Business Finance for SMEs in South Africa

 With private equity firms becoming increasingly involved with business financing for SMEs in South Africa  and abroad we take a look at what this is, what small business owners should be aware of  and the various issues involved in acquiring this type of financing for business.workig with the right business plan consulting team is often a significant advantage.

Private equity funds in South Africa are the pools of capital invested by private equity firms. Although other structures exist, private equity funds are generally organised as either a limited partnership or limited liability company which is controlled by the private equity firm that acts as the general partner. Some of these firms will get involved in providing venture capital in South Africa while others will he involved in larger deals.  The limited partnership is often called the "Fund", and the general partners are sometimes designated as the "Management Company" (although at times, that is a separate company affiliated with the general partner). The fund obtains capital commitments from certain qualified investors such as pension funds, financial institutions and wealthy individuals to invest a specified amount. These investors become passive limited partners in the fund partnership and at such time as the general partner identifies an appropriate investment opportunity, it is entitled to "call" the required equity capital at which time each limited partner funds a pro rata portion of its commitment. All investment decisions are made by the General Partner which also manages the fund's investments (commonly referred to as the "portfolio").

Over the life of a fund which often extends up to ten years, the fund will typically make between 15 and 25 separate investments with usually no single investment exceeding 10% of the total commitments.

General partners are typically compensated with a combination of a management fee (defined as a percentage of the fund's total equity capital), monitoring fees (fees paid to the general partner by portfolio companies for services), as well as transaction fees (fees paid to the general partner in their M&A advisory capacity). In addition, the general partner usually is entitled to "carried interest", effectively a performance fee, based on the profits generated by the fund. Typically, the general partner will receive an annual management fee of 1% to 2% of committed capital and carried interest of 20% of profits above some target rate of return, which is typically 8% to 10% (called "hurdle rate"). Gross private equity returns may be in excess of 20% per year, which in the case of leveraged buyout firms is primarily due to increasing levels of leverage in the portfolio companies, and otherwise due to the high level of risk associated with early stage investments. Although there is a limited market for limited partnership interests, such interests are not as freely tradeable like mutual fund interests.

South African private equity firms generally receive a return on their investment through one of three ways: 

1) an IPO, 

2) a sale or merger of the company they control, 

3) or a re-capitalization.

Unlisted securities may be sold directly to investors by the company (called a private offering) or to a private equity fund, which pools contributions from smaller investors to create a capital pool.

Only certain types of startup companies fit the right profile to raise their small business funding with private equity funds.

Considerations for investing in private equity funds relative to other forms of investment include:

  Substantial entry costs, with most private equity funds requiring significant initial investment (usually upwards of R100,000) plus further investment for the first few years of the fund called a 'drawdown'.

 Investments in limited partnership interests (which is the dominant legal form of private equity investments) are referred to as "illiquid" investments which should earn a premium over traditional securities, such as stocks and bonds. Once invested, it is very difficult to gain access to your money as it is locked-up in long-term investments which can last for as long as twelve years. Distributions are made only as investments are converted to cash; limited partners typically have no right to demand that sales be made.

 If the private equity firm can't find good investment opportunities, they will not draw on our commitment. Given the risks associated with private equity investments, you can lose all your money if the private-equity fund invests in failing companies. The risk of loss of capital is typically higher in venture capital funds, which back young companies in the earliest phases of their development, and lower in mezzanine capital funds, which provide interim investments to companies which have already proven their viability but have yet to raise money from public markets.

Consistent with the risks outlined above, private equity can provide high returns, with the best private equity managers significantly outperforming the public markets.

For the above mentioned reasons, private equity fund investment is for those investors who can afford to have their capital locked in for long periods of time and who are able to risk losing significant amounts of money. This is balanced by the potential benefits of annual returns which range up to 30% for successful funds.Ê Likewise, access to small business funding from priviate equity funds is limited to very specific types of startup companies.

Most private equity funds are offered only to institutional investors and individuals of substantial net worth. This is often required by the law as well, since private equity funds are generally less regulated than ordinary mutual funds. For example in the US, most funds require potential investors to qualify as accredited investors, which requires R1 million of net worth, R200,000 of individual income, or R300,000 of joint income (with spouse) for two documented years and an expectation that such income level will continue.

WHAT ARE THE CHANCES OF RAISING PRIVATE EQUITY in SOUTH AFRICA?

On average, this is what happens to business plans presented to investors: 

60% are rejected after a 30 minute review 

25% are rejected after a 3 hour appraisal 

10% are rejected after a full day evaluation 3% are rejected following failed negotiations 

2% succeed in raising funds

Yes, read it again, only 2% of businesses seeking private equity are successful.

For this reason, you need to consider all the various sources of finance, as outlined above. If

necessary, seek advice from an industry body such as SAVCA or business finance network such as Investors Network.

WHAT ARE THE ADVANTAGES OF PRIVATE EQUITY SOUTH AFRICA?

 

Long-term equity finance with no interest charges (although there may be a requirement to pay

dividends from profits), no sudden requirement to repay and no personal security to provide. As well as finance, the investor can bring skills, contacts and experience to the business. Financial flexibility for future borrowing opportunities in that it may be easier to raise further

bank debt on the back of equity provided by the investor. The investorÕs interests are closely aligned to those of the entrepreneur in helping to make

the business work. Can bring discipline to policies and procedures, e.g. external reporting requirements.

WHAT ARE THE DISADVANTAGES OF PRIVATE EQUITY SOUTH AFRICA?

Dilution of ownership which can be diluted further with successive funding rounds. The cost of capital can be expensive in the long term, as investors may look for a return

of at least 50%. It takes time to raise private equity, anything between three and 12 months.

This can deter many entrepreneurs who find it too distracting at a crucial time for the business (i.e. early stage and high growth). It is hard to find the right investor i.e. one you can get along with. Possible loss of control with investor agreement required for key strategic and financial issues.