Social benefits and diversification benefits of investing in private equity

This article is the fourth in a series of seven, exploring private equity investment. It will focus on the social and diversification benefits of investing in private equity (points B, C and D in the list below).

The main benefits of investing in private equity can be categorised as follows:

  1. Higher expected returns
  2. Social and sustainability impact
  3. The ability to gain exposure to the real South African economy; and
  4. Diversification benefits (or reducing volatility in a portfolio).

There is a lot of focus and emphasis on sustainable investing, ESG matters and the positive impact of investment. And rightly so, as South Africa is in a precarious economic position. Beyond the need for responsible investment, we need capital to reach the real economy and have an impact.

An investment in South African listed equity simply bids existing share prices higher. That capital does not reach the businesses, unless there is a new share offer or capital raise. Conversely, capital invested in private equity usually does more than just buying companies – capital is employed to grow the business. Many private equity funds play in the mid-market space, which tends to lead to aggressive growth and employment strategies.

In fact, in 2014 SAVCA (the South African Venture Capital and Private Equity Association) and DBSA (the Development Bank of Southern Africa) did a combined study (currently being updated) which came to the conclusion that:

  • Private equity drives good corporate governance.
  • Private equity is valued for its strategic guidance.
  • Private equity supports capital expenditure, expansion plans and innovation.
  • Private equity is a driver of B-BBEE transformation.
  • Businesses reported notable employment gains during the private equity partnership

In terms of point C above, South African listed companies have invested heavily outside the borders of the country. So much so that more than 70% of earnings declared by all the listed companies in aggregate come from outside our borders / in non-rand currency. However, the domestic economy does allow for more investment than the listed companies represent. The two pie charts below contrast the sector splits in the general economy to those of the listed equity market.

It is clear that the South African economy (right) is much more diversified than the listed market (left). The economy can be accessed more effectively through private equity investment.

Moving on to point D above, private equity valuations are managed conservatively by private equity managers (also called General Partners or GPs). Therefore an investment is not subjected to the kind of volatility that listed equities experience. The chart below shows the Societies of Actuaries modelling of the introduction of private equity to an investment portfolio. It shows the positive impact on reducing volatility while increasing returns for marginal increases in allocation up to 40% in private equity (Regulation 28 only allows 10% in South African retirement funds).

In additional, investment into private equity reaches a different part of the economy compared to listed equities. Therefore, the diversification is even greater. To illustrate this point, consider the fact that there are many listed companies in the UK that simply invest in private equity (similar to property companies that invest only in property). The correlation of these vehicles to the listed market in the UK is on average 0.3 and the highest correlation is 0.5. This shows significant diversification benefits!

It is not often that an investor is able to increase expected returns and reduce expected volatility at the same time, and both at a substantial margin. Add to this the social impact explored in this article and it does seem as though at least some investment in private equity is a “no-brainer”.

Willem le Roux
Principal Investment Consultant and Actuary

This communication provides information and opinions of a general nature. Simeka Consultants & Actuaries accepts no liability or responsibility if any information is incorrect or any loss or damage that may arise from reliance of information contained herein. It does not constitute advice and no part thereof should be relied upon without seeking appropriate professional advice.