storm". "From 2003 through 2007, nearly all private equity firms were able to grow exponentially, thanks to an unusually favourable financial and economic climate and in particular, four major drivers of growth: huge amounts of cheap debt, rising profitability across all industries, escalating asset prices and the allocation of significant assets from institutional investors to private equity," they said. But Boston Consulting concluded that the financial crisis "sent all these drivers racing rapidly in the opposite direction".
Most disturbingly, the study predicted that 20%-40% of private equity firms would disappear within the next two years.
"When we analysed the credit spreads of 328 private equity portfolio companies in November 2008, we found that roughly 60% of their debt was trading at distressed levels. At current levels, this suggests that almost 50% of these companies could default on their debt during the next three years," said Boston Consulting.
Total leveraged buyouts in 2008 in the US and the UK both dropped about 80%, the study found.
Warren Watkins, KPMG head of Private Equity Markets for Africa, says the difference between SA and many European markets was that in many developed markets the banks just closed. "They said that's it. But in SA, [banks] said they were looking for better coverage ratios."
Typically local banks would lend to private equity houses at three or four times Ebitda (earnings before interest, taxes, depreciation and amortisation), whereas during the boom times, they would do so at five or six times. "In many First-World countries, they went from eight times Ebitda right down to zero [last year]. But the banks weren't providing as much debt here," he says.
The stark difference between local and foreign markets led to an intense local debate about whether SA is simply behind the curve or would ultimately be less affected by the implosion of credit. "We are really going against the grain. Now the question is, are we just behind the curve, or are we on the curve?" says Southern African Venture Capital & Private Equity Association (Savca) executive officer JP Fourie.
The argument that SA is simply behind the curve and will ultimately be hit hard got some credence from the speed of the downturn during the second half of last year. "It really was a year of two halves," says Watkins. "In the second half of 2008, there was no doubt that SA was being sucked into the global gloom."
Fourie agrees: "In the second half of the year, there was greater difficulty in raising finance, more uncertainty about the market, and more uncertainty about future earnings. The result was a price expectation gap, where sellers still believe in yesterday's prices and the buyers generally want to factor more gloom and doom into the price."
Yet the fallout has fundamentally changed the lives and jobs of players in the industry. One of the biggest issues in the industry comes down to blind luck, and that has to do with the stage of the fund raising cycles that private equity houses find themselves in.
Several of the bigger players were clearly getting to the end of the road with their existing funds, and were looking to raise more. Yet, at least as far as foreign fund raising is concerned, the shutters of most institutions are effectively still closed. Though there is still some appetite for emerging markets, this is at a far lower level.
For others, whose fundraising cycle matched this particular downturn, their prospects (theoretically) are good as asset prices decline. Judging by the total third party funds raised during the year, a respectable number were able to get their funds built just in time.
KPMG's survey found that the value of third party funds raised almost halved, from R15,4bn in 2007 to R7,2bn in 2008. Yet this remains a substantial war chest for the few lucky ones able to get their fundraising done in time.
According to Ethos partner Cláudia Koch, one immediate effect of the financial crisis is that deals will get smaller. "Local banks don't have quite as much appetite. For the right deal, you could probably raise R2bn and then you would have to find about R2bn in equity to back that up [creating a R4bn deal]. We don't think too many of those deals will be done any more. The deals that will get done will probably be in the R2bn enterprise value range."
This makes the largest deal done in 2008 - the R5,16bn acquisition of electrical engineering group Alstom SA by Actis and Old Mutual - seem positively miraculous.
Notably, if there is a R2bn cap to any deal, this would exclude all the stocks in the JSE Top 40.
Conversely, one of the effects of a smaller average deal size may be a more competitive middle sector. Yet Dave Stadler, head of Nedbank Capital Private, which operates largely in this sector, says the possibility of increased competition needs to be balanced against another trend - an increased number of "club" deals in which funders team up.
"There are always enough opportunities to go around. There are new companies and delisting opportunities, so in general we don't find ourselves in a competitive position unless it is an auction process. A number of deals are likely to be done on a club basis, especially in the R1bn to R2bn range, where even the funds want to diversify their risk."
Stadler says another trend is likely to emerge - a new focus on particular sectors that might be more resilient to downturns. "With the bull run we have had in the SA economy, virtually every sector has had its own story to tell. And often we have made investments that are not flavour of the month, but they have [produced good returns]," he says.
Typically, private equity players would try to ride the investment through its growth period. But making investments in 2007 and 2008 meant investing in an expensive market. "It is imperative to pick good companies with growth potential over the period of the investment, in spite of the market," Stadler says.
With economic growth dropping, this wheel now turns, and private equity firms are now eyeing investments in sectors where growth is more likely. The infrastructure sector is the most obvious candidate, since many government infrastructure projects are still coming on-stream.
There will also be an obvious concentration on existing portfolios. Stadler says it will be critical to preserve and create value in those portfolios.
But there is also a negative side to that process - making sure that companies in the portfolio don't suddenly develop cash-flow problems, or breach covenants with their banks. If they can't meet repayments, these companies need to renegotiate terms with their debt providers.
Surprisingly, there have been no examples where these breaches of covenant have leaked onto the front pages of newspapers. Yet, there is no doubt that private equity players are girding their loins for such an occurrence - particularly since several have already been recorded in Europe and the US.
The flip side of the same problem is the possibility of investment partners, such as pension funds, not honouring their commitments to private equity funds.
Actis director John van Wyk says: "There are some big dynamics going on within [pension] funds. They typically allocate 5% to alternative investments, and that category has gone way out of kilter within their portfolios."
He says some pension funds have lost billions of dollars due to the falling equity markets, and they may not be able to honour their commitments to private equity.
Once again, no instance of an investor failing to honour its commitments has hit the headlines yet. But, this would be precisely the kind of thing all sides would want to keep as quite as possible. Hence, "pre-negotiation" in circumstances where there may be a danger of default has become critical.
All of these problems converge in a critical issue: how long and how deep will the downturn be?
Ethos' Koch says global players typically ask why SA is different. Her answer is this: First, SA's banks have held reasonably firm. The banks are rated highly overseas, and have a healthy loan-to-deposit ratio relative to global peers. The balance sheets of SA companies are also stronger on many metrics such as a high ratio of cash-to-assets. Prudent monetary policy management has also allowed for a normal interest rate cycle.
Second, the local private equity industry - if seen as a proportion of GDP and of mergers and acquisitions activity - remains below international levels, partly for legislative reasons.
Third, SA has clear, emerging market growth drivers, which will provide our economy with some resilience to the global crisis. "There is momentum in the growth of SA's black middle class, and though the higher interest rate cycle has dampened demand from this group, we don't believe the fundamentals have gone away," she says.
Fourth, SA is also changing from consumer-led to investment-led economic growth.
"The R787bn set aside in SA for public infrastructure projects over the next three years represents about 25% of GDP. Compare that with the announced infrastructure spend component in the US, which at US$78bn represents only 1% of US GDP."
Fifth, SA has a leadership position in Africa. As the continent begins to show some real change with enormous improvements in governance, the platform that SA offers as a continental springboard is becoming more attractive.
Says Koch: "In 2000, SA was the only country with a Fitch Sovereign credit rating in sub-Saharan Africa. In 2008 there were 18 countries with this rating." And interestingly, African economic growth has become more diversified, with resources representing less than 20% of GDP, and the biggest contributors to growth being telecoms and banking.
"We have found foreign partners listen much more attentively to the African story as an alternative growth destination."
It's a hard sell, but there is a convincing story to be told. Nonetheless, everything still ultimately depends on when the upturn will happen. Most pundits are looking for it in 2010 - but it's easy to see a scenario where this unfolds differently.
Research house Adveq has attempted to answer the question of how long the downturn is likely to last by analysing previous crises on a global scale.
For private equity, this analysis is particularly enlightening because it includes research about the provision of credit. Adveq found that house prices take the longest to turn around, and previous downturns have lasted for 20 quarters on average - or five years.
However, previous credit crunches have lasted about 10 quarters, which is about the same duration as stock price busts.
But the amplitude of the stock price bust is typically higher, as shares typically fall by 50%, with house prices declining by only 30% and prices during a credit crunch falling by only 20%. For private equity, that would mean a turnaround could be expected next year.
Shockingly, Adveq found that house prices in the US, for example, could fall further - if history is anything to judge by.
Sceptics would question to what extent these figures apply to the current crisis, and to what extent the prognosis will apply to SA. With economic growth in SA just barely negative, there was hope that SA would be brushed by the storm raging overseas, but perhaps escape its full force.
"SA's advantages are that we have headroom in interest rates and we still do have gearing available," says KPMG's Watkins. "There is not an absolute credit crunch and exchange controls did not allow our banks to participate in some of the more exotic products on offer."
Watkins says the infrastructure spending could also spur activity, in contrast to the US and Europe where growth is being driven by bailout plans. And there is still the elixir of the 2010 soccer World Cup to promote growth.
As Savca's Fourie says, he hopes "we could still get a free pass".
