Geoff Blount, Member of Motswedi Economic Transformation Specialists’ Investment Committee

The retirement industry, in essence, is about investing people’s savings over the long term to grow a pot of money that they can live off once they retire. One of the critical components for building this pot of money is the returns made on these savings.

But what are the options for where a retirement fund can invest. Historically, the South African pension industry has focused investing in what is referred to as traditional asset classes, namely listed shares (companies that have listed their shares on a stock exchange), bonds (essentially lending money to the government or companies), property and cash, whether such investments are made in South Africa or abroad.

Diversifying across these asset classes and regions makes sense, as different assets will go up and down (but mostly up) at different times. The diversification of returns means a smoother return for investors over time, and makes sure you don’t have “all your eggs in one basket” from a risk perspective.  This is a critical way in which retirement funds earn returns and manage risk for their members.

But what if you could add another asset class that behaves differently to the assets you already own?  This would make great sense as it would further diversify your portfolio (from a risk perspective) and provide another source of returns, not linked the assets you already own.

Step in PRIVATE EQUITY…… an asset class that has existed longer than listed shares and provides attractive returns that move differently to any of the traditional asset classes i.e. is decorrelated to typical pension fund investments.

What is private equity? It is the buying of shares in privately owned businesses that are not listed on a stock exchange. These might be small firms such as a small manufacturing business down the road, to very big companies  (such as Food Lovers Market). These business are often owned by the founders, and / or the management teams of the company, and they sometimes allow external investors to buy shares in their companies, often to raise capital for the company to expand.

Retirement funds can invest in private equity, through investing in private equity funds, which are managed by private equity fund managers (also known as General Partnerships or GPs). These fund managers’ jobs are to find interesting business to invest in, due diligence them, and then take an investment stake in them if they pass muster. You can imagine that is much more complicated than simply buying into listed shares, as there is no ‘market’ that private equity shares trade on, and so each deal in unique. Also, given there is no/limited liquidity (as no exchange to trade these shares) such investments are held for 7 to 10 years and hence need to be seen as very long-term commitment.

Given the complexity and time horizon of private equity, it is relatively small as an asset class (especially in South Africa), which is unfortunate as it brings very attractive return and risk attributes to retirement funds.

But it is also critical as a source of capital for the South African economy. A key pillar to a successful economy is strong and growing companies that create employment, provide goods and services to people, generate returns for investors, and provide tax revenue for government to function.  To prosper, companies need capital to grow, and there are essentially three sources of capital a company can call on, namely equity (money invested into the company by its shareholders), debt (borrowed from the banks or other lenders) or retained income (profits from previous years) which essentially belongs to the shareholders anyway.

But South Africa has hundreds of thousands of companies and only 431 are listed. Where can the rest of these companies find funding, if they don’t want to borrow? Through private equity, or other derivatives of this type of investing such as venture capital.  South African privately held companies are typically short of capital, more so in years when economic growth is low.  And private capital like retirement funds, are crucial to fostering a healthy overall ecosystem and economy.

In fact, one of the ways to boost economic growth is through growth in fixed investment, which currently sits at around 14% of GDP. Such levels of fixed investment correlate to about 1% economic growth. Lifting fixed investment to 25% correlates to economic growth of 4%. Apart from the need for government to create a conducive  environment to lift fixed investment to 25%,  investors and companies need to drive new investment as well. And a large source of this investment can come from private equity investments into unlisted companies, especially to support medium to medium-large sized business that are incredibly important for job creation.

Private equity investments in South Africa are estimated to be about R237bn, less than 1% of the JSE’s market cap (value of all listed companies on the JSE) of R24,2 trillion. Increasing the size of investments into private equity can provide further important support to lifting our economic growth rate, as well as creating attractive return diversifiers for our retirement savers, ensuring they retire into a healthy environment.

ENDS

Ed’s note: To understand more about private markets, watch EBnet’s latest podcast series “Inside Private Markets” here.