The record breaking amount of new capital raised by South African private equity funds in 2006 – over R11 billion – may appear to be cause for celebration by the industry.  However closer inspection reveals that very nearly all of the new funds raised are intended to finance buyouts and other ownership changes in large mature companies, adding to the country's considerable supply of capital in this area. 

Richard Flett, Managing Director of Horizon Equity Partners, sees two disturbing trends emerging from the latest 2006 KPMG/SAVCA survey:   

Firstly, South Africa's private equity pool is heavily underweight in its proportion of development and venture capital and becoming more so.  Flett expects that only a small fraction of the capital raised in 2007 will find its way into development capital for growth and expansion of companies, and none whatsoever will find its way into venture capital for start-up businesses. Indeed KPMG and SAVCA report that no significant early stage capital has been raised by the industry since 2003. Flett attributes this in part to fund managers that are uncomfortable with the business risk inherent in unprofitable development stage companies, preferring to take financial risk instead through leveraged equity investments in mature, cash generating companies.   

Secondly, he believes the industry is rapidly moving upscale in deal size at the expense of investment in smaller and medium sized businesses. Many of the larger funds are already turning their attention to publicly listed companies in order to find targets of sufficient size to satisfy their appetite, a phenomenon that has been underway in overseas markets for some years already. This is likely to continue says Flett, opening up a sizeable gap in the market for equity funding of small to mid-cap companies. 

The combination of these two trends means that privately owned SMEs are facing a tough challenge to finance their growth, even as the country's economy booms. Emerging black owned companies face pretty much the same challenge as their white counterparts.  Although there are plentiful sources of BEE funding starting to appear as a result of the Financial Services Charter and specialist funds, many of these sources choose to concentrate on financing shareholding changes in established companies rather than injecting growth capital into young companies. 

Whilst many overseas private equity markets are also dominated by large buyouts, Flett feels that the proportion of venture and development capital in the South African private equity market is abnormally low by comparison. He points out that other emerging markets - notably India and China - have seen huge growth in private equity funds raised in the last five years, yet nearly all of it is in the form of venture and development capital, not buyout capital.  

Flett believes that South Africa's lop-sided distribution is bad for the industry and bad for the economy. "I do not see how South Africa will meet its economic growth objectives over the longer term if we do not create, nurture and grow more small and medium sized enterprises. These companies are the backbone of any economy and the feedstock for tomorrow's large corporations. The private equity industry should be doing more to finance emerging enterprises with above average growth potential."   

To help address this shortage, Horizon recently announced a first closing of Horizon Fund III, a R500 million fund focused on the provision of equity capital to entrepreneurial, unlisted companies with an enterprise value in the range of R20 million to R200 million. Flett comments "It is not a start-up fund, but will provide development capital to existing businesses that may or may not be profitable at the time of investment. We are particularly interested in growth companies that have reached an inflection point in the development of their business – a point in time when they require both capital and strategic guidance to grow their business to significantly greater levels of revenue and profitability.  We will also consider funding management buy-outs and BEE buy-ins within our size range, provided there is a strong growth story.  Horizon Equity has funded SMEs of this nature throughout its 15 year history, and we believe the gap between capital supply and demand has never been greater." 

Previous companies financed by Horizon Equity include Prism (now part of NASDAQ listed Net-1), ATM Solutions (winner of Business Day's Unlisted Company of the Year award in 2003 and now part of unlisted Transaction Capital), Denny Mushrooms (now part of JSE listed AVI), and bedding retailer Renaissance Retail (now part of JSE listed Ellerines).

Horizon's new fund will consider investment in most industry sectors, but management expects to focus on areas it knows well: IT, Wireless Communications, Payment Technologies, Healthcare, Food, Retail and Engineering. It will invest between R10 million and R75 million per transaction. 

Interestingly, international investors have shown greater interest in the new fund than local investors. There are only a handful of local institutions that systematically invest in private equity funds, and Flett states that they have shown a marked preference for large buyout funds and debt funds in recent times. Flett comments "Although many institutions associate smaller private equity funds with high risk, we have shown good investment returns with all our previous funds, achieving top quartile returns. At the same time, these funds have produced strong social and economic returns for South Africa, with many investee companies developing into significant job creators and exporters following our investment."  

Horizon Fund III held its first closing in April and is expected to hold a final closing before year-end.

The record breaking amount of new capital raised by South African private equity funds in 2006 – over R11 billion – may appear to be cause for celebration by the industry.  However closer inspection reveals that very nearly all of the new funds raised are intended to finance buyouts and other ownership changes in large mature companies, adding to the country's considerable supply of capital in this area. 

Richard Flett, Managing Director of Horizon Equity Partners, sees two disturbing trends emerging from the latest 2006 KPMG/SAVCA survey:   

Firstly, South Africa's private equity pool is heavily underweight in its proportion of development and venture capital and becoming more so.  Flett expects that only a small fraction of the capital raised in 2007 will find its way into development capital for growth and expansion of companies, and none whatsoever will find its way into venture capital for start-up businesses. Indeed KPMG and SAVCA report that no significant early stage capital has been raised by the industry since 2003. Flett attributes this in part to fund managers that are uncomfortable with the business risk inherent in unprofitable development stage companies, preferring to take financial risk instead through leveraged equity investments in mature, cash generating companies.   

Secondly, he believes the industry is rapidly moving upscale in deal size at the expense of investment in smaller and medium sized businesses. Many of the larger funds are already turning their attention to publicly listed companies in order to find targets of sufficient size to satisfy their appetite, a phenomenon that has been underway in overseas markets for some years already. This is likely to continue says Flett, opening up a sizeable gap in the market for equity funding of small to mid-cap companies. 

The combination of these two trends means that privately owned SMEs are facing a tough challenge to finance their growth, even as the country's economy booms. Emerging black owned companies face pretty much the same challenge as their white counterparts.  Although there are plentiful sources of BEE funding starting to appear as a result of the Financial Services Charter and specialist funds, many of these sources choose to concentrate on financing shareholding changes in established companies rather than injecting growth capital into young companies. 

Whilst many overseas private equity markets are also dominated by large buyouts, Flett feels that the proportion of venture and development capital in the South African private equity market is abnormally low by comparison. He points out that other emerging markets - notably India and China - have seen huge growth in private equity funds raised in the last five years, yet nearly all of it is in the form of venture and development capital, not buyout capital.  

Flett believes that South Africa's lop-sided distribution is bad for the industry and bad for the economy. "I do not see how South Africa will meet its economic growth objectives over the longer term if we do not create, nurture and grow more small and medium sized enterprises. These companies are the backbone of any economy and the feedstock for tomorrow's large corporations. The private equity industry should be doing more to finance emerging enterprises with above average growth potential."   

To help address this shortage, Horizon recently announced a first closing of Horizon Fund III, a R500 million fund focused on the provision of equity capital to entrepreneurial, unlisted companies with an enterprise value in the range of R20 million to R200 million. Flett comments "It is not a start-up fund, but will provide development capital to existing businesses that may or may not be profitable at the time of investment. We are particularly interested in growth companies that have reached an inflection point in the development of their business – a point in time when they require both capital and strategic guidance to grow their business to significantly greater levels of revenue and profitability.  We will also consider funding management buy-outs and BEE buy-ins within our size range, provided there is a strong growth story.  Horizon Equity has funded SMEs of this nature throughout its 15 year history, and we believe the gap between capital supply and demand has never been greater." 

Previous companies financed by Horizon Equity include Prism (now part of NASDAQ listed Net-1), ATM Solutions (winner of Business Day's Unlisted Company of the Year award in 2003 and now part of unlisted Transaction Capital), Denny Mushrooms (now part of JSE listed AVI), and bedding retailer Renaissance Retail (now part of JSE listed Ellerines).

Horizon's new fund will consider investment in most industry sectors, but management expects to focus on areas it knows well: IT, Wireless Communications, Payment Technologies, Healthcare, Food, Retail and Engineering. It will invest between R10 million and R75 million per transaction. 

Interestingly, international investors have shown greater interest in the new fund than local investors. There are only a handful of local institutions that systematically invest in private equity funds, and Flett states that they have shown a marked preference for large buyout funds and debt funds in recent times. Flett comments "Although many institutions associate smaller private equity funds with high risk, we have shown good investment returns with all our previous funds, achieving top quartile returns. At the same time, these funds have produced strong social and economic returns for South Africa, with many investee companies developing into significant job creators and exporters following our investment."  

Horizon Fund III held its first closing in April and is expected to hold a final closing before year-end.